Could Be Better
Richard Quinn | Apr 19, 2024
EVERY TIME I READ about the decline in traditional defined-benefit pension plans, and the rise and supposed failure of 401(k) plans, I get annoyed.
You’d think all Americans once had good pensions that provided a secure retirement. That isn’t—and never was—true. Barely half of American workers ever had a pension and many of those received little value from them because their job tenure was too short. Job tenure has long averaged some four years or so.
A defined-benefit pension accrues value based on earnings and years of service with the plan sponsor. An employer might require five to seven years of service for an employee to be fully vested in the pension. Let’s do the math: average four years working for an employer, typically five years to vest, so what pension?
You might have heard folks say the birth of the 401(k) caused the decline of defined-benefit pensions. That’s not accurate. The demise of the defined-benefit pension began long ago and—except for the public sector—it’s now nearly complete. The causes are many, but a major impetus was the Employee Retirement Income Security Act (ERISA) of 1974, and the hundreds of rules and regulations that followed.
This and other laws, along with changes in accounting rules by the Financial Accounting Standards Board, hurt reported corporate earnings and doomed the private sector pension plan. Meanwhile, 93% of public sector workers have both a defined contribution plan and a pension plan—because such plans don’t have to deal with the same rules.
To be sure, the emergence of 401(k) plans in the 1980s allowed employers to offer an alternative retirement plan, accelerating the termination of traditional pension plans or prompting the closure of these plans to new hires. One benefit of 401(k) plans: For an employer, there are no long-term employer liabilities, as there are with a defined-benefit pension plan.
Does any of this make the 401(k) a bad deal? Compared to what, no retirement plan at all?
According to Fidelity Investments, 85% of 401(k) plans have some employer contribution. In my opinion, if there’s one valid criticism of 401(k)s, it’s the requirement that an employee needs to contribute to receive the employer’s contribution. Employers that provided a pension typically spent about 8% of payroll to do so, along with the considerable cost of administration. With 401(k)s, the cost to the employer is far less.
I think it would be reasonable for an employer to contribute at least 4% of pay, regardless of what employees did. In 2023, the average employer match was $4,600. Stick with just that and earn 8% a year, and you’d have some $360,000 after 25 years.
The 2023 UAW contracts with the big three automakers included a significant boost in the automatic employer contribution to 401(k) plans, with no required employee contribution. For those union members not covered by a pension plan, the automakers will contribute 10% of base pay.
For retirement plans, there are two key issues: portability and the stream of income they can produce. A 401(k) provides portability, while a pension plan offers an income stream. The answer seems obvious: combine them.
To that end, the UAW contract includes use of an organization to construct low-cost annuities as part of the enhanced 401(k). Linking annuities to 401(k) plans is an important step in providing retired workers with a guaranteed income stream. The annuity option needs to be included in all 401(k) plans, perhaps mandated or made more appealing with special incentives.
No doubt about it, 401(k) plans have their challenges. But they all relate to financial literacy—in other words, people issues, not plan issues:
- Too many employees don’t participate, perhaps 35% of those eligible, says the Federal Reserve Bank of New York.
- When employees leave their job, too many spend their plan balance. According to Harvard Business Review, 41.4% of employees cashed out 401(k) savings on their way out the door, with 85% of these folks draining the entire balance.
- Workers who participate in 401(k) plans contribute too little. One report found that in 2022 workers contributed an average of 7.4% of their pay to their 401(k). Add in employer contributions, and the average was 11.3%. The report describes these percentages as “impressive.” I don’t think so.
- Investment choices can present problems. Sometimes, there are too few or too many, and often participants make poor investment decisions.
Clearly, the 401(k) places more responsibility on the worker. But in my opinion, it also creates a responsibility for employers to educate and advise workers. It’s in the employer’s best interest to have a viable retirement system to help attract and retain workers, while also ensuring that employees are financially able to leave the workforce when the time is right.
Would I trade my pension for a 401(k)? No, I wouldn’t trade it for five times the balance in my 401(k). But that’s not the issue. There’s no point dwelling on what many Americans never had. Instead, our focus should be on making sure today’s 401(k) works better than it currently does.
HumbleDollar
We can’t control what others do and we can’t stop misfortune from striking. But we can control our own actions. Those who are financially prudent will most likely enjoy success, even if events don’t always go their way.
