This week is National Retirement Security Week! Proclaimed by an official declaration from Congress in 2016, each year supporters of 401(k)-style defined contribution plans use this week to promote their products. We’ve decided to take back retirement security from the salesmen of the financial industry and focus on the most reliable source of retirement security: defined benefit pensions. On Monday, we discussed the true state of retirement security in the United States. In today’s post, we’ll highlight how defined contribution plans contribute to the retirement savings crisis. On Friday, we’ll wrap up by focusing on the strengths of defined benefit pensions.
Defined contribution plans really took off about three decades ago, in the early 1980s. Congress created section 401(k) of the tax code when it passed the Revenue Act in 1978. Defined contribution plans existed before then, but they were not very common. According to the Center for Retirement Research (CRR), in 1983, twelve percent of workers only had a defined contribution retirement plan through their employer. Most workers who had a retirement plan through their employer — which even then was only about half of workers — had a pension. CRR reports that in 1983, 62 percent of workers had a defined benefit-only plan and 26 percent had both a defined benefit and a defined contribution plan. This means that in the early 1980s, 88 percent of workers who had a plan had some kind of defined benefit pension.
After Ronald Reagan became president, his administration changed the IRS’s legal interpretation of section 401(k) of the tax code. This opened the door for more companies to exclusively offer defined contribution 401(k) plans to their employees. By 1998, 60 percent of workers had a defined contribution plan only and 40 percent had a defined benefit plan, either alone or with a defined contribution plan. This is a dramatic shift in just fifteen years.
The problem with defined contribution plans, like 401(k)s, is they are not a reliable or secure vehicle for retirement savings. 401(k) plans place too much risk on individual workers. These plans leave workers exposed to the ups and downs of the financial markets. During the financial crisis in 2008, many people lost a significant chunk of their 401(k) savings. These losses forced workers to delay a planned retirement or accept a lower standard of living in retirement.
Additionally, most working people recognize that they themselves are not investment experts. They may be highly skilled at their job, but that does not mean they know how to invest or how much to invest or which financial products to invest in. When 401(k)s were originally created, they were meant to be a supplement to Social Security and pensions for working people. This is why individuals were given so much choice in 401(k)s: it was something extra for employees to invest in as they saw fit to meet their individual needs and goals. The problem is that companies abandoned the pension portion of that “three-legged stool.” This removed one of the most secure elements of their retirement savings and left them with Social Security, which is really a floor to prevent elder poverty, and the much less secure defined contribution component.
As more Baby Boomers continue to retire, we are beginning to see the impact that the dominance of 401(k) plans has had on retirement security. Unlike pensions, 401(k)s are much more skewed in favor of high-income workers. Those in the top 20 percent of income earners are much more likely to have a 401(k) plan and have much greater savings in that plan. According to CRR, in 2016, 70 percent of people in the top 20 percent had a 401(k) and the median account balance for that group was $780,000. For those in the bottom 20 percent, only 25 percent had a 401(k) and their median account balance was only $26,700 – clearly not enough to retire with.
Workers who save in 401(k) plans also face higher fees, which eat into their savings. Workers face a number of fees associated with these plans, including both fees charged based on their specific investments and fees associated with the cost of the 401(k) plan itself. The Investment Company Institute, an industry trade group, offers a lengthy discussion of the wide variety of fees in their 2017 Fact Book. Since pension plans are pooled investments managed by professionals, fees are often much lower, which leads to higher returns. The Center for Retirement Research found that pension plans earn higher investment returns than 401(k) plans and attributed much of the difference to fees.
The shift from defined benefit pensions to defined contribution 401(k)s dramatically changed the retirement savings landscape in the United States. By 2016, 73 percent of workers had a defined contribution plan only. The remaining 27 percent had a defined benefit plan either alone (17 percent) or in combination with a defined contribution plan (10 percent). This shift has had real world consequences. As we mentioned in Monday’s blog post, senior bankruptcy has increased significantly in recent decades, in part due to less retirement income for seniors. If the current state of things continues, there is the very real prospect of millions of seniors facing either a lower standard of living or poverty in retirement.