Pensions Vs. 401(k)’s: Why you should Care that Pensions are Going Extinct
This post is a tad bit longer than the typical post on this site, but in my opinion, it should be an eye opener. I have some strong opinions on this topic and I’m VERY curious to see what you all think as well.
Today’s Retirement Reality
Most twenty-somethings have never and (unfortunately) probably will never sniff the sweet security provided by a pension plan. So what are these mysterious things called pensions that many of our parents and grandparents lean on in their retirement? Why are they disappearing? And what are our chances of ever getting one? This is an essential issue for our generation, and I encourage you to read on and actively lobby your employer should you see fit. If you want change, it has to start with someone. Why not you?
What is a Pension?
A pension is basically another word for a retirement plan. There are two types of pensions.
1. Defined Contribution Plan
A defined contribution plan is a type of pension where an employee, employer, or both contribute funds to an employees retirement plan. 401(k)’s are defined contribution plans. These plans are dependent on the returns of the investments that are chosen within them.
2. Defined Benefit Plans
A defined benefit plan is what most of us commonly refer to as a ‘pension’. These plans offer guaranteed automatic payouts in retirement based on a formula that usually takes into account your salary and years of service. The longer you work and the more you make, the higher your automatic payouts. Most employers offered defined benefit plans at one point. Social Security is a type of defined benefit plan.
The History of the Pension
For generations, pensions were the retirement plan standard for just about every employer. This may be hard to believe, but it wasn’t until the early 1980’s that 401(k)’s even existed. Ironically, 401(k)’s were originally added to the IRS code as a way for companies to offer additional retirement benefits to high ranking executives, above and beyond their defined pensions. This didn’t last long.
Over time, most employers have made the shift from defined benefit pensions to 401(k)’s. 401(k)’s were sold as the fresh new thing, giving employees all of the power to choose their own investments. In reality, they were often times a low to modest cost savings over their defined benefit counterparts. The combination of the appeal to the American individualistic ambition and cost cutting possibilities were the perfect storm to sell 401(k)’s over their elder relative.
A Pension Story that Hits Home
My father retires on May 1st. He put in 36 years with the State of Michigan. At one point in the early 90’s, the State offered him a 401(k) cash exchange for the existing value of his defined benefit pension. He turned it down. It was the wisest decision he ever made. In May, he will begin to receive over $3,000 per month in pension benefits above and beyond his living expenses. And this doesn’t even include Social Security, or the 401(k) that he started from scratch! He’s set for life and has the security in knowing that his pension benefits are safe and guaranteed.
Could he have had a bigger payout if he switched? Maybe, but most likely not. The stock market hasn’t advanced in the last 12 years, after all. Either way, I’m almost positive that he’s been able to sleep a whole lot easier back then and he certainly is now.
Eliminating the Security of Pensions
Unfortunately, stories like my father’s are disappearing. Not only has the guaranteed security of pensions been attacked, but I fear that we’ve hit a critical point of no return. 401(k)’s are now so ingrained in our culture that pensions are viewed as a Jurassic, boring old benefit of yesteryear.
To add insult to injury, employers have not only changed the plans, but they’ve scaled back the benefits as well. Many of my peers have 401(k)’s that only offer a 2 or 3% max match. How can anyone retire on that, especially in light of recent market turmoil?? That kind of limited benefit is an absolute tragedy.
Even Social Security, a type of defined benefit pension, is under attack. Had the Bush administration gotten its wish, it would have shifted to private management as well. Right before one of the biggest drops in stock market history.
An Increase in Employee Turnover Without Pensions
Another unintended consequence of this benefit switch is employee turnover. At present, the employer turnover rate in the U.S. is over 40% per year! It didn’t use to be that way. Defined benefits offered employees a strong incentive to stay around and be loyal to their employers. How many baby boomers do you know that have been at their job for 20, 30, or 40 years? Sure, there has been a cultural shift away from loyalty in the workplace, but with the disappearance of pensions, is there any wonder why?
