Would you rather have a pension or a 401(k)? Most people are worried about the reduction in the number of employers offering pensions. It can be comforting to have a “guaranteed” amount of income each month that continues for the rest of their life rather than a 401(k), whose value is uncertain, and can drop when markets become volatile.
Should investors necessarily prefer pensions to defined contribution plans like 401(k)s (or similar plans like 403(b)s or 457s)? The answer depends on the individual’s situation.
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Under most scenarios, 401(k) plans tend to provide more retirement income than traditional pension plans. The one caveat is that 401(k) plans tend to be better for younger people rather than older people. The reasoning behind this comes down to the “magical” power of compounding.
Dimensional Fund Advisors (DFA) completed a study in June 2013 that looked at various income-based savings rates to determine how successful someone would be in retirement with a 40% replacement rate. For example, a 40% replacement rate would mean you would spend 40% of preretirement income in retirement. While it could be debated what an appropriate replacement rate should be, DFA concluded 40% is a conservative estimate. Here were their major findings:
- “Saving consistently and throughout one’s career is more important than the choice of asset allocation…”
- “Increasing the probability of achieving goals is relatively costly…and so is delaying saving.”
What does this mean for you? It is prudent to save often, and to save more than you think is necessary.
In the DFA study, a 25 year old who started saving at age 25 and wanted to retire at age 66 would need to save around 16.8%-17.2% of their annual income to replace 40% of preretirement income with a 95% success probability.
What happens if you were to start saving later? If you started at age 30, you would need to save 19.5% of your annual income. At age 35, you would need to save a whopping 23.8% of your annual income. To put that in perspective, for someone making $50,000 the 35 year old would need to save $11,900 while the 25 year old would need to save $8,600 – a difference of $3,300 annually.
While it is easy to become bogged down in the details and asset allocation strategies, the key takeaway is that 401(k)s are not necessarily inferior retirement vehicles. They just require more discipline on the part of the investor to achieve better results than a pension.
Another study done by the Employee Benefit Research Institute found that, depending on annual income, workers who are 25 to 29 years old and continue with their 401(k) retirement plan for 30 to 40 years end up with a 15 to 44 percentage-point higher income replacement rate at retirement versus a pension plan.
Chances are you will not have the opportunity to participate in a pension plan if you are a younger worker today. That is not necessarily a bad thing. It will just require you to keep in mind these simple strategies to help you retire:
- Start saving early, even if it is a little amount.
- Save consistently throughout your life.
- Increase your savings rate as your income rises.
- Take advantage of employer contributions – do not leave free money on the table.
Whether you are a business owner or retirement plan participant, if you have questions about how to optimize your retirement success, give us a call.