HOW DO DEFINED CONTRIBUTION PENSION PLANS AFFECT RETIREMENT?
September 22, 2004
Economists Andrew A. Samwick and Jonathan Skinner, writing in the American Economic Review, finds that defined contribution pension plans such as 401(k) are as good as or better than defined benefit plans in providing for retirement.
Their research compares the rates of return of defined benefit (DB) plans, which were most common two decades ago, and defined contribution (DC) plans, such as 401(k)s, that have risen to prominence since 1993:
- DB plans are characterized by firms promising to pay their workers an annuity based on a set of formulas related to the worker's age, years of service and final average pay.
- DC plans typically involve the employer matching the contributions made by their employees, commonly ranging from 10 cents to a dollar for each dollar paid in by the worker.
There have been concerns about whether the rates of returns offered by 401(k) plans are comparable to traditional pension benefits, and that workers would spend their pre-retirement money early. However, the economists conclude that even after controlling for the extraordinary gains made in equity markets during the 1990s, 401(k) plans performed exceedingly well:
- For the average individual, 401(k) plans yielded roughly the same benefits as defined benefit plans between 1983 and 1989.
- Since 1990, all but the most risk-averse person would prefer the expected return of a 401(k) plan to a defined benefit plan.
Despite some ongoing concerns with 401(k) plans, such as inadequate contribution rates, Samwick concludes that the trend toward DC plans has strengthened the retirement security of current workers.
Source: Andrew A. Samwick and Jonathan Skinner, "How Will 401(k) Pension Plans Affect Retirement Income?" American Economic Review, March 2004.
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