With a few notable exceptions, the age of pensions is
largely over in the U.S., with traditional defined benefit plans mostly being
replaced by defined contribution retirement vehicles like 401(k) plans. A new
study from the National Institute on Retirement Security, though, seems to
suggest that the end of pensions may not actually be as beneficial to companies
as once thought. In fact, a giving employees a traditional pension plan may
actually be less costly than operating a 401(k) or other defined contribution
plan.
If you want help saving for retirement, consider finding a
financial advisor using SmartAsset’s free financial advisor matching service.
Why Are 401(k) Plans Costlier Than Pensions?
The logic behind why companies wanted to switch to defined
contribution plans is pretty simple. In a traditional pension plan, the company
is on the hook for a predetermined payment every year until a worker dies. If
they live particularly long, that can get expensive. With a defined
contribution plan like a 401(k), however, the payment is entirely determined by
how much an employee saved during their working years — and of they run out, it
doesn’t impact the employer.
The group nature of a pension plan, though, may actually
result in lower costs for the employers, though, according to the new NIRS
study.
“Pensions have economies of scale and risk pooling that just
can’t be replicated by individual savings accounts,” said Dan Doonan, the NIRS’
executive director, in a statement. “This means pensions can provide retirement
benefits at a much lower cost.”
The study found that in order to replace 54% of income for
employees after retirement, a DB plan required contributions of 16.5% of total
payroll. A DC plan, meanwhile, required 32.3% of payroll to get to the same
endpoint.
“These cost differences are a key consideration for
employers and policymakers given that most Americans are deeply worried about
retirement and retirement savings levels are dangerously low for the typical
U.S. household,” Doonan notes. “Policymakers are wise to protect existing
pensions while also fostering innovation in DC plans to improve the financial
security of those relying on 401(k) accounts.”
Pension Plan Basics
A pension plan works by having money contributed to a pool
by both the company and employees who are enrolled in the plan. There may be a
cliff at which point a person becomes vested in the plan — meaning that you
become eligible for benefits after working at the firm for a certain amount of
time.
The money put into the pool is then invested in the market
so that it grows. There will often be either an investing board or a financial
advisor who makes investing choices. The money from the pool is then used to
pay predetermined amounts of money to retired employees, often based on how
long a person has worked at the company and what their salary was while they
were there.
401(k) Plan Basics
A 401(k) plan is much more individualistic. Each person
contributes money to their own account and choose from a menu of investment
options. Once they retire, they can schedule their own drawdown plan to take
money out as needed. Money contributed to a 401(k) is put in pre-tax, so
participants will pay taxes when they take money out in retirement.
There is sometimes an employer element to 401(k) plans — an
employer match. This is an option some employers use as a part of employees
compensation package. Basically, a firm will match a certain amount of money
the employee contributes. This could be a dollar-for-dollar match or a possible
match, but generally the company only contributes based on how much each
employee contributes.
The Bottom Line
For the past several decades, pension plans have largely
been phased out in favor of defined contribution plans, except in a few
industries, notably the public sector. New research, though, shows that the
conventional wisdom may be wrong and pension plans may actually cost employers
less than offering a 401(k) plan.
Retirement Planning Tips
No matter what type of retirement plan your company offers,
a financial advisor can help you plan for your golden years. Finding a
qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool
matches you with up to three financial advisors in your area, and you can
interview your advisor matches at no cost to decide which one is right for you.
If you’re ready to find an advisor who can help you achieve your financial
goals, get started now.
It’s important to know how much you’ll need to live your
retirement dreams. Use SmartAsset’s retirement calculator to see what you’ll
need and if you’re on pace to get there.
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