In the first post in this series, Are Pension Plans Good Ways to Save for Retirement, Part 1, we looked at both pension plans and 401k plans and compared both the benefits and dangers of each. This time we'll look at pension plans from a company perspective.
Let's say that you own a large company and have a pension plan. Your company has agrees to pay your employees a certain amount per month after they retire until they die based on their years of service and their salary while working for your company. Some plans also require employees contribute a certain amount of their salary to the plan while others do not. Because the amount the employee will receive is specified, a traditional pension plan is known as a defined benefit plan. How would you manage this to make sure you could pay your employees when the time comes?
Well, you would want to let the markets do most of the hard work for you, just as would any investor who was investing for retirement. You would need to make sure that you had the cash needed for employees who were currently retired or will retire soon, however. How would you approach this issue?
Well, for the people who were retired or will soon retire, you will have been making contributions for them and possibly been having them contribute for a significant period of time. You would have invested this money while they were still a couple of decades or more away from retirement so that they money could grow. The better your investment returns, the less you would need to put into the plan from your business. Because they would be retiring soon, you would start to transfer the money into cash, buy annuities (that pay a specified payout), and/or move money from stocks to bonds to reduce volatility and start to generate the income you need to make the pension payments.
For the workers who were just starting, you'd know that you had a long time before they are going to retire. Since you have a long period to wait, you would want to make your investment returns as large as you could while taking reasonable risks. Remember that if your investments are doing well, it reduces the payments that the company needs to put into the pension plan to keep it solvent. If investments do badly, however, they might need to add more, so they do not want to take any extreme risks.
How does this compare with a 401k?Really if you look at the way the pension plan is invested, it is similar to the way that you would invest a 401k. When workers are young, the company would invest mainly in stocks and other growth assets that can make good returns and that would grow with inflation. When workers are getting near retirement, the company starts to move money into cash, bonds, and other income investments that are less volatile to reduce the risk that a market move would cause there to be not enough money available to pay the pension payments.
Let's look at the risks of a 401k versus a pension plan:
Poor Investing:Pension: If a company's investment do poorly, such that the amount of money in the pension plan drops below levels needed for solvency, the company will be required to add more money to make it solvent. If the company fails, the pension will be covered up to certain limits by the federal government.
401k: If you invest badly, there is no one to bail you out. The company provides whatever they are going to provide at the start, and that is all they will provide.
Market event near retirement:Pension: The pension manager should be shifting funds needed for near-term retirees to cash, bonds, and other income investments. As long as this has been done, there should still be money to pay benefits while waiting for the markets to recover. If the pension manager does a poor job, the company will be required to add more money into the plan or the government will insure the pension up to specific levels.
401K: The investor should start shifting to income investments and cash as retirement nears to give him/her the ability to pay living expenses while waiting for the markets to recover. If this is not done, the investor may face difficulties in retirement and run out of cash quickly. There is no issue if you manage your account correctly (or get good advice from a financial planner), but could be a big one if you do not.
Pension: A good pension manager should be leaning towards stocks and growth investments for the portion of the pension plan covering the younger workers, but if they invest too much money in this way and the market falls, the company might be forced to add more money to the pension plan. Many managers would, therefore, err on the side of caution, reducing risk but also reducing long-term rewards. Note that since the reward is predefined (you won't get more money if the pension plan does really well), and because companies would tend to be cautious on what they would provide in the way of returns to make sure they can pay them with a bit of a cushion, possible returns will be lower than market returns.
401k: Properly invested, choosing growth assets early in career and shifting to income investments late in career, an investor can get better returns with a 401k than with a pension plan. Investors can also make bad choices, either moving money around, chasing returns, or investing too much in income (or worse, money market funds) early in their career. A pension manager will probably not make similar mistakes.
Pension: Should the economy collapse, the investments in the pension plan would be wiped out, as would the company. It is unliklely that the government, which gets its funds from the economy, would be able to bail anyone out.
401k: In the event of an economic collapse, 401k funds would be wiped out. An investor entirely in cash might be able to salvage some value, but inflation would probably quickly wipe out any cash reserves. Gold would be of little use since people can't eat gold.
hSo in conclusion, an investor who invests well in a 401k will probably do better than he/she will with a pension plan. A pension plan will provide a return below what is possible with a properly invested portfolio, and also tend to be more conservative in how they invest. The biggest reason that people tend to do better in pension plans than in 401k plans is the employee/investor. Too many people invest poorly, doing things like leaving all of their money in the money market fund or keeping all of their money in stocks when they are close to retirement. Even worse, many people take money out of their wo1k plans before retirement age - something you can't do with a pension plan. You are your worst enemy. If you can control yourself and just get a little bit of information on how to invest (or get a good investment advisor), you'll be better off in a 401k most of the time.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.