Chuck Jaffe recently had a good retirement article on Marketwatch. He covered a number of topics, especially longevity estimates, but he also had the most succinct explanation of the difference between how a pension and a 401k plan works. Here it is:
In the days when corporate pensions were the primary supplement to Social Security, Americans were able to generate a lifetime income, effectively, by putting everyone’s lifetime in a pool, then saving and managing the pooled assets to meet the target.
The individuals in a pension plan would live out their lives, but the actuaries and money managers would adjust the pool based on the life experience of the group. Thus, if the group had a life expectancy of living to age 75 – which statistically would mean that half of the pensioners would die before that age, and half would die afterwards – longevity risk was balanced out by the group experience.
Now that we have shifted to making individuals responsible for generating their lifetime income stream, there is no pool that shares the risk of outliving assets.
The bold is mine, but the distinction should be pretty clear. With a pension plan, you’re covered if you live a long time—because your extra payouts are covered by the early mortality of some of the other participants. It’s a shared-risk pool.
In a 401k, there’s only one participant. You. In other words, you’re on your own.
With a 401k, the only way to cover yourself adequately is to assume you are going to live a long time and save a lot to reserve for it. If you’ve got enough assets to cover yourself to age 100, the most negative outcome is that your heirs will think very fondly of you. If you are covered for only a few years of retirement, you’ll need to either keep working, eat Alpo, move in with your kids, or possibly take up motorcycle racing and sky-diving. None of those sound like great options to me.