How to Lose Your 401 (k)

This article appeared in The Washington Post on June 12, 2007.
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Would you favor a promise from your employer of a regular pension after retirement? Or would you prefer your regular paycheck to include money to save and invest for retirement? Careful folks would ask two questions before deciding: (1) How good is the employer’s promise and (2), how much more pay would they receive without that promise?

These two ways of preparing for retirement — deferred compensation by way of a pension during retirement and higher gross pay that workers could themselves save and invest for retirement — are known respectively as “defined benefit” and “defined contribution” plans.

Neither approach is without pitfalls. Recently, however, defined contribution plans have been criticized rather unjustly. For instance, a Washington Post “Financial Futures” column last month highlighted a Society of Actuaries’ report lamenting that employers’ switching to defined contribution plans put “too much responsibility on individuals — creating too much risk of failure.” It claimed Americans’ retirements would be more secure if they remained with employers and government pension fund managers.

Assuming that the actuaries who make such claims are disinterested commentators, are those claims really true? Are public and private defined benefit plans more secure, more beneficial and better suited to today’s economy than IRAs and 401 (k) plans? We think not.

For much of the last century, defined benefit plans were popular because they allowed employers to bind workers to the firm to secure their investments in worker skills. And workers’ could accrue retirement income to supplement their Social Security benefits without having to master investment skills. But under defined benefit plans, employers were responsible for eventually setting aside enough money and investing it wisely to meet future pension obligations.

The last few decades, however, witnessed many defined benefit plan terminations. They occurred because employers of bankrupted firms had funded their plans insufficiently; or they had promised generous pensions that adverse market developments later rendered unsupportable; or because firms’ pension funds were raided via hostile takeovers. The last few decades have, therefore, also witnessed a switch from defined benefit to defined contribution plans. Under the latter, the responsibility to save for retirement resides with workers who must decide for themselves how much of their paychecks to allocate toward retirement and how to invest and manage those funds.

The shift to defined contribution plans and individual retirement planning is better for American workers under today’s considerably faster pace of technological change. It reduces employers’ incentives to retain workers with outdated skills. And it compels workers to adapt to changing market conditions by upgrading skills. This has created greater worker mobility across firms, sectors and occupations. In turn, that calls for greater portability of pension assets — which defined benefit plans cannot sustain.

Supporters of defined benefit plans often claim that those plans — whether in the form of private pensions or Social Security — are less risky than defined contribution plans. But saying so doesn’t make it so. Concerning public pensions, the combined Social Security and Medicare unfunded liability is approaching $90 trillion, and we cannot predict with any confidence how it will be resolved. The likely political fallout from cutting Social Security benefits or increasing payroll taxes inhibits politicians from addressing Social Security and Medicare. But that “government failure” hinders workers’ ability to assess the risks to their overall economic security when planning for retirement.

Concerning private defined benefit plans, the waves of defaults in recent decades, the poor protection levels offered by the Pension Benefit Guarantee Corporation, and the corporate desire to dispense with the “legacy costs” of retired workers speak to the uncertain security in this form of retirement saving.

The supporters of defined benefit plans also lament that workers would not participate adequately in defined contribution plans, would likely contribute too little if they did, and would invest their savings too conservatively. There is some evidence of low enrollments by younger workers in defined contribution plans. However, there is also evidence that those workers do enroll after a few years. Moreover, delays in enrolling may be warranted by other spending imperatives — such as acquiring more skills, a professional wardrobe, paying for children’s schooling, making mortgage payments, paying off education loans, and so on that require more immediate attention.

Defined benefit plan supporters also argue that workers lack the financial savvy to manage their own retirement funds but recent evidence shows this claim to be untrue. A study of the Employee Benefits Research Institute shows that 70 percent of savings in tax–preferred saving plans — IRAs and company 401(k) plans — are directly or indirectly invested in equity securities, as is appropriate for long–term savings.

Yet another lament is that workers are vulnerable to unforeseen events that could wipe out their defined contribution retirement savings. But the same would be true of assets in defined benefit pension funds: As the LTCM and other debacles have shown, even savvy investment managers are not immune to large losses from unforeseen financial market developments.

The concern is not about saving per se, but about insuring that saving. One approach is for the government to insure retirement savings. However, social insurance programs have worked more as tools for politicians to acquire electoral advantage by awarding new and more generous benefits without regard to future fiscal consequences. That’s not insurance — it’s just robbing (the yet unborn) Peter to pay today’s (voter) Paul.

If ever it becomes necessary, a government bailout of retirees could be implemented via normal tools of public finance: deficit–financing benefits to retirees in response to a widespread failure of financial institutions. Special social insurance programs for retirement security don’t work and seem anachronistic in the presence of today’s globally diversified capital markets.

Contemporary world capital markets have become increasingly integrated and new financial instruments are expanding the distribution of various types of risks among those who can efficiently hold them. These capital market dynamics provide increased protection to savers. It no longer requires special skills to acquire access to the most diversified financial instruments — just a modicum of knowledge about the advantages of low‐​cost index funds.

As ex–Fed Chairman Alan Greenspan recently noted, the most salient lesson of the past decade is the enormous resiliency demonstrated by the U.S. economy despite significant disastrous economic and financial shocks. That speaks volumes about how much economic flexibility and strength new information technologies, financial instruments, and investment options have introduced over the last few decades. defined contribution plans constitute and important element of those developments. They are not perfect, but dismissing the important role they play is like making the perfect the enemy of the good.

On the whole, workers can be trusted to oversee their own retirement savings — or, at least, they are no less trustworthy than politicians and employers. The shift toward defined contribution plans appears to us as a move in the right direction.