401k vs Pension: How To Make Your 401k Pay As Much As a Pension

For the most part, 401k plans replaced pension as the prevailing vehicle for people’s retirement. Surveys and studies show very bleak numbers. The balances in 401k and IRAs aren’t nearly enough to pay for a comfortable retirement as the previous generation’s good ol’ pension once did.

Most public sector employees still get a pension. This often brings envy. People who don’t get a pension and don’t get enough from their 401k’s are increasingly unwilling to pay those who do.

It also leads to some people saying the 401k system is a failed experiment and that we are better off with a pension. A recent New York Times article by Joe Norcera quoted Teresa Ghilarducci [*], an economist at The New School as saying

[People’s] retirement plan is faith based. They have faith that it will somehow work out. The 401(k) is a failed experiment. It is time to rethink it.

Why can’t 401k and IRAs provide as much retirement income as a pension? There are many reasons such as

  • Not all companies offer a 401k (not all companies offered a pension in the past either)
  • Expensive funds and hidden fees in 401k plans (see how to uncover hidden fees in your plan)
  • Poor stock market returns since 2000
  • People don’t understand investing

These are all true. The biggest reason though, I would say, is that people don’t want 401k and IRAs to provide as much retirement income as a pension once did. In other words, 401k and IRAs don’t succeed because people don’t want them to succeed.

I came to this conclusion from reading Vanguard’s report on the 401k-type plans it manages: How America Saves. It shows in aggregate how much people contributed to their 401k plans, how much people accumulated in their 401k plan accounts, how much they traded in their accounts, etc. etc. Vanguard publishes this report every year.

I highlight these interesting statistics:

  • 32% of employees don’t contribute
  • 59% of employees younger than 25 don’t contribute
  • 27% of employees older than 55 don’t contribute
  • 12% of employees with incomes of greater than $100,000 don’t contribute
  • Median employee contribution rate is 6%
  • 21% of employees contribute more than 10%
  • 9% of employees contribute the maximum allowed by law

Remember the participants covered by the Vanguard report (a) have a 401k plan; and (b) have low cost funds from Vanguard. The picture is very clear. If people don’t contribute to their 401k’s or if they don’t contribute enough, of course they are not going to have enough in their accounts to cover their retirement.

How were pension plans able to do better? I once worked in the employee benefits department at a large employer with a pension plan. The annual funding to the pension plan often came out to about 20% of payroll. To the employer, whether it’s cash salary or pension contributions, it’s all money coming out of its pocket as employee compensation costs. The company was basically automatically putting 20 / 120 = 17% of an employee’s compensation into the pension plan. There wasn’t any choice. That 17% went in no matter what. It was forced savings.

When competition forced the employer to freeze the pension plan, all employees basically got a pay cut. With a 3% 401k match, they are now paid 103 instead of 120. Instead of taking the 17 / 120 = 14% pay cut across the board and still saving the same percentage of the new total compensation for retirement, employees took a large part of the pay cut directly from retirement savings. After saving 6% in a 401k and receiving a 3% match, their cash salary is down from 100 to 94, but retirement savings are cut more than half from 20 to 9. When you cut your retirement savings in half, of course your 401k won’t be able to pay as much as a pension would.

Why, when faced with a 14% pay cut would people take the majority of the cut directly from retirement savings? People clearly expressed a preference for more cash today. If the employer didn’t have a pension plan and it just paid 120 to the employees as cash, the employees probably wouldn’t have contributed 20 toward retirement anyway. In other words the old pension setup forced the employees to save for retirement more than they wanted to.

Is the preference for cash today over retirement in the future bad? I’m not the one to judge. I subscribe to the philosophy of “live and let live.” If people want to spend more when they are young and spend less when they are old, what’s wrong with that? Why should an employer be able to force them to save for retirement more than they wanted to?

Now, back to the question in the title. How do you make your 401k pay as much as a pension? One word: contribute. It takes about 15-20% of your pay to get to the level a typical pension plan once paid. If you want to achieve the same level of retirement income, you will need to target the contributions at 15-20% of your pay, counting your employer match.

The Vanguard report says that including employer match, employees with an income between $50k and $100k should save at least 12% of income; 15% of income if the income is over $100k. Given the uncertainty over Social Security and salary growth, I would bump these numbers up by a few percentage points.

Then again, maybe people don’t want to save that much for retirement. They have other plans for their money. Then there’s nothing wrong with low savings numbers in 401k accounts and IRAs. They are low because people want them to be low.

Next time you hear people used to have a pension, think people used to save 15-20% of their pay. Nothing stops people from doing so today. That is, unless people don’t want to.

