Human Capital & Careers

Can 401(k)s Replace Pensions?

Many employees can earn as much retirement income with a 401(k) as they can with a traditional defined-benefit plan, a pro-employer advocate asserts.
David KatzSeptember 15, 2006

Even though he’s one of the staunchest advocates of 401(k)s around, David Wray’s contention still seems startling: over time, defined-contribution plans can match the income that traditional defined-benefit plans dole out to retirees.

To be sure, many benefits experts say that 401(k)s can form a nice tandem with a scaled-down traditional pension plan or cash-balance arrangement. Add to that a hefty chunk of savings — in, for example, an Individual Retirement Account — and a monthly Social Security check, and you begin to have something that looks like income replacement for a retired worker.

But almost no one outside of Wray — president of the Profit Sharing and 401(k) Council of America, an association of 1,200 employers — is maintaining that retirees can do as well with a 401(k) as they can with a traditional DB plan. After all, in a DB plan, it’s the employer, not the employee, who’s subject to the vagaries of the financial markets: the employee is sure to get a stated benefit, regardless of how the plan’s investments do. In a 401(k), on the other hand, it’s the employee — in many cases a fairly unsophisticated one — who takes on all the risk.

That widely held belief underlies some of the current criticism leveled at the new Pension Protection Act and the Financial Accounting Standards Board’s pension-accounting project. By tightening funding standards and requiring companies to put their pension obligations on their balance sheets, the act and the FASB project will spur employers to freeze or terminate their DB plans, the reasoning goes. Even if employers boost their 401(k) contributions substantially and motivate employees to save large amounts, there would still be a big shortfall for retirees. In that scenario, employers would face a public-relations nightmare and a possible government backlash in terms of benefit mandates.

Wray, however, thinks it won’t be such a bad thing for all concerned if plan sponsors go directly from DBs to DCs. By overriding state salary payroll withholding laws that might bar automatic 401(k) enrollment, the new pension act will enable plan sponsors to make plan participation the default option. Boosting participation in that way could mean better DC income for retirees and thus a better case for employers to make for the plans. Indeed, says Wray, senior managements now have “a lot of opportunity to develop a really fine DC program for employees and achieve the same goals as before — and maybe even do better.”

Do better? Contrary to popular belief, traditional DB plans aren’t designed to fully replace a worker’s income at retirement, Wray, a former DB plan administrator, says. Instead, the goal is to supply about 40 percent of final pay. In a 401(k), that percentage “is easy to replicate if you just put the money there,” he argues. “If you put a lot of money in the program, you’ll have a lot of money in the end.”

Of course, DB plans, which tend to reward seniority, may provide better retirement income for workers who have spent many years with a company than they do for younger workers who move around a lot, he acknowledges. If the latter group keeps adding to their 401(k) accounts over the same 35 or 40 years that senior workers with DB plans accrue, they could do just as well, according to Wray.

That of course, presupposes that the younger, more mobile workers will invest their 401(k)s wisely. The conventional wisdom, of course, is that nonexperts will invest, well, inexpertly. Wray, citing a new report by the Center for Retirement Research at Boston College, asserts that the 401(k) system is not so “dramatically” underperforming the DB system as many think. The report, based on Federal Reserve Board and U.S. Department of Labor data as well as information from other sources, found that from 1988 to 2004, DB plans outperformed 401(k)s by only one percentage point.

The Boston College researchers, however, say that the slim difference belies a world of investor naiveté. For one thing, the 401(k) plans, burdened by high investment fees, still trailed DB plans even though the DCs were more heavily invested in stocks during the bull market of the 1990s.

Further, they say, “the one percentage point shortfall understates the investment problem in 401(k) plans, since an aggregate number does not reflect the fact that more than half of participants in 401(k) plans do not follow the prudent investment strategy of diversifying their holdings.”

Nearly half of 401(k) participants are either close to fully invested in stocks or have no equities at all in their portfolios. Given that lack of diversification, making balanced portfolios the default option — which would take decision making out of the hands of the account holder — might be a good way to boost the performance of 401(k)s, according to the Boston College researchers.

Indeed, plan holders do seem to be giving up the dream that they can generate high returns on their own or even with the aid of advisers. “We’re actually moving past advice,” says Wray. “Employees are saying they just want employers to do it for them.”

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