Pensions or 401(k)s

Sat, 05 Mar 2011 19:05:44 +0000

I made a brief radio appearance on Marketplace Money yesterday, in a story with the same title as the post, asking which type of retirement plan is better.  The segment was motivated, I think, by this article last month in The Wall Street Journal decrying the inadequacy of 401(k) plan balances for near-retirees.The answer is that there need not be any important difference.  If I were tasked by a plan sponsor to provide an adequate retirement income for plan participants and to keep the plan properly funded, I could do just fine under either a defined benefit plan or a defined contribution or 401(k) plan.  It just requires a projection of the retirement income that is needed and a funding strategy of contributions and investment returns to get there.  What differs across the two plans is the exposure to risk and the responsibility for making choices. 

Under the DB plan, the plan sponsor makes all the choices, subject to federal guidelines about funding requirements.  Almost all of the problems that exist in DB plans come from the simple fact that some DB plan sponsors invest the pension fund in equity, use an equity-like rate of return to discount future liabilities, and avoid making any contributions beyond the required minimum.  When we get any of the last three recessions -- an asset market deflation followed by sharp reductions in interest rates -- they get a double whammy.  The fall in the stock market dramatically reduces the value of the pension fund's assets, and the reduction in interest rates dramatically increases the value of the plan's liabilities.  Voila, major underfunding.  The next steps are cram down for the plan participants and intense(ly successful) lobbying by plan sponsors to amortize the funding gap over several decades.  Or the PBGC has to pick up much of the tab -- more transfers from the prudent to the profligate.

Under the 401(k) plan, the question is one of adequacy rather than underfunding.  People could choose not to contribute.  (This is less common than is generally believed when the 401(k) is the only employer-sponsored pension plan.)  They could also choose to put their contributions in company stock (or the company's contributions could be required to be there, as in the Enron case), which is excessively risky.  Or they could invest too conservatively, not taking on enough risk to earn reasonable returns over their working lives.  There are other differences, like whether the benefits are paid out as an annuity or not, that could also be noted.

The other guests on the Marketplace segment, and the WSJ article, may in fact be correct that current near-retirees do not have enough accumulated to hit the standard of post-retirement income equal to 85% of pre-retirement income.  I think that's a ridiculously high target.  (The best research I have seen on this puts the amount of so-called undersaving at a much lower figure -- with perhaps 20% of people approaching retirement with inadequate resources.)  And when evaluating the title question for the post, it is the wrong standard.  The right comparison is to what people would have if they remained under a traditional pension plan, which itself may have been inadequate (even in the absence of cram down or reductions when the PBGC takes over).

My colleague Jon Skinner and I made that comparison in an article in the American Economic Review.  The result was that the projected distributions of retirement income were surprisingly similar under the old-style DB plans that were dominant in the 1980s and the 401(k) plans that supplanted them in the 1990s, assuming workers were covered by the same plan over a long career.  (The comparison was better for 401(k) plans when workers switched jobs -- vested deferred benefits under DB plans are often quite low.) 

In truth, this should not really come as a surprise.  The amount of retirement income that will come from pensions is determined by workers' willingness to give up current earnings for current pension contributions, regardless of whether they are making the contributions directly or the employer is (allegedly) contributing for them.  If 401(k) plans are proving to be inadequate, it is because we are a nation of inadequate savers, not because we had a great system of DB pensions that we no longer have.