When it comes to retirement planning, we are currently in a state of transition between the pension and 401k. The pension’s days are numbered, but that doesn’t mean the skies are gray. In the battle between the pension vs. 401k, you can still come out ahead.
I strongly advise my clients to assume that someday Social Security will not be a viable retirement income source. That I discuss in another article. The other options out there are long-term investments in tax-sheltered accounts offered by employers.
The Pension is Going the Way of the Dodo
In the middle of the 20th century, many companies and American governments created pension plans for their employees’ retirement. The idea of a pension is certainly great in theory. But it practically has not performed as well or sustainably as other options we have now. Between the pension and the 401k/IRA, I strongly prefer the latter over the former.
My issue with the pension lies not in the idea, but in the general performance and projections of the pension versus 401k/IRA performance.
One of the biggest failures of a company with a pension system was Enron in 2001. For years, the company cooked the books and hid from shareholders and employees its true financial status. At the same time, its retirement and pension plans were greatly tied into the company’s stock value.
When Enron when bankrupt, nearly $2 billion of pension value was lost. Top executives went to prison for fraud. Former employees spent years fighting in court to gain even a small fraction of their pension’s value back. Many of these former employees had to find other jobs to pay their bills during what ought to have been retirement years.
Some state governments and local municipalities are dealing with probable failures in the future, as well. The state of Illinois, now famous for its “Pension Crisis,” is drastically under-funding its pension liabilities. The state has about $214 billion in pension obligations, but only has about $85 billion available to pay retirees.
Other states like New Jersey and Kentucky also have very large unfunded pension liabilities. These states’ credit ratings spiral downward each year. California has had to cut pension payouts over the years to keep the California Public Employees’ Retirement System afloat.
How the 401k and IRA Are Better
Even for pensions not facing such dramatic shortfalls, the returns are well below that of market mutual funds. The assumed rate of return for the CalPERS plan is about 7% (down from 8% in 2001). But the actual annualized rate of return has been more like 5.7%. Even a mediocre 401k does better than that pension’s performance!
For comparison’s sake, the S&P 500 index, since 1928, has had an average rate of return of 9.8%. There are periods within those decades where the compound rate of return was 18%. This happened in 1985-1999, for example.
At the beginning of July 2009, the S&P 500 was at 898. In the last week of June 2019, the index was at 2941, a tripled value in 10 years.
Many actively-managed mutual funds have outperformed this rate of return as well, going up to 11 or 12%. This exceeds the S&P 500’s average rate of return. You can find these funds more easily in your own retirement account.
Pension plans are often in a state of crisis and are underperforming the market in many way. The 401k and IRA plans offer individuals a greater variety of solid investments to choose from. Even low-expense, passively-managed funds that track the indexes offer much better rates of returns than pension plans typically do.
Private pensions sometimes do better. But they still do not offer the greater ownership and returns that are available in modern retirement plans.
One of the best aspects of 401k and IRA plans is that you have full control over your money. The pension is held by the company or the government. The pension’s value hinges greatly on that particular company or government’s ability to properly manage it.
With your 401k and IRA, you fully own it. And you can pass to your heirs whatever you do not use in retirement. That is usually not the case with a pension.
The Effect on Your Financial Outcomes
When you take control of your money, it empowers you to make better decisions for yourself long-term. You can protect yourself from individual companies or governments going bankrupt. There are dips in the market, but you controlling your money is always preferable to someone else doing so.
No one can manage your money as well as you can; not your employer’s human resources department, nor the government. When the choice is between the pension and the 401k/IRA, for me it’s the latter all the way!
Nearly 80% of American millionaires used their company-sponsored 401k plans and IRAs to achieve that status. With all the opportunities available in these investment accounts, it’s the obvious answer to the decline of the pension.
