The private pension system in the
US is in transition from defined benefit plans to defined
contribution plans. On balance, this may be a step in the
wrong direction. The jury is still out, however, and much
will depend on how defined contribution plans evolve in the
future.
Essential Differences Between
Defined Benefit and Defined Contribution Plans
Early in my career I worked for the Federal Reserve
Bank of New York, which had a defined benefit plan for their
employees similar to those at most large firms. Under this
plan, the Bank contributed periodically to a reserve fund
earmarked for future payments to retired employees. The
promised future payment amounts were based on the employee’s
compensation levels and years of service. The pension
vesting period was 10 years, which meant that if you left
the bank after 9 years, as I did, you lost the pension
rights.
In accepting a professorship at the University of
Pennsylvania, I also transited from the defined benefit
pension plan of the Bank to a 401K defined contribution plan
at the university. Under this arrangement, I assumed control
over my pension. 401K accounts were opened in my name at
TIAA/CREF and Vanguard, into which I made periodic
tax-deferred contributions. With this type of plan, I vested
immediately in that the money contributed to the accounts
belonged to me.
Employers offering defined contribution plans may
or may not contribute to the plans. In many cases they offer
to match the employee’s contribution up to some maximum
amount. Employer contributions may be subject to a vesting
period.
While states, municipalities and public agencies
have continued with defined benefit plans, private business
firms have largely shifted to defined contribution plans.
This enables them to avoid the large balance sheet liability
generated by the commitment to provide defined benefits over
an indefinite future period. From a retiree perspective,
however, defined contribution plans have some major
weaknesses.
Pre-Retirement Weaknesses
The weakness that has generated the most attention
is that employees have not been saving enough in their 401Ks
to assure a comfortable retirement. With a defined benefit
plan, employees qualify automatically, but with defined
contribution plans they must enroll and authorize a
deduction from their paycheck. Short sightedness is part of
the human condition, it results in procrastination, which
results in underfunding. A number of initiatives aimed at
combating this problem are in process including automatic
enrollment.
A second pre-retirement weakness is that small
firms find the costs of administering a 401K plan too
burdensome to bother. For this reason, a large number of
private-sector employees do not have access to a 401K at
work. Legislation that would authorize plans covering
multiple employers is now making its way through Congress
with bipartisan support.
A Post-Retirement Weakness:
Unmanaged Mortality Risk
The post-retirement weaknesses in 401K-based plans
have not generated nearly as much attention. Perhaps the
most critical is the problem of managing mortality risk.
With defined benefit plans, the employer manages mortality
risk by spreading pension commitments across a population of
employees with different lifespans. The employee who retires
with a 401K, in contrast, is on her own. She knows how much
is in her accounts when she retires, and she can estimate
the future earnings rate on those funds, but she does not
know how long those funds have to last because she does not
know how long she will live.
The obvious remedy is to purchase an annuity, but
she will have great difficulty finding an investment advisor
who will support that decision. Many are hostile to
annuities, and none offer a service package that integrates
the management of financial assets with annuities.
Another Post-Retirement
Weakness: Unmanaged Home Equity
Another weakness of 401K-based plans is applicable
to retirees who have a significant part of their wealth in
their homes. The conversion of home equity into spendable
funds using a HECM reverse mortgage is ad hoc and separated
from the other elements of retirement planning. The retiree
has to do it on her own, just as she must purchase an
annuity on her own.
Concluding Comment
To deal with the two post-retirement weaknesses
identified above, I am involved in a project to integrate
financial asset management, annuity purchase, and the HECM
reverse mortgage into a coherent retirement plan. It is
called the Retirement Income Stabilizer or RIS. Stay tuned.
