A pension system that needs fixing
The private pension system in the U.S. 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.
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 nine years, as I did, you did not receive a pension.
In accepting a professorship at the University of Pennsylvania, I also transited from the defined benefit pension plan of the bank to a 401(k) defined contribution plan at the university.
Under this arrangement, I assumed control over my pension. 401(k) 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, mainly 401(k)s. 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.
The weakness that has generated the most attention is that employees have not been saving enough in their 401(k)s 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 401(k) plan too burdensome to bother. For this reason, a large number of private-sector employees do not have access to a 401(k) at work. Legislation that would authorize plans covering multiple employers is now making its way through Congress with bipartisan support.
The post-retirement weaknesses in 401(k)-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 life spans. The employee who retires with a 401(k), 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 adviser 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 weakness of 401(k)-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.
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.
• Contact Jack Guttentag via his website at mtgprofessor.com.