* Teresa Ghilarducci appeared in a short interview with Tess Vigeland on public radio program Marketplace. I don’t agree with her, for reasons stated above.

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  1. KD says

    A thoughtful and insightful article! Thanks, TFB!

    A classic pattern has emerged since the 1980s – when 401ks started gaining ground & a host of other economic policy changes started to take root – is where individuals have gained increasing say over their own safety nets and when these individuals fail either by not saving enough for retirement or face medical bankruptcy etc, the society doesn’t care and it views these as isolated cases and not as a systemic problem.

    The actual flaw/benefit of 401ks is being able to decide how much to contribute and when to cash out. Having a 401k to pay for certain life events or being able to stop contributing in case of extenuating circumstances is a boon. If you are not disciplined enough then they are a bane.

    It leaves us to think about what kind of society we want. Not many are giving it a thought except may be those who think they can buy elections.

    Sorry for the political overtones, but 401k and its problems and benefits do not exist in isolation. They all ebb and flow with social and political equations.

  2. Arthur Shunk says

    Good article, although I am not certain I agree that people are making a conscious choice to not save enough. I think many people just do not understand what they are going to need and how much they will have to save to get there. So of course the present is going to win out over the future.

    I am currently maxing out my 401k and a Roth(way more than 20% of my salary) but when I was younger, I just put in enough to get the match. And when in my 20’s, when my company killed our pension, I certainly did not realize I had just received a 20% pay cut and am sure many others, although upset over losing the pension, did not realize it was such a huge number either.

    So, the trend these days is to let people be responsible for their on future but I do not think the education needed for them to do it is provided. Instead, they are or will be like me, playing catch up once they understand, if they are lucky enough to figure it out while they have some time to save left.

  3. J says

    Thank you for posting this.

    My job does not offer a 401(k). I do contribute the max to my Roth IRA and my husband’s Roth IRA each year, but two things only occurred to me recently:

    1) $10,000/year may not be enough, especially since my husband and I started retirement saving in our 30s/40s instead of our 20s.

    2) Retirement saving can happen outside of retirement accounts.

    I plan to do additional retirement saving in the form of I-Bonds and a Vanguard stock index fund (most likely VTSMX). Could the 15-20% savings rule work for taxable investing as well?

    Also, folks who worked 40+ years at a job with a pension presumably started saving 15-20% of their income from their first day of work in their early 20’s. For folks like me, who started at age 30, shouldn’t the savings rate be higher than 15-20% to catch-up with the savings rates of those who worked all their lives at a job that offered a pension?

  4. Matthew Amster-Burton says

    To put your thesis another way, most people retiring with a pension, if asked, should say that they are indignant that their company forced them to save so much money, and they wish they had been allowed to enjoy a higher standard of living during their working years and a lower standard of living in retirement.

    I am not being facetious at all. You’re making a big assumption: that people have consistent preferences, and those preferences can best be understood by looking at the choices they make under a particular regulatory regime.

    Here’s another way of looking at it. If people prefer, as you suggest, to live big while working and live small in retirement, it’s quite possible to achieve that even if you’re stuck with a DB pension. The easiest way to do so is to go heavily into debt during your working years and use your pension to pay off the debt when you’re retired. All else being equal, under your theory, we should expect to see DB workers enter retirement with much higher levels of debt than 401(k) workers. I doubt that is the case, but I encourage you to look it up and let me know–as always, I’m happy to eat my words.

    Here is a competing hypothesis:

    1. People would like to enjoy a high standard of living in retirement.
    2. People have a limited supply of willpower.
    3. A retirement system that requires less exercise of willpower will result in better retirement outcomes for most people. Such a system can preserve the freedom of those who genuinely want an impoverished retirement, by allowing them to “borrow against their retirement” using housing loans, credit cards, and student loans.

  5. KD says


    Thank you for the lucid explanation!

    My parents enjoy a pension, and they did carry substantial debt all their life to improve their standard of living and paid it down upon retiring.

    I, on the the hand, do not have a pension to look forward to and I am stuck with a 401k plan with no matching. I wish to retire all my debts way before retirement in the hope that I can enjoy same standard of living as now.

  6. Harry Sit says

    @KD – There’s no rule against political overtones here. So please feel free to express yourself.

    @Arthur, @Matthew – I apologize if I confused you with my half serious half tongue-in-cheek argument. I understand the basics of behavior economics. The observed behavior is likely not a conscious choice but it has the same effect nonetheless. It doesn’t change the conclusion. If you want a 401k to pay as much as a pension once did, you must contribute as much as the previous generation did (even though they may not know they contributed that much).

