7/15/2013 2:45 PM ET|
Which is better: 401k or a pension?
Managed correctly and over a sufficiently long haul, 401k's can produce more money at retirement than traditional private-sector pension plans, new research suggests, though the risks are obviously higher.
Most people bemoan the loss of the traditional pension plan, and they cite its disappearance -- and the rise of the save-it-yourself 401k -- as key factors in the retirement crisis facing American workers. But new research suggests the new kid on the block is not to blame.
In fact, workers with 401k's in some cases are likelier to end up with more money at retirement than they would with a traditional private-sector pension plan, according to a study by the Employee Benefit Research Institute, a nonpartisan think tank in Washington.
Some people "have termed 401k's a failed experiment," said Jack VanDerhei, a research director at EBRI and author of the report.
"But it's just not what the evidence is suggesting," he said.
For example, lower-income workers who are now aged 25 to 29 and who remain eligible for their retirement plan for 30 to 40 years end up with a 15 percentage point higher income-replacement rate at retirement with a 401k than with a traditional pension plan, according to the study's median finding for that scenario.
"Replacement rate" means the percentage of annual income they'd be able to create from their account balance at retirement. (As an example, unrelated to the study, 80% of income is replaced versus 65%.)
A 401k is even more valuable for higher-income workers, the study shows.
Under the same scenario as above, but looking at workers who earn more, the difference in income replacement rates at retirement rises to 21 and 30 percentage points more for 401k's over pension plans, at the median, for people at the next two income quartiles.
The study found a hefty 44 percentage-point gain in favor of 401k's for workers at the highest income level, according to the median finding for the above scenario.
In the above scenarios, the EBRI study assumed historical rates of return on an equities and bond portfolio, and historical annuity costs. (In order to compare 401k's to traditional pension payouts, the research assumes that retirees purchase annuities at age 65.)
The report is based on data for more than 2 million plan participants, and accounts for the fact that not all people who have a 401k choose to save money in it.
If the study focused only on those who save, VanDerhei said, "that would clearly alter this and 401k plans would always do much better, especially for low-income workers."
But if you reduce the assumed rate of return, the traditional pension starts to look better for lower-income people, the study found.
For example, when the rate of return is decreased by 200 basis points, a 25- to 29-year old lower-income worker who is eligible for a plan for 30 to 40 years would see his income replacement rate at retirement with a 401k plan drop to 4 percentage points lower than he would have enjoyed with a pension plan, at the median.
For the next highest income group in the above scenario, their replacement rate with the 401k would be 1 percentage point less than with a traditional pension.
However, for the two highest-income groups, the 401k is still better: that plan provides a 6 percentage point and 15 percentage point replacement-rate benefit over the pension, at the median, even when a lower rate of return is assumed.
And combining the lower-return assumption with a higher-cost annuity assumption (reflecting the current low-interest-rate environment, which is substantially different from recent history), then traditional pensions look even better.
Also worth noting: Workers, of course, contribute to their 401k out of their own pocket, unlike the traditional pension plan, which is fully funded by the employer.
"There are different financing streams going on here, I admit that," VanDerhei said.
His focus was, he said, "from a retirement-income adequacy standpoint, which of these two [types of plans] seems to be providing larger retirement account balances?"
than he would have enjoyed with a pension plan, at the median.
He added: "The sole objective was to look at: 'Is Plan A or Plan B providing a larger source of retirement funds at age 65, not adjusting for how those are financed?"
In an ideal world, VanDerhei said, workers would have access to both a traditional pension and a 401k or similar defined-contribution plan.
"If you have both," he said, "then obviously you have less employee investment risk, you have less employee longevity risk and you still are giving employees the upside if they choose to participate in the 401k plan."
In his study, VanDerhei points to previous research that came to a similar conclusion: In many cases, retirement savers ended up with more money under a 401k than they did with a traditional pension plan. See the full EBRI report.
What was left out
The study is based on a robust sample of more than 2 million people. "I know what they're doing in their 401k plan. I know their salaries," VanDerhei said.
"Given the specific set of job changes and wage paths that I assumed for them under the 401k, I did the exactly same person, exactly same assumptions, and said: 'What would you end up with if you had a [traditional pension] plan?'" he said. "If you really do want to have a direct comparison of Plan A versus Plan B, I think it's helpful to actually track the same person under the two plans, and do the person by person comparison."
This study does not include workers who are automatically enrolled into their 401k by employers, though he said that would likely push the results even more in favor of such plans.
Also, the data looked at private-sector pension plans. It did not include public-sector plans. Doing so would have pushed the data more in favor of pensions.
"I can promise you I would get much different results had I done a public defined-benefit as opposed to a private defined-benefit comparison," VanDerhei said.
Public pension plans -- those offered by government entities -- generally offer more generous benefits than private-sector plans, and usually include cost-of-living adjustments in retirement.
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