How 401(k)s screw us all

[Philip Brewer]

Time Magazine has a really interesting article on 401(k)s and how inferior they've turned out to be compared with old-style pensions:

http://www.time.com/time/business/ar...929119,00.html

One point they make is that 401(k)s work great when they're new, because fresh contributions swamp market losses.

If you've only been in your 401(k) for a few years, even a 40% or 50% drop in your investments is only a small setback, because you're getting to make new investments at those same low prices--when the market recovers, the money you invested at the bottom will drive huge gains for your portfolio.

But things only work out that way if your account size is relatively small compared to your new contributions. A guy who's been making contributions for 25 years stands to lose a huge amount of money from a 40% or 50% drop in the market, and that loss isn't going to be made up by a couple years of contributions going in at good prices.

Most companies didn't switch over to 401(k)s until just 20 years ago. Most people retiring now had a traditional pension plan for at least part of their working life, and the 401(k) (as it was supposed to be) was only one piece of their retirement preparations. In the next few years, though, that'll change. Soon, lots of people will be hitting retirement age with nothing but their 401(k) and Social Security.

See the Time article for a preview of what that's going to look like.

[Ms. Ferret]

Interesting article. I have to admit I find the concept of pensions somewhat alien -- I have always assumed that Social Security would be broke by the time I was able to get anything out of it, and that I would have nothing but my own personal savings to retire on. The idea of a company that's around long enough to employ me for 30+ years straight, AND will even pay me money after I've retired? I'd say "oh sure -- maybe in fantasy-land", but clearly this kind of thing used to actually happen.

Having worked at 4 different companies in the last 10 years, I can't imagine being able to work for 40 years at the same (non-government) job. In today's layoff culture, you're super lucky if you manage to survive 10 years at one company without having your job shipped off to Bangalore.

[Julie Rains]

Even if you have multiple employers over the years (and most people do), you could still have a defined benefit (for example, a pension) rather than a defined contribution (the 401k plan) -- that is, you could get a certain amount (hopefully adjusted for inflation) rather than just knowing that contributed a certain amount.

My reaction is that it has been tough for the folks caught in the middle so to speak, losing pension dollars, getting trapped in 401ks that didn't perform well in many cases, and well before Roths came of age. I do think that the idea that you'd have loads of money in retirement has been over-hyped -- many pensioners are doing well but they still need to live conservatively and/or develop multiple streams of income in "retirement."

[Philip Brewer]

Besides the issue mentioned in the article (the difficulty in recovering from a late-career market drop), defined benefit plans offered a couple of other big advantages.

One was just that they were more generous. Employers have generally contributed (as matching or whatever) just 2% to 6% of a person's salary to their 401(k). (And, of course, considerably less these days.) Defined benefit plans were considerably more generous, especially to longer-term employers.

Aside from that, though, there's also the big advantage that it's a different kind of pool of money. I'm a big believer in keeping your assets in different kinds of pools of money--not just a 401(k) but also an IRA, a Roth, and ordinary savings. Adding a defined benefit plan to that gives you a whole other kind of diversity that can help protect you from various kinds of disasters--big drops in the market, bankruptcy, lawsuits, etc.

[The Wise Buck]

Originally Posted by Philip Brewer

Time Magazine has a really interesting article on 401(k)s and how inferior they've turned out to be compared with old-style pensions:

http://www.time.com/time/business/ar...929119,00.html

One point they make is that 401(k)s work great when they're new, because fresh contributions swamp market losses.

If you've only been in your 401(k) for a few years, even a 40% or 50% drop in your investments is only a small setback, because you're getting to make new investments at those same low prices--when the market recovers, the money you invested at the bottom will drive huge gains for your portfolio.

But things only work out that way if your account size is relatively small compared to your new contributions. A guy who's been making contributions for 25 years stands to lose a huge amount of money from a 40% or 50% drop in the market, and that loss isn't going to be made up by a couple years of contributions going in at good prices.

Most companies didn't switch over to 401(k)s until just 20 years ago. Most people retiring now had a traditional pension plan for at least part of their working life, and the 401(k) (as it was supposed to be) was only one piece of their retirement preparations. In the next few years, though, that'll change. Soon, lots of people will be hitting retirement age with nothing but their 401(k) and Social Security.

See the Time article for a preview of what that's going to look like.

The defined benefit plan is being somewhat phased out because most employers do not want the liability on their balance sheets. A couple things that have not been fully dealt with:

1) 2008 was a historic event - True, if you are 58 and you just lost 45% - you most likely became more conservative and you will not make all the gains back

2) There are a slew of private pension plans that are underfunded and will be VERY LUCKY if they are ever able to fund their obligations. Think GE, Chrysler, etc. Sure the PBGC is insuring them on paper - however, there is a growing concern that db plans and the enormous effort to save banks and other insolvent banks and financial organizations will eventually come to an end simply because there isn't any money left.

The clear message is that one literally has to take the matter into their own hands and use retirement accounts as helpful tools or the old "one side of the stool" equation -because nothing is guaranteed.

Mike

[Philip Brewer]

Originally Posted by The Wise Buck

The defined benefit plan is being somewhat phased out because most employers do not want the liability on their balance sheets.

