Thoughts on 401k Plans vs Traditional Pensions

The recent 60 Minutes report on 401k plans (The 401k Fallout) has rekindled the debate over defined benefit vs defined contribution plan design and stirred a lot negative commentary on the adequacy of the 401k as the principal retirement funding vehicle for Americans. The broad market declines of 2008-09 left bare the shortcomings of a retirement system that solely depends on the decisions of amateur individual workers/investors. This article at the Huffington Post is representative of the negative commentary asking:

“Why didn’t we just keep company pensions, which worked fine for most people for years?”

Supporters of traditional pensions (defined benefit or “DB” pensions) rightfully point to the fact that traditional pensions are more efficient to manage than individual 401k accounts (defined contribution or “DC”) plans. Investment management costs in a DB plan are lower, for example, since assets are pooled. Moreover, active professional management of DB assets is likely to result in higher investment returns over time than can be achieved with 401k worker-directed investments.

Still, despite the efficiency advantage, there are good reasons why traditional pensions have been so widely abandoned:

• Portability – DB pensions “worked fine” particularly for the company man of the 1960′s – when the norm was to stay with an employer for a whole career. DB plans don’t work so well for today’s workforce where workers frequently change employers and even careers. Unless you get vested (minimum 5 years service typically required), quitting a job at a DB employer can mean leaving with nothing to show in your retirement account. 401k’s and other DC plans are portable, meaning you can carry accumulated retirement account balances from one employer to the next.
• Contribution Requirements- The funding gap in DB plans is filled by contributions from the employer. That is, each year an actuary assesses DB plan assets vs liabilities and computes an employer contribution amount that must be paid into the plan. When investments perform well, it is possible that the employer will have little or no contribution requirement – a fact that DB supporters point to as an advantage. Unfortunately, actuarially determined employer contributions tend to peak at the worst possible time – i.e. when investments aren’t performing, economic conditions are poor and the company can least afford the higher payments. Matching employer contributions to DC plans, on the other hand, typically are a much more stable throughout the economic cycle.
• Sustainability – DB plans are lifetime promises: work long enough to qualify, and the plan sponsor guarantees you a monthly annuity payment for the rest of your life. But like most long-term promises, the DB promise proved harder to keep as time wore on. Longer than projected life expectancies, accumulative costs of incremental benefit improvements, and global competitive pressures spurred companies to rethink the sustainability and risk of funding lifetime pension promises.

   
  “Why didn’t we just keep company pensions, which worked fine for most people for years?”

  Well, many organizations did keep them…particularly state and local governments. The same economic tsunami that has wreaked havoc on 401k’s has bludgeoned state and local pensions. Many, perhaps most, of these plans will be forced to raise taxes to fund lifetime pension promises made to millions of public employees. By the way, these tax increases will fall mostly upon people whose own retirement accounts have been severely eroded.

• Bloated Benefits – To make matters juicier, in coming months, the taxpaying public will learn just how rich state and local government DB pensions have become. Politics, collective bargaining, and incremental yearly benefit enhancements have combined to create DB pension programs where it is not at all unusual for retirees to get paid more in retirement than when they worked. DB pensions have been dubbed the “gift that keeps on giving” by some because of the seemingly neverending benefit improvements. The administrative efficiencies that DB supporters point to are marginalizeded when retirement ages are negotiated lower, expensive COLA’s introduced and “multipliers”¹ enhanced on a regular basis.

   
  “Why didn’t we just keep company pensions, which worked fine for most people for years?”

  My guess is that had it been somehow possible to set a fixed DB pension benefit at a uniform and moderate level (say 1% of salary per year of service with retirement at 65), not subject to constant bargaining and “enhancement”, DB plans might still prevail. As it is, many organizations saw the financial blackhole that DB plans were becoming and made entirely rational decisions to switch to the DC model.

To second guess the move to 401ks and assert that organizations should have just stuck with traditional pensions seems simplistic. The market downturn has revealed shortcomings in both the DC and DB retirement system models. The “ideal” pension plan policy that emerges from the current crisis hopefully will be a hybrid that includes best features from both DC and DB models.

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This article is an editor’s choice in the latest Carnival of Personal Finance at Weakonomics. Check out all of the informative personal finance blog articles at this site.

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Notes:

1. The multiplier in a DB plan is generally a percentage of salary earned for each year of sevice. A 2% multiplier would provide a pension equal to 60% of final salary to a worker who retired with 30 years service. [↩]