Which retirement vehicle provides the better results for workers — a pension or a 401(k)?

Michael Hogue / DMN

The question is an important one right now, as the country's corporate pension structure continues to be dismantled in favor of worker retirement accounts like 401(k)s.

While other factors are at play, the answer to the question largely depends, of course, on how generous the 401(k) is compared with the pension.

And that comparison will never come into clearer focus than when your employer, as companies are doing seemingly every week, announces that it's freezing your pension plan and, in return (if you're lucky), will sweeten your 401(k).

Should that happen, you need to know if the effect on you will be a straight swap; an improved retirement picture; or, in effect, a cut in your compensation. (Hint: Don't expect a raise out of this.)

Experts say such a comparison is difficult to make, but not impossible.

"There is fundamentally no simple answer to the question of how all workers will be affected by a pension freeze," says Jack VanDerhei, a fellow at the Employee Benefit Research Institute.

But a report he issued in March offers some insight by figuring out how much larger a percentage of income would have to go into workers' 401(k) plans if their pensions were frozen, to ensure that the workers don't fall behind in retirement savings.

Generally speaking, when a company freezes a pension plan, benefits accrued to that point still will be paid to workers in retirement, but the accrual stops. The burden of replacing that benefit accrual falls to the 401(k).

There are many complicating factors, but for workers in so-called final-average pension plans, the replacement contribution to the 401(k) would have to rise by an average of 8 percentage points to cover the lost pension benefits, says Mr. VanDerhei, a professor at Temple University in Philadelphia and an expert on Social Security reform and pension planning.

That means, if the company offers a 3 percent match, the match would have to rise to 11 percent for the workers to come out even.

"These are the benchmarks you're going to have to hit in order not to lose money," he says.

If the match doesn't rise that much, then workers who don't want to fall behind on their retirement savings should increase their contribution so that the total contribution to the 401(k) rises by 8 percent of income.

For example, if you currently put 6 percent of your income into the 401(k), and the company matches that at 50 percent, or the equivalent of 3 percent of your income, then your 401(k) has been receiving contributions at 9 percent of your income.

To make sure you come out even, you'll have to make sure that the new contribution to your 401(k), counting the amount that comes out of your income and the company match, totals 17 percent of your income.

If this puts you over the allowable contribution to tax-deferred savings plans, then you'll need to save the money in an after-tax account.

Mr. VanDerhei stressed that the 8 percent is just a benchmark, representing the result for average-income, average-age workers in an average pension plan making an average return.

Generally speaking, for older workers, the new percentage would be even higher. To understand why, you have to understand how pension payments are figured.

Easier to understand

One benefit of the shift from pensions to 401(k)s, at least, is that 401(k)s are a lot simpler to understand.

Tom Setzer / DMN

For example, while most workers have a good idea of how much their employer matches in the 401(k), very few know how generous the pension is. Think back: When you started your job, you knew your employer offered a pension, but did you make sure you understood how the plan would calculate your monthly retirement checks?

"Most employees who have a pension plan have no idea what they will actually receive," says Michael Busch, president of Vogel Financial Advisors in Dallas. "The benefit formulas are rather involved, making it difficult for employees to assess the sufficiency of the income streams they will receive during retirement."

In most traditional pension plans — called defined-benefit plans, because you get the same defined benefit every month in retirement until you die — payments are calculated using a "final-average" formula.

A company typically multiplies the number of years worked by the average of the worker's three highest years of pay, times a percentage. Workers who stay with the same company throughout their career maximize their benefit because their entire pension is based on their highest level of income.

In a pension, the sharp accumulation of retirement benefits starts when people are in their 50s and early 60s, when their salary is highest.

"Older workers and loyal long-term employees will often be better off with a pension plan, which awards significant credit for length-of-service and places an emphasis on the salary level attained in the last few years before retirement," Mr. Busch says.

A 401(k) is called a defined-contribution plan, because the contribution is defined but the benefit you take from it in retirement is up to you.

You contribute part of your salary, and if you're lucky, your employer offers a match, meaning that for every dollar you save up to a certain amount, your boss will also make a contribution. That essentially is free money to you.

Generally, younger employees and mobile employees will fare better with a 401(k) plan, because it enables them to accrue benefits more quickly early on, and their accumulated balances can continue to grow with them as they change jobs, Mr. Busch says.