    The story of the Ant and the Grasshopper has been around for centuries. People have different ideas about what level of freedom should be given to the individuals. Should a higher authority (government, employer, parent, …) just do it for them because the authority knows better? Cue the “eat broccoli” argument. Should marriage be limited to between a man and a woman? Should a woman be allowed to have an abortion? Should people be allowed to smoke and damage their own health? Should people be allowed to buy lottery tickets because it’s a waste of money? Should people be allowed to buy load funds when we think index funds will perform better?

    I’m an Ant. Should I make sure everyone lives like an Ant or should I let the Grasshoppers die (too cruel)? Social Security takes care of the Grasshoppers. If it were up to me, I would mandate a 10% contribution to the TSP, invested in a target date fund, and annuitized at the same time when people apply for Social Security. I’m not sure if I’m supposed to impose my way of life onto others though.

  7. Alex says

    In addition to wanting to enjoy a high standard of living in retirement, people also:

    a) would like to enjoy a higher standard of living now
    b) have low will power
    c) have relatively poor understanding of saving and investing
    d) expect someone else (usually gov’t) to take care of things

    Not all of these points apply to all people, but some combination applies to many, and I also feel that they are positively correlated. Therefore, NOW wins for many people.

    Better education and less moral hazard is probably the answer.

    I also wish that employers had a higher default contribution to 401k. Today most employers have it set at 3%. I wish they had it at the max, and also wish that the max allowed by law were higher.

  8. banff says

    So basically when the employers dropped pensions, your compensation dropped 20%? With no commensurate increase in salary to make up for it? Man, that sucks.

    But yeah, this is a great blog post. People need to contribute way more.

    I’ve always felt that the 3% match on 6% contribution is pathetic on the part of the employer. Media doesn’t seem to talk about this much.

  9. Shawanda @ You Have More Than You Think says

    I think a lot of people make the mistake of blaming the vessel instead of its contents. The 401(k) is only a vessel. The individual as well as their employer is responsible for making sure low cost, high quality funds are an option in the company’s 401(k). And the individual is responsible for making sure their contributions are adequate enough to fund their retirement.

    Although it’d be nice to have a pension, if you asked me to choose between getting a pension or receiving my employer’s contribution in cash, I’d choose the latter. Give me my money, and I’ll decide how it should be invested. Unfortunately, many Americans spent the money that should’ve been invested.

  10. Wai Yip Tung says

    From what I read from your article and from the vanguard data, let face the truth –

    401k (as it is) has failed as a retirement saving tools

    The conclusion come straight from the numbers. It is hard to argue otherwise. The issue is not 401k is not good enough. The issue is people are not using it when you leave it to the to choose. People’s behavior should count as much as the instrument itself if not more.

    One way to fix it is to make contribution to 401k the default and employer should be required to make a 10% match. Practically this may only be possible for new job offer or if employer can negotiate a small pay cut from the employee. Otherwise all these years of 401k participation tell us one thing, people underfund their own retirement account and will make much less then pension.

  11. Jonathan says

    I think the difference between the forced savings of pensions and the voluntary savings of 401ks is that when a large amount of people reach retirement age without any money, they will collectively vote to raise taxes on everyone in order to feed and house themselves. SS will be means-tested for sure eventually in my opinion, I would bet within my lifetime. That’s what I worry about.

    What if the end of the fairy tale was that the grasshoppers rise up and take the ants stuff. 🙂

  12. Harry Sit says

    @J – Those two things you mentioned are absolutely true. If you don’t have a 401k and you already max out the IRAs, save in regular taxable accounts. If you had a late start, save more.

  13. Chad says

    The real take away is the stealth pay cut. In general, people are clueless, so it was an easy way for companies to cut salaries while still looking “good.”

    When you inlcude this stealth pay cut with all the future growth/profit moved to the present with all the ill advised leverage the future doesn’t look great.

    That’s why you can’t tie yourself to one country, as you may get screwed if you do.

  14. Financial Advice for Young Professionals says

    Let’s face it: people are dumb. Most people reading this blog see that if they make small sacrifices now, they can be very comfortable in retirement. You may save too much, but who cares? Give it to your kids when you die.

    In a perfect world, there should be a mandatory 10-15% contribution, otherwise most people won’t do it. I don’t need to read a study to tell me that 🙂 That’s how people are, they want instant gratification. But as it stands now, I sure don’t trust the government to manage 10-15% of my money, who knows what they’ll do with it? 401k’s work fine like TFB stated if you contribute 20% like you would with a pension. So I think the argument is more of a political one as others have alluded to.

