Gauging the gap in retiree benefits
Be prepared to invest more if your pension is frozen.
DALLAS MORNING NEWS
DALLAS -- Which retirement vehicle provides the better results for workers -- a pension or a 401(k)?
The question is an important one right now, as the country's corporate pension structure continues to be dismantled in favor of worker retirement accounts like 401(k)s.
While other factors are at play, the answer to the question largely depends, of course, on how generous the 401(k) is compared with the pension.
And that comparison will never come into clearer focus than when your employer, as companies are doing seemingly every week, announces that it's freezing your pension plan and, in return (if you're lucky), will sweeten your 401(k).
Should that happen, you need to know if the effect on you will be a straight swap; an improved retirement picture; or, in effect, a cut in your compensation. (Hint: Don't expect a raise out of this.)
Experts say such a comparison is difficult to make, but not impossible.
"There is fundamentally no simple answer to the question of how all workers will be affected by a pension freeze," says Jack VanDerhei, a fellow at the Employee Benefit Research Institute.
But a report he issued in March offers some insight by figuring out how much larger a percentage of income would have to go into workers' 401(k) plans if their pensions were frozen to ensure that the workers don't fall behind in retirement savings.
Generally speaking, when a company freezes a pension plan, benefits accrued to that point still will be paid to workers in retirement, but the accrual stops. The burden of replacing that benefit accrual falls to the 401(k).
There are many complicating factors, but for workers in so-called final-average pension plans, the replacement contribution to the 401(k) would have to rise by an average of 8 percentage points to cover the lost pension benefits, says VanDerhei, a professor at Temple University in Philadelphia and an expert on Social Security reform and pension planning.
That means, if the company offers a 3 percent match, the match would have to rise to 11 percent for the workers to come out even.
"These are the benchmarks you're going to have to hit in order not to lose money," he says.
If the match doesn't rise that much, then workers who don't want to fall behind on their retirement savings should increase their contribution so that the total contribution to the 401(k) rises by 8 percent of income.
For example, if you currently put 6 percent of your income into the 401(k), and the company matches that at 50 percent, or the equivalent of 3 percent of your income, then your 401(k) has been receiving contributions at 9 percent of your income.
To make sure you come out even, you'll have to make sure that the new contribution to your 401(k), counting the amount that comes out of your income and the company match, totals 17 percent of your income.
If this puts you over the allowable contribution to tax-deferred savings plans, then you'll need to save the money in an after-tax account.
VanDerhei stressed that the 8 percent is just a benchmark, representing the result for average-income, average-age workers in an average pension plan making an average return.
How they are figured
Generally speaking, for older workers, the new percentage would be even higher. To understand why, you have to understand how pension payments are figured.
In most traditional pension plans -- called defined-benefit plans, because you get the same defined benefit every month in retirement until you die -- payments are calculated using a "final-average" formula.
A company typically multiplies the number of years worked by the average of the worker's three highest years of pay, times a percentage. Workers who stay with the same company throughout their career maximize their benefit because their entire pension is based on their highest level of income.
A 401(k) is called a defined-contribution plan, because the contribution is defined but the benefit you take from it in retirement is up to you.
You contribute part of your salary, and if you're lucky, your employer offers a match, meaning that for every dollar you save up to a certain amount, your boss will also make a contribution. That essentially is free money to you.
Generally, younger employees and mobile employees will fare better with a 401(k) plan, because it enables them to accrue benefits more quickly early on, and their accumulated balances can continue to grow with them as they change jobs, Busch says.
In other words, a 401(k) offers relatively steady savings growth over your career, compared with a pension.
Also, the investment risk is on you, and how much you accumulate in your 401(k) depends in part on how well your investments have performed.
That's important to note, because private 401(k) plans have underperformed traditional company pension plans by 1 percent a year, according to a recent report by the Center for Retirement Research at Boston College.
That 1 percentage point shortfall may seem insignificant, but compounded over time, it would result in a significant gap of funds at retirement, center director Alicia Munnell says.
That's something to keep in mind if your employer freezes your pension and leaves your 401(k) as your sole retirement vehicle.
Because a pension's benefits are loaded on the back end of your career, your age at the time your company freezes your pension is crucial. The older you are, the more you'll have to contribute to your savings -- above VanDerhei's 8 percent-of-income benchmark -- to stay even.
If your company doesn't sweeten your 401(k), or if your pension freeze is accompanied by a job loss, you're facing long odds of maintaining your retirement outlook.
"It's almost impossible at an older age for that to happen," VanDerhei says. "You'd have to put in so much per year. It's not technically impossible, but it's highly unlikely."