If you work for a company that has 25 or more employees, chances are that you have a comprehensive employee benefits package. This typically includes health, term life, and disability insurance, with 50% or more of the cost paid for by your employer. Once you enroll in these benefits, unless there are personal or family changes, there’s generally no ongoing work required on your part to maintain them.
There’s one benefit that’s included in most private company benefit packages today for which this isn’t the case. 401(k) plans, which were introduced in the Revenue Act of 1978, dramatically changed the retirement planning landscape. Employer-provided lifetime monthly pension payments that were previously provided by defined benefit pension plans have virtually been replaced by these employee savings plans.
When compared to a defined benefit pension plan, a 401(k) plan is a much less desirable employee benefit. There are six deficiencies every plan participant needs to address in order to use them successfully as a retirement planning tool.
No Employer-Provided Pension for Employee and Spouse
From an employee perspective, a defined benefit pension plan is straight forward. Depending on years of service and final salary, a plan participant receives a monthly lifetime pension at no cost to the employee. 50% to 100% of the monthly income continues to be paid to a surviving spouse depending upon the income payout option selected.
A 401(k) plan, on the other hand, is an employee savings plan with no employer-provided pension. Traditional 401(k) plans provide for pre-tax employee contributions and tax-deferred savings. Contributions to Roth 401(k) plans, when offered, are made after-tax, however, they accumulate tax-free.
Retirement Savings Responsibility Transferred From Employer to Employee
100% of the cost of funding a defined benefit pension plan, including administration and benefits themselves, is borne by the employer. Other than administration costs and potential matching employer contributions, employees assume the responsibility of making contributions to 401(k) plans. Employer matching contributions, when offered, are typically limited to a percentage of an employee’s contributions with a cap on qualifying employee contribution percentages.
Limited Opportunities for Converting Plan Savings to Lifetime Income
A 401(k) plan offers diversified savings vehicles to accumulate funds for retirement. This typically includes a choice of mutual funds from the cash, fixed income, and equity investment asset classes. Given the fact that the focus is on accumulation, there are generally limited options, if any, for converting savings into predictable lifetime income streams.
Often Falls Short in Providing Adequate Retirement Income
Employees can count on receiving a predictable monthly lifetime income based on years of service and final salary with a defined benefit plan. Given the fact that this can be as much as 60% of one’s final salary, the combination of a defined benefit pension and Social Security often satisfies the majority of a retiree’s financial needs.
401(k) plans, on the other hand, are notorious for not meeting lifetime retirement income planning needs. Beginning with the fact that they’re simply a savings plan, they aren’t designed to provide sustainable lifetime retirement income. In addition, the ability to accumulate sufficient savings to generate a meaningful income stream is limited by contribution limits, employee and employer contribution amounts, and investment performance.
Requires Ongoing Employee Involvement
Unlike a defined benefit pension plan which requires virtually no employee involvement until it’s time to choose a monthly payout option, a 401(k) plan is a different story. Plan participants are faced with two, and sometimes three, decisions when they enroll in a 401(k) plan:
- Percentage of salary or fixed dollar amount they will contribute to the plan
- Allocation of contributions among available investment choices
- Allocation of contributions between traditional vs. Roth option assuming the latter is offered
The foregoing decisions need to be revisited whenever there are changes in salary, personal tax situation, and investment choices. In addition, participants need to decide if they will leave their 401(k) plan intact, transfer it to a new employer’s 401(k) plan, or roll it over into a traditional IRA if employment is terminated.
Needs to be Coordinated with a Retirement Income Plan
A defined benefit plan is designed to provide a known sustainable lifetime income stream. As previously mentioned, when supplemented by Social Security, the majority of one’s retirement needs can be met with this type of plan.
A 401(k) plan needs to be coordinated with other nonretirement and retirement savings plans to determine the amount of projected after-tax income that will be available to cover projected retirement expenses. Projected annual required minimum distributions from 401(k) plans as well as from all qualified retirement plans must also be considered.
A 401(k) plan can be a great vehicle for accumulating retirement savings. It’s important, however, to be aware that there are six deficiencies compared to traditional defined benefit pension plans that need to be addressed by plan participants when planning for retirement.
The six deficiencies of 401(k) plans transfer the retirement accumulation and retirement income planning responsibilities provided by defined benefit pension plans from employers to employees. 401(k) plans may need to be converted into, and/or supplemented by, sustainable income-producing investments to provide comparable lifetime income streams and reduce investment risk.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.