A few tweaks to your 401(k) can make it better than a pension

Remain flexible in retirement
Remain flexible in retirement
Image: Reuters
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According to surveys, 64% of Americans think they haven’t saved enough for retirement. Funding retirement is a tall order. Many of us live paycheck to paycheck, let alone have enough left over to finance 30 years of living without a salary and rising health care expenses.

It’s tempting to wish we could go back to the 1970s when employers paid a traditional “defined benefit” pension after retirement. But don’t give in to this misplaced nostalgia. Odds are you are much better off with your 401(k) than you would be with a defined benefit pension; you just have to make a few tweaks to make it work for you.

How you ended up with a 401(k)

Really, you probably never would have had a defined benefit plan to begin with. At their peak in the early-1970s they only covered 40% of workers. A few years before 401(k)s were invented, defined benefit pensions began to disappear and now mostly only exist for state and municipal workers. But the invention of the 401(k) isn’t what killed pensions.

The problem with defined benefit plans is they were always an expensive promise. Employers must put aside enough money to fund long retirements and bare all the market risk. Companies often skimped on paying in enough money and tried to make up for it by taking more risk. They also lowered their costs with restrictive vesting rules that made pensions worthless if, for example, you worked at a company fewer than 15 years.

After a piece of legislation called ERISA (the Employment Retirement Income Security Act of 1974) forced companies to offer fairer vesting rules, they recognized just how expensive pensions really were. Once they had to pay for them, companies ditched pensions and made their employees bear the risk instead.

Often when pundits argue that defined benefit plans were better than 401(k)s, they compare an idealized defined benefit plan (fully funded, at a company where everyone has lifetime employment) to a mediocre 401(k) plan. But when you compare apples to apples, a 401(k) plan is often a better choice for employees. One reason why 401(k)s seem so much riskier is that their risks are just more transparent. A defined benefit plan exposes you to risk, too—often ones you can’t control. They include:

  • If your employer goes bankrupt, your benefits are cut
  • If your employer underfunds the pension or invests it poorly, it puts financial pressure on your employer—especially in a bad financial market. It makes it harder for firms to invest and even puts your job at risk.
  • Defined benefit plans are often skimpy unless you work at a company for a very long time, and if you lose your job you also lose a big pension benefit.

Because 401(k)s are cheaper and less risky, more employers are able to offer retirement benefits. In 1979, 47% of workers were active in some kind of pension plan, in 2014, 61.6% were. 

401(k)s still have problems

Many people, especially with low incomes, don’t have access to a workplace pension—even a 401(k), making it harder to save. And if you do have a 401(k), the same expenses and risks that existed with defined benefit plans are now on you.

That’s both good and bad news: It’s bad because it forces everyone to become an expert risk manager; good because now the risks are transparent and under your control. Here’s what you can do so you can save better than any defined benefit plan would save for you.

  1. Make sure you enroll in your employer’s 401(k)—(and if you don’t have a workplace account start an IRA).
  2. Save as much as you can.
  3. Save even more in the future: increase your contribution rate as you get older and/or you get a pay raise.
  4. Invest in low-cost, well-diversified index funds, preferably ones that move you into bonds are you get older.
  5. Start planning for spending in retirement now.

The last point is the hardest. Defined benefit plans invested and planned (though often poorly) around paying a regular stream of benefits to workers when they retired. Regulators forced the plan managers to value liabilities (paying income one day) and compare them to assets. The problem with most 401(k)s is they are invested to build a pile of wealth when you retire. That is a great start, but it does not help people know how much to spend and make that money last in retirement. A better 401(k) plan offers simple annuities and helps people develop sustainable spending strategies.

If you want to make the most of your 401(k), you have the control to do what defined benefit plans did right (plan for spending in retirement) and avoid what they did wrong (underfund and take silly risks). If you can pull it off you will get the best of both worlds.