There is an inconvenient truth about retirement savings. Unless people are forced to save, they won’t save. At least not enough to make a meaningful dent in what they need for retirement. That is why Defined Benefit pensions are the perfect retirement savings tool.
How much does the typical family have saved?
Data from the Federal Deposit Insurance Corp (FDIC ) indicates that the median American household only has $11,700 saved. That includes both regular bank accounts and retirement accounts.
Even with more than 10 straight years of economic expansion and job growth, the household savings rate in the U.S is only 8.3% according to data from the U.S Bureau of Economic Analysis.
401k’s are not getting the job done
As I’ve written in the past, the 401k is an incredible tool to build wealth. A 401k is a kind of defined contribution pension. You deposit money into the account and your employer will match the money you deposit up to a certain limit. Usually 5% of your salary. Another critical thing to understand about your 401k is that you must choose how to invest the money in the plan.
A well informed, completely rational person could use a 401k to easily build long term wealth. They would immediately enroll in the plan and contribute at least enough to get the full match from their employer. This is essentially “free” money. That money can be invested in a tax-sheltered account, slowly building wealth over the long term.
The problem with the 401k
As I’ve just laid out the 401k is the perfect retirement savings tool for a well informed rational person. However, 401k’s have one very fatal flaw; people are neither well informed or rational.
401k and other Defined Contribution (DC) pension plans require people to make a lot of choices.
- First, many DC plans and 401k require the employee to choose to opt into the plan. Many employees fail to do so as soon as possible which reduces their income during retirement.
- Second, under a DC or 401k plan, the employee must make all the investment decisions. Since our human brains tend to make bad investment decisions, most people tend to invest aggressively when they should be cautious and too cautiously when they should be aggressive.
- Third, when it is time to retire, employees under a DC plan must decide how to live off their retirement nest egg. The now-retired employee must decide how to ensure their nest egg can fund their retirement while at the same time ensuring they do not outlive their money.
The more choices people are forced to make, the more chances to make the wrong choice or worse, make no choice at all. That’s why 401k plans are perfect on paper, but in reality, they have failed to help many people save enough to fund their retirement.
What is a Defined Benefit (DB) pension?
A Defined Benefit (DB) pension plan provides employees with a guaranteed income during retirement. Typically, a DB pension is funded equally between employee and employer contributions. How much a retired employee will receive each month is determined by several factors;
- Number of years the employee worked for the company
- The employee’s career earnings
- The percentage of income the DB plan aims to replace
It’s probably easiest to demonstrate how a DB plan works with an example.
Let’s say you worked for a company that provided a DB plan that aimed to replace 2% of your average salary for each year you worked at the company.
Let’s also assume that you worked at this company for 30 years and during that time your average annual income was $50,000.
How much would you expect the pension to pay you each year in retirement?
$50,000 X (2% X 30) = $50,000 X 60%= $30,000
Based on what we know about this DB plan you would expect to bring in $30,000 in retirement income.
DB plans are designed to be more generous the longer you work at the company. In the above example, if you had worked at the company for 40 years rather than 30, your annual pension income would increase from $30,000 to $40,000.
Why Defined Benefit pensions are the perfect retirement savings tool
There is a simple reason DB pensions are so effective; they only require employees to make one decision, what age they want to retire. Let’s review all of all the decisions the employee in the 401k or DC pension plan had to make and compare that to a DB pension plan.
- Most members of 401k and DC plans have to choose to enroll, whereas most DB plans have a mandatory enrollment. If enrollment is not mandatory, employees must choose to opt-out rather than opting in. This dramatically increases the enrollment rate.
- Recall in the 401k and DC plans, employees have to choose how to invest their money. Under a DB plan, the employee has no control over how the money is invested. This is typically decided by a pension committee.
- Finally, in a 401k or DC plan, employees have to decide how to live off their retirement savings without running out. The retired employee with a DB pension does not have to worry about that, they know exactly how much income they will have during retirement.
In full disclosure, I should mention that my wife and I both have DB pensions and I wish at times we had DC pensions. I am an economist who is obsessed with personal finance. I am among the minority of people who would be comfortable making the various decisions required in a DC pension.
Personally, I would value the ability to have more flexibility in my pension. For example, given my age (31), I would invest more aggressively than my pension committee which has elected for 60/40 stock/bond allocation.
My personal preferences aside, there is no question that the vast majority of people would be much better off if they had a DB pension. We have enough decisions to make and things to worry about on a daily basis. Removing the choices required under a 401k or DC pension would put most people in a much better position.