Investing for retirement in the US: Old school pension vs 401k.

Other countries may have similar analogues, but from my experience, the United States has structured many things correctly to encourage people to invest in the stock market. Take the 401(k) system, for example — a retirement account that employees can manage themselves. Its potential is far greater when the money is invested in an equity index fund rather than parked in low-yield government bonds, as is often the case with many traditional defined-benefit pension plans.

A retiree can accumulate substantially more wealth through a 401(k) because those extra percentage points of annual return from equities work their magic through long-term compounding. The reason is not rocket science, yet it is still insufficiently appreciated by many investors: fixed income is an excellent wealth-preservation tool, but at current interest rates it is, at best, a mediocre wealth-building tool. Real wealth creation happens in the equity markets.

If you already have a substantial nest egg, then by all means, remain cautious and conservative by investing in government bonds to preserve your portfolio’s purchasing power. However, if you are building wealth from scratch, what are you doing holding 3–4% interest paper?

401(k) retirement accounts in the U.S. give ordinary people the freedom to participate in wealth creation through stock ownership. Of course, there are horror stories of financially illiterate individuals or gambling addicts burning through their retirement savings by withdrawing funds early or investing in reckless ventures. Such behavior would have been nearly impossible in the old days, when everything was controlled through government-managed pension systems. In that sense, the system is a double-edged sword.

Yet, with the benefit of hindsight, it is plain to see that giving individuals control over their retirement investing decisions has been an enormous wealth-creation engine for disciplined and financially literate Americans. Defined-benefit pensions certainly provide stability and peace of mind for people who know little about finance, and they should continue to exist as an option for parts of the workforce. However, pensions typically die with the retiree, whereas a 401(k) can be passed on to the next generation as an inheritance — creating opportunities for descendants down the line.

I did a simple comparison to demonstrate how a 401(k) investor could potentially end up with far more retirement income than someone relying solely on a traditional pension.

A defined-benefit pension is often calculated by taking the final salary and multiplying it by 1.6% for each year of service. Assume 40 years of work and a final salary of $100,000. That would result in a pension of roughly $5.3k per month — not bad.

Now let’s examine the same scenario using a 401(k) invested in stocks. Assume an average salary of $80,000 over the career, with the employee contributing 6% annually and the employer matching another 6% — a common arrangement at many companies. The stock market has returned around 11.7% annually over the past 50 years, but let us conservatively assume a 10% return instead.

Over 40 years, this savings arrangement would grow to approximately $5.1 million. If the retiree withdrew 5% annually from the portfolio, that would amount to roughly… drum roll… $21k per month.

All I can say is: viva la free markets, and viva la the American 401(k) retirement system!