This is National Retirement Security Week. Typically, this week is used by the private investment industry to promote their products, such as 401(k)s, that provide little in the way of actual retirement security for working families. On Monday, we documented the many ways in which 401(k)s fail to provide an adequate retirement for most workers. Today we’re going to look at how pensions can meet the retirement needs of working families.
Defined benefit plans are designed to provide a specific level of income in retirement, after, say, 30 years of work. Thus, the adequacy of the benefit is considered upfront. In contrast, 401(k) plans are often designed based upon a certain level of contributions and there typically is no feature that automatically adjusts those contributions to deal with events over time – like a stock market crash or an unexpected disability. That fact alone means that a worker with a pension is likely to enjoy a greater degree of retirement security than a worker who contributes 3 percent to a 401(k) and is unable to re-evaluate whether it’ll provide enough income in retirement.
Auto-enrollment and auto-escalation are Wall Street’s answer to 30 years of failures – basically, give them more money. But, as pensions have stronger returns and lower fees, Wall Street’s so-called solution is to be inefficient with more of your money, instead of building around a more efficient plan structure.
Defined contribution plans, such as 401(k)s, are not designed to provide the same level of retirement security as defined benefit pensions. Originally, 401(k)s were not intended as replacements for pensions, but as supplements to them. The reforms to defined contribution plans in recent years are geared toward making them more like pensions.
Imagine you are a public school teacher participating in a defined benefit pension plan. The employee contribution rate for your pension plan is 6 percent (the national median). Your employer, in this case the local school district, contributes an additional 6 percent toward your pension. You and your employer are contributing a combined 12 percent each year that is then invested and managed by professionals until you retire. Without even taking into account rate-of-return differences on pensions and 401(k)s, contributing 12 percent of your pay toward your retirement will mean you are better prepared for retirement than someone in a 401(k) plan, who may only contribute 3 percent with a small or no employer match. When you consider how much more efficient pensions are, it’s easy to make the argument that one of the virtues of defined benefit pensions is that they force people to save for retirement.
Other recent “solutions”, such as the increased use of target date funds, are intended to help employees avoid making poor investment decisions with their 401(k)s. Unfortunately, this often comes with another layer of fees – one for the lifetime fund manager, on top of more fees for the sub-funds. Pension funds, on the other hand, are professionally managed and achieve higher returns than defined contribution plans – even though, on average, 401k’s had much younger participants (who could invest more aggressively) during the years that were studied. Pension plans can also typically negotiate lower management and investment fees, although that is not always the case.
Defined benefit pensions are the best retirement plan for working families. Employees are automatically enrolled in the pension plan and the amount the employee contributes is predetermined. The contributions of all the employees and employers in the plan are pooled together, so no single individual bears all the market risk of their investment. These pooled funds are then managed by investment professionals, who can achieve higher returns and with lower costs. When it’s time for the employee to retire, they can count on the security and reliability of their pension benefit for the rest of their life. They also don’t have to decide how to spend their accumulated savings, since their pension benefit is paid out monthly in amounts determined by the pension benefit formula.
In addition, it’s really hard to know how long you will live. But, when there are thousands of people in a pension plan, plan managers have a really good idea how long they’ll live on average. This risk-pooling makes planning easier, and it is a key concept that explains why insurance makes sense (it also explains why pension plans rely so heavily on actuaries).
Defined contribution plans, such as 401(k)s, will never be able to provide the same level of retirement security as defined benefit pensions because they are not pensions. A worker retiring today who saved $100,000 will only be able to get income of about $400 a month from their savings – or $4,800 a year with no cost of living adjustment. Very few workers, aside from wealthy corporate executives, will be able to save enough to have a secure retirement with the inefficiencies of 401(k) plans.
If we are going to truly honor the spirit of National Retirement Security Week, then cities and states must commit to maintaining pensions for their public employees and they must consider ways to expand access to pensions for working families.