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Can a 401(k) make up for a lost pension?
IBM, like many corporations, is euthanizing traditional pensions. Here's how one worker can use IBM's exceptional 401(k) plan to make up the difference -- though at a high price.
By Timothy Middleton
IBM jolted its employees two weeks ago when it announced it was extinguishing its traditional pension in favor of a 401(k) plan. It said it would save as much as $3 billion over five years, and employees suspect those dollars are coming directly out of their hide.
I will lose $900 a month because of the switch, says Linda Guyer, an IBM (IBM, news, msgs) project manager in Endicott, N.Y. IBM is shifting responsibility for retirement from themselves to the employees.
While traditional pensions remain the norm in the public sector, in private enterprise they are disappearing. Whether that is good or bad is debatable. Guyer is spot-on, though, when she notes that the risk of saving for retirement has been shifted to employees, at IBM and elsewhere.
But it is hard to dispute that IBMs 401(k) plan is the best in the nation. The investment options are by far the best, and the company match is generous. It equals as much as 10% of pay for long-term employees like Guyer, who joined the company in 1981, and 15% for those with lower-ranking jobs. Even new employees get a dollar-for-dollar company contribution of as much as 6% of pay after one year on the job.
Ive been writing about 401(k) plans for nearly two years, and while Ive found good ones, Ive found more that arent so good. Most plans waste a significant portion of employees money on needless expenses. And even thrifty plans often provide too few investment options to allow thorough portfolio diversification.
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IBMs investment officers have remedied both of those problems, and theyve gone further. Sophisticated investors can combine the 401(k) with a taxable account to maximize retirement income. I have never even heard this subject, which IBM calls asset location, raised outside the financial-planning community. But combined with the plans other attributes, this one virtually guarantees that IBM employees have the opportunity to more than make up for their missing pensions.
Filling the pension gap
Guyer is president of Alliance@IBM, a pro-union group seeking to organize IBM's work force. Her income forecast is based on IBM freezing pension benefits at 2008 levels, whereas she is 15 years from retirement. The shortfall does not include 401(k) benefits. If she were to join the plan today, and invest in the equivalent of what I described several months ago as the perfect portfolio of funds, I think she can triple her missing $900 with income from the 401(k). It will, though, mean reducing her take-home pay by more than $10,000 a year (based on assumptions I'll describe at the end of this column).
That perfect portfolio consisted of Vanguard Group index funds, which usually are the cheapest and best index mutual funds. IBMs 401(k) plan offers equivalent funds but with even lower expenses -- and therefore greater returns.
Some 99% of the $26 billion of assets in IBMs 401(k) plan are invested in institutional portfolios that charge total expenses of 0.1%. The remaining 1% is invested in mutual funds. The typical equity mutual fund charges about 1.5% in expenses.
If you can save even half a percent over 40 years, you end up with 20% more money, notes Jay Vivian, head of IBMs retirement division. Saving nearly three times as much is obviously better still.
IBMs portfolios are so cheap because they are index funds, managed for the corporation by Vanguard, State Street and Barclays, the three thriftiest operators of index funds. There are 23 of them, including the IBM stock option, which accounts for only 8% of plan assets. IBM makes the company match in cash.
The Thrift Savings Plan for federal workers, which is nearly six times as large as IBMs plan, charges only about 0.05% in expenses, but it has fewer than a dozen investment options. It does not offer such useful diversifiers as real-estate investment trusts and emerging-market bonds. IBM does, plus index funds tilted toward growth or value, another option the TSP doesnt offer.
The question of location
What about asset location? This recognizes that you can get optimal results from different types of investments by owning them in both taxable and tax-deferred accounts.
Thats because proceeds withdrawn from a 401(k) are taxed as ordinary income, whereas the rate for capital gains is lower. Weve got a lot of smart, relatively well-paid employees who want to save more than the maximum allowed in 401(k)s, Vivian says. If youre a smart investor, what do you do? You put the stuff that generates a lot of income in the 401(k) and the stuff thats not throwing off yield, like growth stocks, in a taxable account. In the long run, its better to hold that outside the 401(k) anyway.
So IBMs plan has six bond funds, allowing fixed-income investors to cover such bases as high-yield (also known as junk) bonds and inflation-protected bonds, as well as the typical offerings of corporate bonds and conventional Treasurys.
As Ive noted in earlier columns, the fundamental problem with 401(k)s is that most bosses dont bother, or dont know how, to wring maximum value out of a plan. Vivian and his staff of 25, which manages a total of $115 billion of pension funds worldwide, do know how, and they do bother.
IBMs 401(k) leaves me drooling. There is nothing superior to it that I know of. I nominate Vivian to take over the entire 401(k) industry. Then Id vote for him to take charge of private Social Security accounts. If Americans had access to those, and they were operated like IBMs plan, wed all retire richer.
My figures revealed
Heres how I arrived at my estimate of the amount of monthly income Guyer could generate from her IBM 401(k):
Im assuming a current salary of $100,000, of which she sets aside 15%, the maximum allowed this year. To that $15,000, IBM adds 6% of her salary in a dollar-for-dollar match and 4% whether she contributes to the plan or not.
This total of $25,000 is added to the plan every year, and the portfolio delivers a return of 6.02% after inflation, the same assumption used in the perfect portfolio column. She contributes for 15 years until she's 66, which is the first year she can retire with full Social Security benefits.
Obviously, this reduces Guyers take-home pay, although not dollar-for-dollar, since contributions are tax deductible. Setting aside $15,000 would reduce her taxable income to the point that it would cut her federal tax liability by $4,200 in the 28% tax bracket; that is, her cash flow is reduced by $10,800, with Uncle Sam's tax deduction effectively contributing the other $4,200.
In her first year of retirement, her 401(k) balance is $555,303. She can draw down $2,786 per month for life, plus her IBM pension, and still have the half-million in todays dollars to pass on to her heirs.
This is a conservative estimate. The perfect portfolio assumed annual ownership costs of 2%. IBMs expenses are 0.1%. Those savings could boost the portfolio to a total value, in todays dollars, of $639,694.
At the time of publication Timothy Middleton didnt own any securities mentioned in this article.
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