In other words, a 401(k) offers relatively steady savings growth over your career, compared with a pension.

Also, the investment risk is on you, and how much you accumulate in your 401(k) depends in part on how well your investments have performed.

Plan performance

That's important to note, because private 401(k) plans have underperformed traditional company pension plans by 1 percent a year, according to a recent report by the Center for Retirement Research at Boston College.

That 1 percentage point shortfall may seem insignificant, but compounded over time, it would result in a significant gap of funds at retirement, center director Alicia Munnell says.

That's something to keep in mind if your employer freezes your pension and leaves your 401(k) as your sole retirement vehicle.

Because a pension's benefits are loaded on the back end of your career, your age at the time your company freezes your pension is crucial. The older you are, the more you'll have to contribute to your savings — above Mr. VanDerhei's 8 percent-of-income benchmark — to stay even.

If your company doesn't sweeten your 401(k), or if your pension freeze is accompanied by a job loss, you're facing long odds of maintaining your retirement outlook.

"It's almost impossible at an older age for that to happen," Mr. VanDerhei says. "You'd have to put in so much per year. It's not technically impossible, but it's highly unlikely."

Ms. Munnell of the Center for Retirement Research agreed.

"It's just very hard to have a 401(k) generous enough for these midcareer employees to come out OK," she says.

401(k) advantages

But there's hope. A 401(k) does offer some benefits over a pension.

"If all you have is a 401(k) plan, that doesn't mean you don't have a fighting chance to get a decent meal upon retirement," says Don Phillips, managing director of investment research firm Morningstar. "More of the onus is simply on you to invest prudently and to save a reasonable amount."

A 401(k) provides more flexibility. Unlike with a pension, you can put your investments into aggressive or conservative investments, depending on your needs. When you die, your heirs get the balance of your account.

Upon retirement, you can put part of the money into an annuity, to provide a monthly guaranteed base of income like a pension check. Some of the money can be converted to an after-tax Roth IRA, to provide income-tax flexibility.

In our changing world, there's a lot to think about.

"When you think about a pension plan, people think in terms of a future retirement income," says Lynn Lawrance, a certified financial planner at Financial Network Investment Corp. in Dallas. "When you discuss a 401(k) plan, people think in terms of current salary deferral — not the amount they need to save in order to pay their bills for 20 to 30 years during retirement."

Bottom line: If your company freezes your pension, you have to make a big change in the way you think about your 401(k). And you'll probably have to increase your contribution significantly.

VERIZON COMMUNICATIONS INC.

Announced: December 2005

Description: Managers covered by defined-benefit plans stopped accruing benefits on June 30 of this year, at which point they received an 18-month enhancement to the value of their pensions. Managers hired after January of this year aren't eligible to earn pension benefits.

New arrangements: Verizon raised its match threshold for 401(k) plans from 5 percent to 6 percent of salary and increased its match amount from $1 to $1.50 for every $1 contributed to the plan.

INTERNATIONAL BUSINESS MACHINES CORP.

Announced: January

Description: Participants in the defined-benefit pension plans, the pension equity plan and the cash balance plan will stop accruing new benefits Dec. 31, 2007.

New arrangements: Benefits planned under the new 401(k) Plus Plan, beginning in January 2008, are as follows:

Pension equity plan participants receive a dollar-for-dollar match on the first 6 percent of pay deferred and a 4 percent automatic company contribution, for a total of 10 percent of pay. Nonexempt pension equity plan participants, who are administrative support staff, receive an additional special savings award equal to 5 percent of pay.

Cash balance plan participants receive a dollar-for-dollar match on the first 6 percent of pay deferred and a 2 percent automatic company contribution, for a total of 8 percent of pay.

Employees hired after Dec. 31, 2004, receive a dollar-for-dollar match on the first 5 percent of pay deferred and a 1 percent automatic company contribution after one year of service, for a total of 6 percent of pay.

SEARS HOLDINGS CORP.

Announced: May 2005

Description: All employees stopped accruing benefits in defined-benefit pensions in January of this year.

New arrangements: The 401(k) plan will have a company match dollar for dollar of up to 3 percent of salary, and 50 cents for every dollar of contributions on the next 2 percent of salary.