What will happen to retirement security in the United States as traditional pensions fade away and 401(k)s take their place? The answer is actually not much. Most defined benefit pension plans are not going away. For the ones that are, the savings in 401(k) accounts can more than fill the gap.
By any historical standard, retirees are doing well. Their incomes have risen faster than those of working age households, according to the Federal Reserve survey of consumer finances. The share of retirees with private retirement plan benefits has nearly doubled, while the fraction of seniors living in poverty has fallen by almost a third. Just 4 percent of seniors in the Federal Reserve survey of household economics find it difficult to get by, roughly half the rate of the working age population.
But 56 percent of retiree households continue to receive benefits from traditional pension plans, according to a Census Bureau study in 2017. Those benefits totaled $398 billion in 2012, or around a fifth of all retiree incomes, coming to about $12,200 per retiree household. That is a big hole for 401(k)s to fill once traditional pensions go away, except traditional pensions are not going away, or at least not the ones paying the majority of retirement benefits. Participation in private sector pensions has shrunk from a peak of 39 percent of the workforce back in 1973 to just 13 percent today. However, a majority of all traditional pension benefits are paid from government retirement plans. Despite some funding woes of such plans, public pensions will continue paying benefits into the foreseeable future.
In other words, 401(k)s need to replace only about a third of the benefits currently being paid from traditional pensions. Can they do it? The evidence says they can. Over the past half century, private sector pensions held investments worth roughly 15 percent to 17 percent of gross domestic product. Last year, private sector 401(k) balances were worth 29 percent of gross domestic product, while individual retirement account balances, much of which were rolled over from 401(k)s when workers switched jobs, equaled 47 percent of gross domestic product. Moreover, the amount of 401(k) savings show no signs of having peaked. Therefore, the pension gap for 401(k)s to fill is smaller than commonly believed, while 401(k) assets are also larger than commonly believed.
Balances in 401(k) are higher for two reasons. First, more Americans have 401(k)s than ever had traditional pensions, which employers consider to be costly and burdensome from a regulatory standpoint. Second, workers and employers contribute to 401(k)s, while only employers contributed to traditional pensions. Labor Department data shows that contributions to private sector defined benefit plans equaled 3.8 percent of total private sector wages in 1975. Today, 401(k) contributions equal 6.8 percent of total private sector wages. There is simply more money going into 401(k) plans than traditional pensions ever collected, so 401(k)s can do the job.
Federal Reserve research this year finds that the transition from traditional pensions to 401(k)s had only minor effects on the actual distribution of retirement savings. Indeed, the rich hold much more retirement savings than the poor. However, the Federal Reserve finds that when the Social Security benefits of low income households are included, the poor have total retirement savings relative to their incomes that are just as large as middle and high income households. If savings have increased, but the distribution has not, this implies that most people have more saved for retirement using 401(k)s than they would have with traditional pensions.
To be sure, 401(k)s are not perfect, but they are improving. Automatic enrollment increases participation, target date funds shift savings from stocks to bonds as employees approach retirement, and low cost index funds have reduced fees over the years. Congress is considering the Secure Act, which would make it easier for small businesses to open 401(k)s as well as offer employees lifelong annuities when they retire.
Private sector traditional pensions were always small players compared to public sector plans, paying out roughly half as much total benefits spread out over nearly four times as many total retirees. This means that 401(k) savings can easily replace private pension benefits as those plans fade away. That is good news for retirement security in the United States.
Andrew Biggs is a resident scholar at the American Enterprise Institute.