Do 401(k)s Match Traditional Pensions?

Despite nostalgia for defined-benefit pensions, the adequacy of retirement plans has not changed.

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The demise of the traditional pension has been mourned for decades. Beginning in the early 1980s, replacing defined benefit plans with defined contribution plans—401(k)s and IRAs—shifted responsibility for retirement income from employers to employees. Workers were on the hook for saving enough money, making sound investment decisions with those funds, and knowing how to liquidate their portfolios to generate retirement income in their later years. Traditional pensions did all that and promised guaranteed payments until pensioners and, often, their spouses, died. Who wouldn't mourn the disappearance of such a golden retirement benefit?

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Meanwhile, their successors have been rightfully criticized on several grounds: failing to convince employees to set aside enough money, providing them little education in how to invest, larding up plans with employer stock, giving participants poor choices of mutual funds in which to invest their retirement savings, and allowing investment firms to use 401(k)s as an enormous financial trough for steep fees and other opaque charges that even employers often did not understand. What's not to hate about these newcomers?

Of course, as with many stories, this one may just be a little too pat to actually be true. Traditional pensions were often not all they were cracked up to be. Those flaws were the reason Congress enacted the Employee Retirement Income Security Act of 1974, commonly known as ERISA. It mandated extensive employee protections in private pension plans. And in an effort to improve those plans, ERISA also produced the unintended consequence of sending employers fleeing from traditional pensions in search of less onerous retirement programs.

In recent years, the pressure for improving 401(k)s has led to major improvements—more education, better mechanisms to increase employee contributions, and a new category of retirement investments known as target-date funds. Next year, employees will see more improvements to make fund charges more transparent.

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The investment fund industry and its principal trade group, the Investment Company Institute (ICI), have hardly been champions of all these improvements. They've successfully withstood calls for more dramatic changes but have certainly contributed to a new regulatory landscape that is decidedly friendlier to employees and investors.

Taking a step back from the fray, the ICI recently released a study of what's happened to private retirement plans in the wake of all the changes set in motion by ERISA. Despite all the hoopla about private retirement plans, what jumps out from the ICI research is the small share or retirement income provided by these plans.

In 1975, private pensions provided only 8 percent of the retirement income received by people age 65 and older who were not working. Over the next 35 years, that figure rose—not declined—but still totaled only 13 percent in 2010. Pensions to government employees rose from 11 percent to 14 percent of total income over the same period. If government payments seem large, keep in mind that many government employees are not allowed to participate in Social Security.

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Meanwhile, retirement income generated by private savings and investments fell from 19 percent of total retirement income to 11 percent. Investment income has always been trumpeted as a strong leg of the traditional three-legged retirement stool—savings, pensions, and Social Security. Actually, it may be the weakest.

Adding up all these retirement income sources yields less than half of retirement income, with Social Security making up nearly all of the rest—54 percent of all retirement income in 1975 compared with 57 percent in 2010. Despite all the rhetoric and promises about finding ways to augment Social Security with better private retirement tools, we've achieved zero headway in the past 35 years.

The ICI also looked at retirement income among different income groups. It's often claimed that 401(k)s provide few benefits to lower-income workers. Many work for companies without a retirement plan, and those who do have a plan often don't have enough money left over from their paychecks to place into a plan and enjoy matching employer contributions. Looking at the bottom 60 percent of income earners, that criticism is valid in 2010. Looking at the same income groups in 1975, the performance was even worse. There's a reason low-income workers rely on Social Security for nearly all of their retirement income.

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The facts are that traditional pensions may have been great for big industrial union pension plans, but not for everyone. Having a plan didn't translate into actually receiving a pension benefit. However, for those who did receive them, vesting rules in ERISA and later laws have helped sustain traditional pension payouts more than generally thought.

Including all forms of private and government employee plans, the ICI found that in 1975, 34 percent of retirees received pension income. "That percentage increased to 50 percent in 1991" and "has remained above 45 percent since 1991."

"The time before the emergence of 401(k) plans in 1981 has been characterized by many as the golden age of the golden watch," the ICI study concluded. "Against this standard, 401(k) plans are judged to be falling short. The facts support a different narrative: there was no golden age of pensions."

(The validity of many studies rests on the data they use and their definitions. Close students of pension plans should review the ICI research.)

Twitter: @PhilMoeller