With a few notable exceptions, retirement age in the US is largely over. Traditional defined benefit plans have largely been replaced by defined contribution plans such as 401(k) plans. However, a new study from the National Institute on Retirement Security seems to indicate that the end of pensions may not be as beneficial to companies as once thought. It can even be cheaper to give employees a traditional retirement plan than a 401(k) or other defined contribution plan.
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Why are 401(k) plans more expensive than pensions?
The logic behind why companies wanted to switch to defined contribution plans is quite simple. In a traditional retirement plan, the company must make a predetermined payment each year until an employee dies. If they live particularly long, it can get expensive. However, with a defined contribution plan like a 401(k), the payment is determined entirely by how much an employee has saved during their working years – and if they run out, the employer is not affected.
However, according to the new NIRS research, the collective nature of a pension scheme can actually lead to lower costs for employers.
“Pensions offer economies of scale and risk pooling that simply cannot be replicated by individual savings accounts,” said Dan Doonan, executive director of the NIRS, in a statement. “This means that pensions can provide retirement benefits at a much lower cost.”
The study found that to replace 54% of employees’ income after retirement, a DB plan required contributions of 16.5% of total payroll. A DC plan, meanwhile, required 32.3% of payroll to reach the same endpoint.
“These cost differences are an important consideration for employers and policymakers as most Americans are deeply concerned about their retirement and retirement savings levels are dangerously low for the typical American household,” Doonan notes. “Policymakers would be wise to protect existing pensions while promoting innovation in DC plans to improve the financial security of those who rely on 401(k) accounts.”
A financial advisor can help you weigh the tradeoffs based on your circumstances.
Basic principles of the pension plan
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A retirement plan works by having both the company and the employees enrolled in the plan contribute money to a pool. There may be a cliff at which someone becomes involved in the plan, meaning you become eligible for benefits after working with the company for a certain amount of time.
The money put into the pool is then invested in the market so that it grows. There is often an investment council or a financial advisor who makes investment choices. The money from the pool is then used to pay out predetermined amounts of money to retiring employees, often based on how long someone worked at the company and what their salary was while they were there.
A 401(k) plan is much more individualistic. Everyone contributes money to their own account and chooses from a menu of investment options. Once they retire, they can plan their own withdrawal plan to withdraw money as needed. The money contributed to a 401(k) is deposited pre-tax, so participants pay taxes in retirement.
Sometimes there is an employer element in 401(k) plans: an employer match. This is an option that some employers use as part of their workers’ compensation package. Basically, a company will match a certain amount that the employee contributes. This can be a dollar-for-dollar match or a potential match, but generally the company only contributes based on how much each employee contributes. Consider consulting a financial advisor for professional guidance through law changes and beyond.
The bottom line
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In recent decades, pension plans have largely been phased out in favor of defined contribution plans, with the exception of a few industries, especially the public sector. However, new research shows that the conventional wisdom may be wrong and that retirement plans may actually cost employers less than offering a 401(k) plan.
Retirement planning tips
Whatever 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 difficult. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisors for free 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 need to make your retirement dreams come true. Use SmartAsset’s retirement calculator to see what you need and whether you’re on track to get there.
Have an emergency fund on hand in case you encounter unexpected expenses. An emergency fund should be liquid – in an account that is not at risk of significant fluctuations like the stock market. The trade-off is that the value of liquid cash can be eroded by inflation. But with a high-interest account, you can earn compound interest. Compare savings accounts from these banks.
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