Why should employers care? They were able to cut some costs, after all, and that’s good, right? Here’s why they should care – it’s been estimated that employee attrition costs 12 to 18 month’s salary for each leaving manager or professional, and 4 to 6 months’ pay for each leaving clerical or hourly employee. When employees don’t stick around for 3 years, these costs start to add up.
Instead of a loyal, efficient, 35 year lifer, you’re looking at 13 employees who come and leave as soon as they get the skills they wanted to grow, or as soon as they get bored. They have no incentive to stay! So are employers really saving money? I’d argue that they are not. They have cut off their nose to spite their face. And they are paying enormous costs to do so.
You want a Pension?
Lobby your employer. Get others to join your cause. Help your employer research the costs of running such a plan, and the potential savings benefits over 401(k)’s that come from lower employee turnover. Appeal to them on their level – they want to keep good employees, and they want to lower costs that come from having to recruit, hire, train, and get new employees up to snuff. Work with them, not against them. Any research that you can provide regarding potential cost and talent savings is going to help your cause.
Pension Vs. 401K Discussion:
- Are you upset that you may never see the security of a pension?
- Do you like your employer enough to want to stick around for your entire career?
- Would you rather have a defined benefit pension or a 401(k)? Take the poll!
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I got the impression that pensions were not very safe to begin with.
AFAIK, If your company went bankrupt, there went your retirement savings. That doesn’t sound very diversified. With a 401(k), if your employer goes down in flames, you should still get to keep your 401(k) account, which should be diversified (I think).
I’m not sure if the purpose is to keep employees around, or just to not spend any money, but in most 401(k) plans, you don’t get vested in your employer matches in full until 5 years on the job.
I would rather have a 401(k) that I can take with me when I leave a job. If I worked somewhere for 15 years, and then decided to leave, I would have no retirement savings to show for my 15 years if I was in a pension plan (I don’t think you can take it with you, I may be wrong on that).
I am in the military, one place the pension is still one of the major benefits. As Donnie pointed out, however, it does create some of its own dilemmas. If at 15 years I want to try something new, or move in a different direction, I walk away with no pension. I’m saving on the side in a Roth IRA, the TSP (our version of a 401k), as well as other taxable investments, but serving for 15 years and then walking away with no pension would be very difficult. I’m committed until my 11 year point, which will make for a very difficult decision when the time comes.
I don’t think that 401k’s are quite as bad as you make them out, so long as they are used intelligently. If used to their fullest extent, they work just as well as a pension and offer a level of flexibility that pensions do not. The problem is not with the 401k or the employers that offer them. Instead, the problem is with financial education in our country which produces high school graduates (and often college grads) that can’t tell the difference between a pension and a 401k. If the school system doesn’t instill this type of knowledge, parents must start educating their children on the intricacies of personal finance. Bottom line, I think it is the personal responsibility of the parent and eventually the individual to learn how to take advantage of any opportunity they have to make their retirement the best they can.
Honestly, I don’t think that it is in any twenty-first century company’s best interest to have people sticking around for 25+ years. I know this sounds crazy, especially with the cost of hiring and training new employees.
It’s a known fact that most people who are in long-term jobs learn a skill set and then rarely bother to improve themselves or keep up with the latest technology. As the employment culture continues to shift from physical labor to mental labor, it is increasingly important that employees stay on top of the game in order to be valuable to their companies. How many people really make the effort to do that when they’ve been at a job for ten or 15 years? Look how many people have been laid off in the current economy and immediately start trying to learn new skills since they realize they are behind in the game. If someone’s resume wouldn’t make them a valuable resource to potential new employers, why do we assume they’re a valuable resource at their current job, just because of the amount of time put in there? If I were an employer, I wouldn’t want people working for me who would be happier and more productive elsewhere, but who want to put in their time so they’re vested in the company pension. If “loyalty to the company” is defined as wanting to stick around until I can get a pension, there are major potential downfalls for employers.
