In recent decades, the 401(k) retirement savings plan has surged in popularity, gradually overshadowing traditional pension plans, also known as defined benefit plans.
This shift has been driven by several factors, including:
- the changing nature of the labor market
- the preferences of employers and employees, and
- regulatory changes
This article looks at the reasons behind the growing preference for 401(k) plans over pension plans.
Key Takeaways – 401(k) Popularity vs. Pension
- The shift from traditional pension plans to 401(k) retirement savings plans has been driven by economic and labor market factors such as rising labor mobility, declining union membership, and increased life expectancy.
- Employer preferences for cost savings, simplified administration, and attracting and retaining talent have also contributed to the growing preference for 401(k) plans over pension plans.
- Employee preferences for investment control and contribution matching, along with regulatory changes like the Revenue Act of 1978 and the Pension Protection Act of 2006, have further propelled the popularity of 401(k) plans.
Economic and Labor Market Factors
Rising Labor Mobility
Traditional pension plans are often tied to a single employer, making them less appealing for employees who change jobs frequently.
401(k) plans, on the other hand, are portable, allowing employees to take their retirement savings with them as they transition between jobs.
Declining Union Membership
Unions have traditionally been strong advocates for pension plans, which guarantee a defined benefit for their members upon retirement.
However, union membership has been on the decline in the United States, reducing the bargaining power of workers and leading to a decrease in pension plan coverage.
Increased Life Expectancy
As life expectancy has increased, the cost of providing pension benefits (i.e., contributions + returns vs. payouts) has also risen.
This has made 401(k) plans more attractive to employers, as the responsibility for retirement savings is shifted from the employer to the employee.
401(k) plans are typically less expensive for employers to maintain compared to pension plans.
Employers do not have to commit to a guaranteed benefit level and can shift some of the risk to employees, who bear the responsibility for making investment decisions and ensuring that their savings are sufficient for retirement.
Pension plans require complex actuarial calculations and financial management, increasing the administrative burden for employers.
In contrast, 401(k) plans are simpler to administer and manage.
Attracting and Retaining Talent
Offering a competitive 401(k) plan can be an effective tool for attracting and retaining top talent, as it demonstrates an employer’s commitment to their employees’ long-term financial well-being.
401(k) plans allow employees to have more control over their investments, selecting from a range of funds and making decisions based on their risk tolerance and financial goals.
This flexibility can be appealing to individuals who prefer to manage their own retirement savings.
Many employers offer contribution matching programs, which incentivize employees to save more for retirement.
This additional “free money” can make 401(k) plans more attractive to employees compared to pension plans, which do not typically offer matching contributions.
The Revenue Act of 1978
The creation of the 401(k) plan was made possible by the Revenue Act of 1978, which added Section 401(k) to the Internal Revenue Code.
This enabled employees to defer a portion of their income for retirement savings on a pre-tax basis, leading to the rapid growth of 401(k) plans.
The Employee Retirement Income Security Act (ERISA)
ERISA, enacted in 1974, established minimum standards for pension plans and other employee benefit plans, including 401(k) plans.
The increased regulatory requirements and reporting standards made pension plans more costly for employers to maintain, contributing to the shift toward 401(k) plans.
The Pension Protection Act of 2006
This legislation strengthened the funding requirements for pension plans and introduced new rules for automatic enrollment in 401(k) plans, further promoting the growth of 401(k) plans over pension plans.
How 401(k) Plans Work And Why They Killed Pensions
FAQs – 401(k) Popularity vs. Pension
What is the main difference between a 401(k) plan and a pension plan?
The main difference between a 401(k) plan and a pension plan is the way they provide retirement benefits.
A 401(k) plan is a defined contribution plan, where employees and employers contribute a specific amount to the employee’s retirement account, and the final benefit depends on the investment performance.
A pension plan, also known as a defined benefit plan, provides a predetermined monthly benefit to employees upon retirement, based on factors like years of service and salary history.
Why are 401(k) plans more portable than pension plans?
401(k) plans are more portable because employees can transfer their retirement savings from one employer’s plan to another or roll them over into an Individual Retirement Account (IRA) when they change jobs.
In contrast, pension plans are often tied to a specific employer, making it difficult for employees to maintain their benefits when changing jobs.
How do employer matching contributions work in a 401(k) plan?
Employer matching contributions are when an employer contributes a certain amount to an employee’s 401(k) plan based on the employee’s own contributions.
We’ll do some examples below:
The matching formula varies by employer, but a common example is a 50% match on employee contributions up to 6% of their salary.
This means that if an employee contributes 6% of their salary to their 401(k) plan, the employer will contribute an additional 3%.
For instance, if the employee earns a $100,000 salary per year, then if the employee contributes $6,000 per year to their 401(k), the employer will provide an additional $3,000.
So, from that vantage point, it’s like the employee making $103,000 per year.
Another common formula is a full match up to 4% of their salary.
For example, if we again assume the employee makes $100,000 per year, then if the employee contributes $4,000 per year to their 401(k), the employer will also chip in $4,000.
Essentially it’s like the employee making $104,000 per year.
Are there any downsides to 401(k) plans compared to pension plans?
One downside of 401(k) plans is that the investment risk is shifted from the employer to the employee.
In a pension plan, the employer guarantees a specific benefit, regardless of market performance.
In a 401(k) plan, the employee’s retirement benefit depends on their investment choices and the performance of those investments.
This means that employees need to take an active role in managing their retirement savings, which can be challenging for those without investment experience.
This is where the professional management of a pension plan can have a lot of value over the self-management of the 401(k).
Can I have both a pension plan and a 401(k) plan?
Yes, it is possible to have both a pension plan and a 401(k) plan.
Some employers still offer pension plans alongside 401(k) plans, giving employees the opportunity to participate in both types of retirement savings.
However, the prevalence of employers offering both plans has decreased as the popularity of 401(k) plans has grown.
It’s now fairly rare for employees outside unionized public sector professions (e.g., public school teacher, public law enforcement) to have pensions.
The rise in popularity of the 401(k) plan over traditional pension plans can be attributed to a combination of economic and labor market factors, employer and employee preferences, and regulatory changes.
These factors have collectively contributed to the increasing portability, flexibility, and cost-effectiveness of 401(k) plans, making them more appealing to both employers and employees.
As the labor market continues to evolve and retirement savings needs change, it is likely that the 401(k) will continue to be a popular choice for retirement planning.