QUINNSCOMMENTARY 
Historically it is true more people didn’t have pensions because the workforce was different during the last century. Almost half the workforce in 1900 was farm labor. That percentage was gradually reduced but that is history and we have to live in the present.
The 401k can be improved but I don’t know how much more you can expect workers to put in if the rate is 7.4% now. Sure, higher wage workers could. I don’t expect the median or below to do better than that especially on top of the 7.65% payroll tax. I also think there would be a lot of kickback if employers were mandated to kick in significantly more. Perhaps the best we can expect is for workers to participate and stay in the plans for their whole working lives and live with the results, which could be decent if the economy keeps growing.
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You could make that argument, but I look around at how people spend money and I am convinced that all but the lowest 20% income wise could easily save at least 10% if they tried, especially two income families.
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Those 401k participants may also save money in an IRA and taxable accounts which increases the percentage above 7.2% (11.3% with match). You are stating the 401k % contribution as if it was the only savings people do. It is a combination of when they start the retirement savings and the % of income saved and what the cost of what they invest in.
One could build a large portfolio if they saved at 7.4% plus company match starting from day one of working 40 years and invest in low cost index funds. But a lot of people don’t put some time to educate themselves and instead pay someone 1% or more to manage their money. 1% is 25% of the generally accepted 4% guideline. It is much harder to build a portfolio if one gives part of it away every year to someone else.
You are looking at the situation with a ‘worked nearly 50 years from the same employer’ bias. I worked in the same building for nearly 40 years, but the company was sold twice during that time, though my phone number never changed. The first time our pensions were not sold as part of the purchase, so my pension was frozen after 11 years – unfortunately the early years rather the my later working years. But the second company introduced a 401k plan to replace the saving plan the original owner had and I continued my my contribution. The third company did keep the 401k plan, but changed the administrator. The government raised the IRA contribution limit to $4k and I started maxing a Roth IRA for the last 14 years of employment. I don’t have the income sources you have, but I am doing Roth conversions the last few years to avoid IRMAA surcharges when the survivor has our max SS taken at 70 plus RMD from the rollover IRA. I am now starting to look at how to fit QCDs into our estate planning. People have to adjust to life’s changes by educating themselves of the possible options along the way – personal responsibility of one’s life.
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very good article and lot to think about–a minor issue is the 8% annualized you discussed–as you know projecting 8% on an annualized basis is something that cannot be done as markets are volatile–you, I assume, take a dollar amount and assume 8% every year–maybe in a fixed income CD 8% for 25-years gives you the dollar amount you came up with.
in the “market” I quickly looked a fund with a 90-year record that averaged 12.1% for the entire period–only one year out of 90 did it hit 12.1% and three times came within 100 basis points.
obviously a way to catch the attention of folks is the 8% for 25-years–good thoughts throughout the article.
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would disagree “an” with the idea of of not working with someone–yes doing it by yourself will save money that goes into your back pocket–the “generally accepted 4% guideline” refers to what exactly?
Many people fail because they lack the German “sitzfleisch”–the ability to sit through the volatility. Too many folks get frightened out of the market like in 2000, 2007-08–2019-20. Someone to provide prospective could work nicely.
I ran hypothetical using the 90-year fund and the 25-years of investing Dick Quinn talked about. Say someone had $100,000–invested at 3.50% load–and expense ratio of .60%. Rolling 25-year periods (36) I believe saw a median value of $1.6 million—worst 25-year period of $630,000– best 25-year period $5.2 million.
S&P 500–no cost–no help—- $1.2 million median– worst was $615,000–best $5.3 million. Expense ratio of the fund is built into total return.
So for $3,500 “load” over 25-years it’s costed $140 annual–and you call twice a year for an office visit to discuss the account and maybe not bail during the dark days. Of course you have lost the invested value of $3,500, but if you did not have not a clue, as millions of Americans don’t, it might be worth,
Today of course there are so many ways to access advice from fee based accounts to hourly fees to fund families having low cost advisors. But however one does it sometimes help is needed.
There are millions that could benefit by working with someone–say Brother Quinn’s company had a 401-k–say as part of the agreement they came to with the provider, they mandated that someone come, maybe twice each year, to sit and work with the employees–to educate them in he basics of retirement planning. That could be a lifesaver for them.
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