My father is a perfect example of this. He’s been doing computer programing for his employer for 20 years. Right now, he does basically the same thing that he’s done since he started there (although he does travel for work significantly less than he did when he was younger). His employer hasn’t encouraged him to keep his skill set up-do-date, because the skills my dad has are perfectly fine for what his employer needs. At this point, my father would be much happier doing something else, but is too scared to pursue another path since he has a stable salary and (meager) benefits. I think this is very typical of people who have been in a job 10, 15, or 20 years. So now, my dad and his employer are both losing: my dad, because he’s not happy or fulfilled at his job, and his employer, because he has a long-term employee who has an outdated skill set and who would rather be elsewhere. I think pensions encourage this sort of situation, and I know I’ve seen it happen with people other than my father (another example: my friend’s mother, who took about 5 months of vacation time during her last year at work before retiring – please tell me how you think she was efficiently and regularly meeting with clients during that year, and how much her mind was on doing the best job she possibly could). I definitely would not want to confuse people like these with the “loyal, efficient, 35 year lifer[s]” that you see receiving pensions.
I might write a post on this of my own sometime. I feel like I could go on about this for quite a while!
I am a teacher in Indiana and am thankful that we still have a pension plan. It is one of the ways to account for the low salary and the lack of a 403b match.
I don’t think GE is suggesting to do away with 401(k)’s completely, rather to still offer some sort of defined benefit pension for those who WANT to stick around for a long time at their employer. Make it an option to choose either based on your personal preferences. Sure, job hoppers won’t get much out of a pension, but why not reward those who embrace longevity with their employer????
@ Donnie – Your first point is a common misconception. Private employers in the U.S. must pay in insurance premium to the Pension Benefit Guaranty Corp, so that if they do go out of business the PBGC oversees the plan and payments.
@ Andy – Thank you for your service. I’m not saying that 401(k)’s are bad. I love my 401(k) because the match is great (50% of my contributions). However, I do think that 401(k)’s where the employer only matches 2-3% or less are worth much of anything. That’s a benefit of just a few hundred dollars per year, and we made the shift away from pensions for that? That type of weak benefit is not an incentive to save for retirement, or stick around at an employer.
@ Stephanie – you bring up some good points, but I don’t agree that ‘lifers’ are all lazy and not willing or eager to learn new skills. Some just truly like their job, the people they work with, and the stability. There should be no shame in that.
@ Steve – exactly, not saying that 401(k)’s should be eliminated, just saying that we should have the option, or have both. There are actually hybrid defined benefit/contribution plans out there and most employers with a pension plan also offer a 401(k) and 401(b) in addition to the pension. The best of both worlds! These employers should be commended.
Pension plans, like moth financial tools, are a double-edged sword, as a few have mentioned above. Personally, I’d rather have my retirement completely in my own hands — it both seems and feels more secure to me.
That said, I hope to start my own business soon, so I suppose that’s a moot point.
G.E.,
I agree that a 2-3% match of a 401(k) is not an incentive to save for retirement. On the contrary, my incentive to save for retirement is the fact that I don’t want to work for the rest of my natural life. The 401(k) and other investment vehicles are simply tools to achieve that goal. Pensions, in a business sense, are suicide in today’s environment (reference the auto industry). The reality, in my opinion, is that no matter how much we lobby employers, pensions will continue to fade away as businesses realize they will not maintain a competitive advantage with them on their balance sheets. Instead, we should move towards policy that forces opting out instead of opting into smart financial decisions. The bottom line is if someone wants to achieve financial independence, they must spend less than they earn and save the difference. The bigger the difference, the quicker financial independence will come. If someone takes this route, eventually a pension will become nice, but unnecessary.
