The disappearance of old-fashioned pensions is changing the way we think about retirement and how we pay for it.
Prudential Retirement examined the financial impact of having a defined-contribution plan like a 401(k) compared to having a defined-benefit pension, which is the old-fashioned kind. I found Prudential's conclusions troubling because they confirm the difficulty that ordinary people have figuring out how to save enough and how to structure that savings so it provides reliable income for 30 or 35 years.
First of all, Prudential found that 40 percent of retirees with old-fashioned retirement plans were satisfied with their financial situation, while only 27 percent of those depending on their 401(k)s and other defined-contribution plans felt similarly satisfied with their finances.
Prudential pointed out that old-fashioned pensions stretch the money more efficiently. The cost to deliver the same level of retirement income to a group of employees is 46 percent lower with an old-fashioned pension than it is with a defined-contribution or 401(k) plan. That's because old-fashioned pensions are based on the average life expectancy of their participants as a group, a number can be reliably predicted by an actuary. In contrast, an individual 401(k) participant cannot predict how long he or she will live. As a result, that saver needs to plan to pay for a retirement that could extend until the person is at least 95 -- maybe more.
Prudential's report confirms what careful investors know: Individual investment expense rates affect how much money a saver in a 401(k) plan needs. While the going wisdom says that a retiree can safely draw down 4 percent, adjusted annually for inflation, and feel confident that he won't run out of money, that calculation doesn't adequately reflect investment costs, Prudential calculates. With only 60 basis points of expenses -- pretty low by most measures -- the safe withdrawal rate drops to 3.2 percent, according to Prudential, which isn't high enough to provide a comfortable retirement for most people.
Retirement planning is also less predictable with a 401(k) than it is with a defined-benefit plan. Savers are heavily affected by fluctuations in the financial markets. Prudential found that a 1 percent increase in the Standard & Poor's 500 index in any given year increases the probability that an employee will retire earlier than predicted by 2.5 percent. The study didn't look at what happens when the market goes south, but it doesn't take a mathematical genius to conclude that a 1 percent market decline would have the opposite effect.
Prudential did this study to point out to its employer customers, for which it manages company 401(k) plans, that making the switch back to some kind of defined-benefit plan or other plan with a guaranteed minimum withdrawal benefit -- GMWB is an increasingly popular acronym in the retirement planning business -- could pay off in cost and workforce stability.
It also could make lots of retirement savers happier.