Retirement is complex and expensive, but pensions have intrinsic benefits
Access to an employer-sponsored pension plan is one of the biggest barriers to preparing for retirement. Unfortunately, retirement coverage is not universal in the United States and only about half of workers participate in a defined benefit plan or a 401(k) account according to the Boston College Center for Retirement Research. That percentage has remained constant for decades, and it’s a chronic barrier to financial security for far too many working Americans.
But even for employees with access to a workplace pension plan, financial security in retirement is not guaranteed. Workers best positioned to be self-sufficient in retirement have what is known as the “three-legged retirement stool” – a defined benefit (DB) pension, individual savings in a defined contribution (DC) 401(k) style and a social plan. Security.
DB pensions are particularly important because they are designed to provide lifetime retirement income with minimal effort on the part of employees. Pension plan assets are pooled and investments are managed by professionals who are required to act in the best interests of pension plan participants. Upon retirement, pensioned employees receive a predictable monthly salary for life.
But what about employees without a pension? Admittedly, retirement is more complex and more expensive when relying on a 401(k) savings account instead of a pension. Rather than retirement income guarantees, DC plans are designed to accumulate Pension saving. Individuals bear full responsibility for saving, making investment decisions and determining how to spend their savings at the right rate. Research indicates that all of these tasks are complex for individuals, especially savings expenses. Retirees may withdraw funds too quickly and risk running out of money. Or, retirees may hold their funds too tightly, resulting in a lower standard of living in retirement.
Another problem associated with DC plans is the change in investments over time. Retirement experts generally advise younger people in 401(k) plans to invest more of their savings in stocks, which typically have higher returns but also greater risks. As retirement approaches, experts often suggest shifting savings away from stocks to safer, lower-yielding assets like bonds. This change helps guard against a significant decline in retirement savings as you approach and retire. But this loss of investment returns makes retirement all the more expensive.
It’s important to note that a typical pension is significantly more cost-effective than a typical DC account, offering the same retirement benefits as a 401(k)-style account at about half the cost.
In other words, to achieve a target pension benefit that replaces 54% of an individual’s final salary, a pension plan requires contributions equal to 16.5% of payroll. In contrast, an individually managed DC account requires contributions almost twice as high as the pension plan, at 32.3% of payroll.
A new analysis Better value for money 3.0, finds that there are three main reasons for the substantial cost advantage of pension plans over DC accounts, as illustrated in Figure 1A.
First, pensions spread longevity risks over a large number of individuals. Pooling longevity risk allows DB pension plans to fund benefits based on average life expectancy and pay each worker a monthly income regardless of their lifetime. In contrast, DC plan participants must have excess contributions saved if they live longer than the average life expectancy. This is important because saving and spending on savings in an individual account is very different if a person lives to age 70 compared to age 100.
Second, pension plans have higher investment returns than individually managed DC plans. Defined benefit pension plans have higher net investment returns due to professional management, as well as lower fees resulting from economies of scale.
Third, pensions have perfectly balanced investment portfolios. Pensions are “ageless” and therefore can perpetually maintain an optimally balanced investment portfolio rather than the typical individual strategy of downgrading over time to a lower risk/return asset allocation. This means that over a lifetime, pensions generate higher investment returns than CD accounts.
To be fair, 401(k)-style CD plans have improved dramatically since this issue was first discussed in 2008, especially with respect to fees, investment options, and investor behavior. . For example, the cost of investing in employer-provided plans has been roughly halved since 2000. And there’s a growing use of target date funds to help correct individual investor missteps. investments and asset allocation. Additionally, annuities continue to attract interest from policy makers as a means of converting DC account balances into a lifetime income stream.
But even with these improvements, 401(k) accounts simply cannot replicate the efficiencies built into the design of retirement plans themselves. In fact, the Better Bang for the Buck study found that four-fifths of the total retirement cost benefit occurs after retirement, typically after a person leaves their employer-sponsored plan.
With longer life expectancies and low levels of retirement savings, employers and policymakers are wise to find ways to provide working Americans with reliable retirement income for life in the most cost-effective way possible. For those in self-saving plans, like 401(k),’ more needs to be done to improve the post-retirement experience in a cost-effective way. This is especially true if the current low interest rate environment persists.
Getting back to retirement basics — providing workers with a pension, coupled with a 401(k) and Social Security — will go a long way to making retirement much easier and much less expensive.