401(k) Plans: Wrong Cure for Pension Blues

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California is having a long-overdue and welcome debate about public pensions. As I’ve detailed elsewhere, many public employees have pensions far more generous than those in the private sector, and larger than needed to provide retirement security.

Unfortunately, many of those coming to the debate enter it with the unexamined assumption that abolishing public defined-benefit pensions in favor of 401(k)-type defined contribution accounts can provide retirement security for public workers at much lower cost to taxpayers. That’s not necessarily so.

As anybody knows who’s been paying attention the last couple of years, the do-it-yourself retirement system based on 401(k) accounts isn’t exactly what it was cracked up to be. The personal finance pages, at least in the papers that still have them, read these days like a daily diary of shattered illusions. Millions of people who thought to they were on a path to a secure retirement now find themselves, thanks to the financial meltdown and the shortcomings of the do-it-yourself system, unprepared for the future.

“The median household headed by a person aged 60 to 62 with a 401(k) account has less than one-quarter of what is needed in that account to maintain its standard of living in retirement,” the Wall Street Journal reports. And they are the lucky ones. Millions of workers, many who toil for employers that offer no retirement plan at all, have less than $1,000 of retirement saving outside their home equity—assuming they have any left after the collapse of the housing bubble.

The financial collapse underlined one of the well-known weaknesses of the do-it-yourself system: It exposes workers to the huge risk of market declines and unfavorable interest-rate environments as they approach retirement age and seek to turn their accounts into an annuity that will protect them against outliving their saving.

But that’s just the beginning of the problems:

  • It is a system that provides workplace retirement savings opportunities to only half of workers.

  • In the name of choice, it lets workers decline to participate;

  • lets workers who do participate save too little and leave employer contributions on the table;

  • lets workers who move from job to job cash out their accounts in lump sums that they too often spend instead of rolling over;

  • lets workers borrow from retirement accounts, loans that are often not fully repaid;

  • lets them invest too much in the stock of their own company or not enough in assets like stocks needed for adequate returns over a lifetime;

  • lets private financial firms skim off a large chunk of savings for overhead and profit, depressing the investment return on accounts.

In short, it’s not a very good system, whether for private workers or public. Micah Weinberg and I propose a better approach—a cash balance plan—in this report.

And then there’s the issue of cost. As the Wall Street Journal article notes, some of the shortfall in 401(k) accounts stems from employers and workers’ contributing too little to the accounts. Financial advisers are now recommending annual contributions of up to 15 percent of wages to assure adequate savings for retirement.

To put that in perspective, the state this year is contributing 14.7 percent of payroll for state industrial workers and 17.5 percent for state miscellaneous workers. These amounts include funding for the survivors death benefits and disability benefits, which would have to be paid for separately.

In other words, replacing defined benefit pensions with 401(k) plans is only likely to yield significant cost savings if 1) contribution rates were set at levels too low to provide adequate income in retirement; 2) the burden of contribution were shifted from taxpayers to workers; 3) the 401(k) plan were also imposed on firefighters, police, and prison guards (the state pension contribution for the California Highway Patrol is 30 percent of payroll and 28.6 percent for prison guards and firefighters).

Pursuing item 1 would be mean-spirited and short-sighted. State and local governments are already negotiating item 2: new union contracts are raising the amount workers contribute to their pension. It’s not necessary to go to 401(k) plans to achieve contribution savings.

That leaves the area where the big pension dollars and abuses live: in the area of public safety, with its huge pensions and early retirement ages.

But as we’ve seen in Wisconsin and in the Meg Whitman campaign, conservative politicians seem worried about pension reform only when it concerns the unions whose members typically have vaginas. They avert their eyes when it comes to public safety pensions. You’ll know they are serious about reform when they take on the unions whose members typically have penises.