  15. dd says

    Nice analysis! So many individuals don’t count money that they don’t see. 401Ks are a good thing, as there were companies that did not offer pensions years ago, they offered nada. With 401Ks more companies at least offer something. 401Ks were supposed to be supplemental, not the primary retirement vehicle.

  16. M says

    I’m one of the few who still has access to a company pension, in addition to a 401k.

    I think the point of this article is a good one – people don’t save enough. Yet another recent study claimed nearly half the country saves NOTHING.

    Even more to the point, pension benefits are generally in the form of an annuity, so you have the potential of getting monthly payments which in total FAR exceed the total you paid in. My pension costs me 1.5% of my salary, and from my calcs, it provides a guaranteed 12-13% return on the money I spent, in addition to being guaranteed for life.

    So to really match a pension with a 401k, you have to invest enough (properly!) so that you could purchase an annuity that provides the same income (which is probably around 60-70% of salary.)

  17. Peter S. says

    TFB, you are correct. The BIGGEST reason 401k/IRAs don’t function well as a pension is because people simply do not chose to put enough money into them. Your point is, there will be little to harvest if too few seeds are planted – no matter how fast or high or for how long they grow. Well put, but planting lots more seeds will not fix the problem.

    You apparently didn’t listen to your wife closely enough. After advising you to “Put more money in it”, she wisely added, “You grow it faster”. You skimmed over that SECOND biggest reason 401k/IRAs don’t function well, the one that can destroy ½ to ⅔ of these account’s potential value. According to DALBAR’s latest 2012 QUAIB report (Quantitative Analyses of Investor Behavior), the average equity fund investor realized only a 3.5% annualized return over the past 20 years, 2.4% annualized over the last 10 years, LOST 2.2% annually over the previous 5 years and LOST 5.7% in 2011. To add insult to injury, these returns were BEFORE taxes and inflation AND required all of the principal and accumulated earnings to be at continuous RISK OF LOSS!

    To put your wife’s second advice in perspective, a 30 year old’s $1,000 monthly 401k/IRA contribution will become $1,045,000 in 40 years growing at 3.5% tax deferred per year, but will be worth only $480,000 pre-tax if inflation is 3.5% per year. On the other hand, those same contributions will be worth the full $1,045,000 IF growing at an annualized 7.0% tax deferred rate and IF distributions are tax free – also adjusted for 3.5% inflation. This number quickly rises to $1,341,000 at an 8.0% growth rate. Unfortunately, the way 401k/IRAs are structured and run, such higher returns are unlikely. For example, according to DALBAR, the average asset allocation investor (includes “target date” funds) earned only 2.12%, 1.11%, -1.48% over the past 20, 10 and 5 years, respectively, while the average fixed income investor earned just 0.94%, 0.93% and 0.95%, respectively. Simply put, if the crop is not tended smartly and prudently, i.e. does not grow at a healthy rate, the harvest will be anemic, no matter how many seeds were planted.

    Your wife’s third and last admonition was, “You give it more time” but you skimmed over that jewel, too. If in the previous example contributions started just five years earlier, at age 25, the end values would be $1,310,000 and $1,746,000 respectively – huge increases over the $480,000. Another example illuminating the value of time is also in the DALBAR report. As already mentioned, the average fixed income investor earned an annualized return of 0.94% over 20 years. However, the average “systematic” fixed income (mostly bonds) investors were able to earn a 3.42% annualized return during the same time! What was the difference between them? TIME. The systematic fixed income investors traded less often i.e. held on to their investments LONGER.

    So, to implement her formula for a healthy pension: regularly set aside 15-20% of your income for retirement, grow it at a 3.5-5.0% annual rate net of taxes and inflation without undue risk, start this process early in life, think long term, and trade seldom. I would only add one thing to her advice: to reduce the chance of having to “raid” the accounts to cover emergencies, buy appropriate insurance to cover the financial consequences of a breadwinner’s disability or early death – even if you have to take the premiums out of the contributions.

  18. Harry Sit says

    Peter S – Thank you for you comments. I don’t see DALBAR as a credible source. See my previous post DALBAR Study Overstates Investors’ Bad Timing. It’s a myth that 401k participants trade their accounts to poor results. If you read the linked How America Saves report from Vanguard, you will see the participants as a whole trade very little (p. 68). Only 1% of assets moved from equity to fixed income in 2010. Even when the market was crashing in 2008, only 4% of assets moved from equity to fixed income. I would call that buy and hold.

