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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