March 9, 2011

Comparing a Pension and a 401k

Would you rather have a pension or a big fat 401k match?   I think a lot of people would automatically answer that they'd prefer the pension.   I'd tend to agree.   But how much better is the pension?   What if one job has a 401k and pays 25% higher salary and the other job has the pension?   Would the higher wages make up for the lower retirement benefit?   If you're comparing between a 401k and a pension it helps to know how much each is 'worth' in the end.   Thats not exact as there are several variables involved.  But we can do a simple approximate comparison by figuring the pension benefit at a given retirement age then comparing how much annuity you'd get from the funds in a 401k.

Lets look at three hypothetical options:

Pension #1 : The pension benefit is equal to the years of service / 55 x the average of the last 3 years of wages and you can retire at age 60.

Pension #2 : The pension is worth 1.65% x years service of the final 5 years pay average and retirement age is 62.

401k plan  : The plan pays 100% match on the first 6% of pay.

I'm going to assume that your 401k investments get average annual growth of 10%.   I don't think that you should depend on getting 10% growth consistently but I'm picking a number just to make the example.   To be more realistic you should probably figure the value of your 401k for a range of returns from lows of 5% to highs of 12% and then expect something in the middle.   For simplicity today I'll stick to just 10%.

Now lets say that three different people start working at the age of 30 making \$40,000 a year.   One of them takes pension #1, one takes pension #2 and the other has the 401k plan.   Each person works 32 years at the same job until they are age 62 and then they retire.   They get 3% average pay raises over the years and end with a salary of \$103,000 approximately.

Pension #1 : 32 years / 55 x average of last 3 years = 32/55 * \$100k = \$58,000 annual pension
Pension #2 : 32 years x 1.65% x average last 5 years = 32 x .0165 x \$97k = \$51,200 annual pension
401k plan : Employer benefit of 6% of pay with assumed 10% annual growth would equate to a lump sum of about \$710,000 in the plan at retirement from the employer match

Now which would you rather have?   Clearly pension #1 is better than pension #2.   But would you take the \$58,000 annual pension or the \$710,000 lump sum in a 401k?

To answer that you should really figure out how that \$710,000 balance in the 401k compares too the  \$58,000 in annual pension benefits.0

WE can equate the lump sum to a pension by seeing how much of an annuity benefit you could buy with the \$710,000 at age 62.   You can get quick example quotes on immediate annuities via ImmediateAnnuities.com  If you bought a 100% joint survivor annuity then the \$710,000 would get you about \$43,300 per year.   But that doesn't account for a cost of living increase which most pensions have.   If the pension has a COLA then you'd have to reduce the annuity payout by roughly 30% to get an annuity with a COLA to compare.   So the \$710,000 in the 401k equates to a pension benefit of roughly \$30,000 per year.

Now lets back track a step.   Remember that pension #1 lets you retire at age 60.   That actually makes a big difference.  If you only work to age 60 and stop then the 401k would have two less years to grow.   If you only worked to 60 then the 401k would only grow to about \$576,000 which would buy you an annuity worth only \$24,000 a year.   But with pension #1 you could retire at age 60 with a pension of about \$51,000 a year.

Not all pensions are as generous as the examples given here.   Some pensions require the employee to contribute half the money from their salary.  Some pensions have lower benefits.    For example today the basic Federal Employee Retirement System (FERS) pension pays out 1.1% per year of service.

Bottom Line:    Comparing pensions and 401ks is really an apples to oranges comparison.   But you can figure how much a pension is worth by equating it to a lump sum and vice versa.

[edit Mar. 10, I added a little detail after the fact to clarify some points ]