More Proof Pensions Better than 401(k)s

A new study out of the consulting firm Towers Watson reports that from 1995 through 2007 pension returns bested 401(k) returns by an average of one percentage point per year, on an asset-weighted basis. The old-fashioned defined benefit plan surveyed delivered an annualized 10.13 percent return over that cycle, while 401(k)s posted an annualized 9.06 percent gain. While 2008 was a down year all around, pension plans still outperformed by the same one percentage point differential.

The $300,000 "cost" of 401(k)s That one percentage point differential makes a deceptively huge difference over decades. In a simple hypothetical I concocted, we're talking $300,000 over a lifetime investing span. I started with a $100,000 401(k) balance. I then presumed a $650 monthly investment (that works out to about half the annual max allowed in 2010). Over 25 years, the higher defined benefit (pension) rate would generate an $883,000 nest egg compared to $737,000 based on the lower defined contribution (401(k)) rate of return. Stretch it out to a 30-year time horizon and the differential is $300,000 ($1.5 million vs. $1.2 million.) I want to stress, that's just a crude hypothetical; you don't invest in a pension directly, nor is money set aside in a personal account for you on a periodic basis. And in real life, your 401(k) contributions will vary from year to year. But the example gives you a good idea of the "cost" of earning lower returns.

What the Pension Pros do Better A main driver of the performance difference seems to be that the pros are better at sticking to a sound allocation strategy. Check out the performance below among asset-weighted plans: During the internet bubble years of 1997-1999 pension funds lagged, but their outperformance was most pronounced in the bear market years of2000, 2001 and 2002.

Now here's a snapshot of the average equity allocation in both types of plans. Notice the DC plans (401(k)s) had their highest stock allocations as the market peaked in 1999 and then again in 2007.
An Increasingly Moot Comparison It's not as if you and I can choose a pension. If only. Fewer than 20 percent of private companies currently offer a pension. Watson Wyatt found that among Fortune 100 companies, just 45 percent still offer a defined benefit plan, down from 90 percent in the late 1990s. But it's another data point that suggests 401(k)s are a suboptimal retirement vehicle for Americans, potentially to the tune of hundreds of thousands of dollars over an investing lifetime.

The potentially good news is that a large part of the underperformance is self-inflicted. You can help close the performance gap in your own 401(k) by acting more like a professional pension manager: have a solid diversification strategy, and then rebalance at least once a year.