Defined benefit pensions schemes are being shut down in the UK as well. One of the major problems is that companies took advantage of good periods of stock market growth to cut back or even stop their contributions to the schemes. Now that the stock market is falling they find the scheme has a big deficit.
I for one would much prefer the security of a defined benefit scheme but my current employer won’t allow employees to join it until they have 3 years service! (1 year to go
)
I think in a post-social security America where retirement is assumed, pensions are a great benefit and likely better for company and employee than defined contribution plans. My question is about why we assume that the goal at the end of life is to stop working yet continue to receive an income. It sounds boring to me and I’d like to continue adding value and earning an income for as long as I’m healthy. I feel like it’s my responsibility to save and invest for myself after that time.
@ Andy – I don’t think pensions are corporate suicide, but I do think that corporations want you to believe they are. GM’s pension is actually well funded.
From U.S. News: Even during a financial downturn it may be possible for companies to continue to provide workers traditional pensions. General Motors, a company that recently asked for taxpayer funds, appears to have enough money in the pension fund to pay its more than 400,000 retirees their promised benefits for many years.
Health care for retirees is another story. The Times reports: “The total cost of these benefits in today’s dollars was estimated at $60 billion at the end of 2007, and G.M. had set aside only about $16 billion to cover the cost.â€
@ Loren – what’s not to like about not working and receiving an income? See the world, spend more time with friends/family/pets, volunteer more, pick up new hobbies, leave the stress of the rat race behind. I don’t want to work until I die unless I’m bored. I have a feeling I won’t be bored in retirement though.
If a business can afford to offer pensions or match more than other companies for a 401(k) then more power to them. However, I believe that we should rely less on employers and more on ourselves. Of course it would be smart to find an employer that is able to provide many benefits but I plan on living as Andy said: spending much less than I earn and investing/saving the rest.
@GE – My dad also retired through the Virginia Retirement System after 39 years. Due to different tax treatment and not having to pay social security taxes, his take-home pay is substantially higher than the last year he worked…!
So I also witness the value in a defined benefit pension on a firsthand basis.
I agree employers should provide the option and let employees choose.
You can then supplement your DB pension with a 401(k), Roth IRA, traditional IRA, 403(b), etc.
@Shaun – I also prefer to have retirement in my own hands. The problem is too many people haven’t proactively educated themselves in regard to their retirement options and the many that have lacked the discipline to carry out a viable plan.
While I could easily say, “Well, that’s their problem…†It could and will become our problem when Social Security goes bankrupt and millions of voters demand that producers like us pick up the bill. You can be sure that there will be no shortage of politicians willing to promise your money to someone else.
That said, I think one of the silver linings in the current financial crisis is that it’s forcing a lot of people to take a more realistic view of their financial situation. People are now interested in personal finance. Thrift and saving is fasionable again. I think these trends are here to stay, and it’s a good thing. In the end, it may be what says the industrialized world from bankruptcy.
There are a few reasons why we’ve seen companies move away from defined benefit pensions to defined contribution plans and Neil touched on the biggest of them. With a traditional pension plan, the company carries the investment risk. During periods of stock growth, the company can contribute little. But when markets decline (as they have recently), significant additional contributions are required – and those contributions come directly off the corporate bottom line. Above all else, Wall Street values consistent and predictable profit growth in companies and the growing volatility of investments subject corporate earnings to uncontrollable market conditions. Pension plans also face the risk of an aging population. The average 65 year old retiree in 1960 might have been expected to live to 75. Today’s 65 year old retire might be expected to live to be 85. Those extra years of pension income means the retirement cost of that employee just went up. With medical science continuing to advance, how long might the retirement of today’s 20 year old be?
By moving away from defined benefits to defined contributions, all of those risks to corporate profits go away. They no longer have to worry about market performance. They no longer worry about longevity and how long the money has to last. They just have to make a nice predictable contribution to 401K Accounts and they are done with no future risk. Of course, the issue with that is that it is us – the workers – who then take on those risks. We now bear the risk of market returns. We are now the ones who have to worry about living longer and running out of money. More than anything else, the move from defined contributions to defined benefits is a transfer of those risks from the company to the workers.
