[Updated with recent numbers from Vanguard.]
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. 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).
- Volatile investment returns.
- 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. Vanguard publishes this report every year.
I highlight these interesting statistics from the latest report based on 2019 data:
- 24% of employees didn’t contribute. At employers that didn’t automatically enroll everyone, 39% of employees didn’t contribute.
- 50% of employees younger than 25 didn’t contribute.
- 6% of employees with an income of greater than $150,000 didn’t contribute.
- Among those who contributed, the median contribution rate was 6% of pay.
- 21% of participants contributed more than 10% of pay.
- 12% of participants contributed the maximum allowed by law. 43% of participants with an income of greater than $150,000 didn’t contribute the maximum.
- 15% of participants at age 50 or older made the allowed catch-up contribution. 42% of eligible participants with an income greater than $150,000 didn’t make the catch-up contribution.
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, they aren’t 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 came out to about 20% of the total payroll*. To the employer, whether it was cash salary or pension contributions, it was all money coming out of the employer’s pocket as the employee compensation costs. It was factored in as the employees’ “worth” when the employer decided to hire. For each $100 the employees earned in salary, the employer paid another $20 into the pension plan. The employees actually earned $120. The company was basically automatically putting 20 / 120 = 17% of the employees’ 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. The company no longer paid the $20. With a 3% 401k match, they were now paid $103 instead of $120. That was a 14% pay cut. Instead of taking the 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 was down from $100 to $94, but retirement savings were cut more than half from $20 to $9. When you cut your retirement savings in half, of course your 401k wouldn’t be able to pay as much as the old pension.
Why, when faced with a 14% pay cut, would people take the majority of the cut directly from retirement savings? People’s behavior revealed 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. In other words, the old pension setup forced the employees to save for retirement more than they would’ve done themselves.
Is it bad to prefer cash today over money for retirement in the future? 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 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.
Next time you hear “people used to have a pension,” think “people used to save 15-20% of their pay.” Nothing stops you from doing so today, unless you don’t want to.
* I didn’t make up the 20% of payroll number. CalPERS runs the pension program for state and local government employees in California. It bills each employing entity for the pension contributions. You can look up the percentages of payroll CalPERS requires. It’s about 20%, and much higher for entities in public safety.