    It’s also a myth that 401k participants cash out their 401k accounts when they switch jobs. The same report reveals that 6% of assets were eligible for a distribution from the plans due to job changes (p. 80). 92% of the 6% stayed in the plan or were rolled over to an IRA.

  19. Peter S. says

    TFB, you apparently missed my two main points or, just as likely, I did not make them clear:

    1. The return ON investment and return OF investment are as or more important than the AMOUNT invested. The historical annualized net return of the average equity fund investor is too low (3.5% or less according to DALBAR) within both short (1-10 yr) and longer term (20 yr) horizons and involves disproportionate market risk – especially for retirement purposes. For a retirement account to perform adequately, pension directed assets should be earning 7-8% without unduly risking the accumulated principal and earnings. The difference in results can be huge.
    2. Investment DURATION can be just as or even more important as investment AMOUNT. The duration of the accumulation period should be maximized by starting a retirement accumulation program sooner rather than later. The difference in results can be huge. Occasionally badly timed trades come under this heading but their impact is not nearly as dramatic.

    DALBAR did not say or even imply that the 4.32% difference between the 3.49% annualized 20 yr actual return of the average investor and the annualized 7.81% “return” by the S&P 500 benchmark was ALL due to investors timing their trades badly. A big portion of the spread is attributable to investors’ trading costs, sales charges, fees, expenses and other costs – which can be substantial. Investing in non-index, fixed income and asset allocation funds also contributed. DALBAR did NOT report that trading from equities to fixed income funds per se contributed to the low returns. DALBAR did say that the Alpha created by portfolio management is lost to the average investor as evidenced by the dismal 3-4.5% average mutual fund retention rate over the past 20 years.

    I referred to the DALBAR report because it clearly presents the actual ANNUALIZED return the average equity, asset allocation and fixed income type investor realized over 20, 10, 5 and last year. Their numbers are not controversial and do not seem inconsistent with those of Morningstar and others. In explaining their methodology, DALBAR defines the reported annualized returns. DALBAR first calculates the investor return DOLLARS, defined as “the net change in assets, after excluding sales, redemptions and exchanges…capturing realized and unrealized capital gains, dividends, interest, trading costs, sales charges, fees, expenses and any other costs.” Then DALBAR calculates the reported annualized returns “as the uniform rate that can be compounded annually for the period under consideration to produce the investor return dollars”. In other words, the rates they report are the Internal Rate of Return (IRR) NOT the meaningless “average” returns to which you referred in your previous post about DALBAR. The beauty of IRR calculations is that it accounts for the TIMING of cash flows – which averaged returns do not (as you correctly point out).

    Finally, there is nothing misleading or wrong with comparing the net annualized return (IRR) realized by the average investor to performance benchmarks such as the S&P 500 Price Index (S&P 500) and the Barclays Aggregate Bond Index (BABI). Of course, because nobody can invest in either benchmark, the comparison is not apples to apples. It is apples to benchmarks that tend to put expectations into perspective, especially from index funds.

  20. bp says

    I don’t think “want” is quite the right word to describe most of the people lacking in retirement contributions.
    It is more of a lack of understanding of the retirement/401k process combined with people thinking that they cannot afford to contribute. I know intelligent professionals who contribute heavily to their retirement, but couldn’t define the term “mutual fund” if their life depended on it… as a matter of fact, try asking some acquaintances who you would consider to be high-earning professionals (who don’t really follow finance) what a mutual fund is; I think you’ll be surprised.

    I do agree that there are a handful of people with a spend the money now mentality.

    One pearl of finance wisdom I don’t like to hear is “you should at least contribute up to the company match because it’s free money.” This causes a lot of people to only contribute up to the match. As long as you are gleaning some sort of benefit (be it a company match or a government tax reduction), it’s all free money.

    I contribute the max and I recommend to others that they do the same.

  21. Richard says

    When public health systems fail or are non-existent, we don’t say that the failure was an individual failure. We understand that it is a systemic failure. Getting or not getting Ebola was not a Liberian “choice”. Systemic failures affect individuals.

    Collectively as a country we have had a flat median real income. One way of obscuring that was to cut pensions, raise salaries modestly and place the burden of savings onto individuals. We made people individually responsible for retirement rather than making a collective decision.

    That was a mistake. Individually people underperform indices by 2%. And defined benefit pension plans permit an actuarial bonus due to mortality. Saving, individually, and making certain that there are sufficient assets for life involves substantial oversaving and/or underspending.

    Those who are wealthy have assets which are large multiples of their annual spending. This simplifies their planning enormously (although it does create the major headaches which accompany estate planning). For the rest of us, the loss of the defined benefit pension plan was a major cultural mistake.

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