Perhaps the worst part about transferring risk from the company to the individual is that you lose the ability to pool and protect against those risks. Someone retiring today will have to start drawing on a 401K balance at the worst possible time. They are selling stocks at their low point. Someone who spends the first few years of retirement when the market is at its peak is in a much better position and is far less likely to deplete his retirement accounts. But when you pool market risk (as in a pension fund), all of that is averaged out. You also pool longevity risk. The person who survives to age 110 doesn’t have to worry about outliving their individual savings. Pooling of risk is the foundation of the insurance industry and it worked well with certain elements of retirements as well. But individual defined contribution accounts remove that pooling and leaves each individuals with more total risk than the company had as a whole.
All that said, pensions were never perfect. For one, they are not owned by the individuals, but rather are an asset of the company and therefore can be raided by the company. 401Ks, as assets of the individual account holders, are more secure in that regard. And pensions gained most of their value in the last few years of a career, so they wouldn’t provide much security to someone who moves between jobs.
Though probably the largest reason, the transfer of risk isn’t the only reason why pensions are disappearing. To a large extent, we have done it to ourselves by fixating on salary numbers and the salary number is bigger when you receive the extra money and then have to pay it into a 401K than when a pension is funded “behind the scenes”. If we had demanded a pension instead of a chasing after the biggest salary, it would have been harder for companies to abandon pensions. But we not only made it easy for them, we probably helped force them to do this to us.
The real question will be what happens when a large wave of retirees emerge with limited savings and no pensions? Will the government be willing to let a huge number of vocal (voting) retirees live on social security benefits alone? Or will it be those of us still in the workforce who will be asked to pay “our fair share” to support those who saved nothing? In the end, did the risk really go to those individuals or will it end up on the back of tax payers?
Although I agree that pensions could be dangerous if your employer goes belly up, not knowing what to do with your 401k could hurt your retirement a lot as well. Most of us aren’t trained in how to deal with even the most basic of finances – that’s dangerous.
My husband is a school teacher, and the pension system is one way to retain good teachers in a tough job situation that doesn’t pay much. I’m surprised more employers don’t use this important tool. Then again, too many employers these days regard employees as disposable assets and don’t care about retention.
My grandmother has a pension. She earned it during her youth years and tt is more than enough to keep her living comfortable. I am at my early twenty’s and I already started a retirement plan. Sad to say, many pre-need companies shut down resulting for the downgrade of pension plans credibility and reliability. The only thing that is left now is the Social Security of which is also facing a challenging time today. Though pension is not as popular as it was before, I would still go for it than the 401(K). Not only that the stock market has not advanced in the last 12 years but it is too volatile which placed 401(k) in a very shaky position. It makes me even wonder if I will be able to receive any money when I retire if I shift into 401(k). I do not think so.
The pension plan is the one of the good way to account for the person who has a very low salary rate (like me).
Thanks! I really very care of pension, because that is money which need for my life & wife
Has voted for Defined Benefit Pension.
Good example about your father. The pension should not be exposed to risk.
This is soooooooooooooooooooooooo true. Pensions were guaranteed money and outpace inflation. The general public has noooooo idea on how to manage their own finances in order to live a fruitful retirement.
I am 55 years old and have worked for the past 15 years for a fortune 100 company. Two years ago we were given an option to stay in the pension or go to the enhanced 401K. The company gave us a chart of expected benefits. I choose to stay in the pension because of the chart. The company announced this week that it was dropping its pension for everybody in two months, and everybody will be part of the enhanced 401K.
The charts they give us now indicate that I will loose about $220,000 in retirement benefits. This is not fair, but is it legal? I am 55 and can not make up $25K a year for 10 years to make up for my loss.
Is there some organization that I can go to to help me fight my battle?
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