Employers like to say that, but it's not really true. The real reason they want to get rid of defined benefit plans is that they're expensive. Eliminating a defined benefit plan is like giving everyone on your workforce a big pay cut.

The liability for pensions is on the books of the pension fund itself. The company has an obligation to keep the pension fund topped off, but that's predictable and can be easily funded, as long as the pension fund doesn't invest too much in risky assets.

The real reason that defined benefit plans are being phased out is that the resulting big pay cut doesn't seem to produce as much outrage by employees as a similar-sized cut in regular pay would.

[Xin Lu]

One point the article seems to miss is that most companies didn't have defined pension plans anyway. Most people work for small businesses in this country, and no company was obligated to offer a pension plan. 401k plans also fail because a lot of people do not contribute at all. Here's a good discussion on the Early Retirement forums about this article:

http://www.early-retirement.org/foru...1-k-46720.html

Basically, I think that defined pension plans and 401ks are really different animals. 401ks give you more choice to direct your money. You don't have to contribute to a 401k, but you should still save in some kind of investments because most companies will not offer you a pension anyway.

[The Wise Buck]

[quote=Philip Brewer;39683]Employers like to say that, but it's not really true. The real reason they want to get rid of defined benefit plans is that they're expensive. Eliminating a defined benefit plan is like giving everyone on your workforce a big pay cut."

The Liability IS the cost; that's no secret. The Pension fund is the Plan Sponsor's responsibility - which is the same thing as the company. Insured "Pension funds" are insured by the PBGC but they have requirements that fall back on the Plan Sponsor which is again the company.
Here are some statistics ·38,000 insured defined benefit plans today compared to a high of about 114,000 in 1985. The main reasons for this decline is the complexity and cost required and the movement to the defined contribution model.

The thing you have to keep in mind is that Defined Benefit Plans funding liabilities go up when something like 2000-2001 and 2008 occur. The (companies investment committees) are not much better and in a lot of cases in the same shape as the 59 year old with a few years to retirement. Who wouldn't prefer a fully funded DB pension plan at retirement? I understand many companies are changing horses on employees and the employees are worse off. But the unfortunate truth is that many companies are not going to be able to meet their obligations. Risky assets? If your pension fund was invested in the typical 60/40 equity fixed income split in 2008, you were no safer and had (in most cases a 30-47% decline) That's not because someone was writing naked credit derivative spreads or buying index puts, but because we had a waterfall event for most asset classes. Fixed income funds (safe investments) experiences losses >20%. "Easy to top off" I don't mean to be flip - but don't kid yourself. That's a major assumption and in this climate just not true for a lot of companies who are trying to meet payroll.

As someone who works as an ERISA advisor along side actuaries, I see it every day.
The "assumed interest rate:" used by actuaries, usually don't account for things like 2000-2001 or 2008. It's a great idea on paper (db Plans) and many plans are afforded the ability to run surpluses and are very employee generous. But the reality is that many are running deficits and can't make the contribution b'c their business is off - and it's not a philosophical change but a reality given the market volatility and weaker business conditions. So, they are freezing their DB plans and offering participants the choice of a DC Plan. In many cases the participants opt out and go to the DC or (401k - same thing) b'c they know they'll never be there long enough for the DB benefit to be meaningful.

Anyone relying or 100% certain their DB Plan is going to perform over the long haul is really making an assumption. Hopefully things "work out" as those who have worked the years deserve the benefit - but it's not as easy as saying all employers who are changing to the DC model are doing b'c they are less employee friendly.

Lastly, as much as I like the idea of the DB plan - and appreciate their simplicity, they were more practical in the 50s-70s when people stayed at 1 company for their career. Today, employees move from one place to the other - on average every 5-7 years. This is one of the reasons the 401k is considered a portable option.

I'm not arguing that there aren't bad apples (companies) who could do "the right thing" that opt to lower their costs. But the reality and today's business environment is a far cry from the simple generalization the DBs are better than DCs or 401ks.

[The Wise Buck]

Originally Posted by ford_jj

Interesting ang useful article. "I can't imagine being able to work for 40 years at the same (non-government) job." In china , worked for a company for 40 years is very normal.Most of the company are the government company.

Exactly and that's one of the reasons for the change in the model overall from defined benefit to 401ks (defined contribution). 401ks are portable and you take the account with you. But I hardly know of anyone that stays with a company for 30+ years, let alone 10. The DB model doesn't work if you are changing jobs every 3-5 years as the benefit is not rolled to your new employer. again,401ks are portable.

In the public sector (teachers, police, etc) they stay in the "system" for their career and the DB model makes more sense there. Florida School system has one of the more "healthier' pension funds however there are some states in worse shape.

[Philip Brewer]

Originally Posted by Xin Lu

One point the article seems to miss is that most companies didn't have defined pension plans anyway. Most people work for small businesses in this country, and no company was obligated to offer a pension plan.

This was less true than you might think. All through the 1940s, 1950s, 1960s, and into the 1970s vast numbers of people worked for the sort of big companies that offered good pension plans: big industrial companies like autos and steel, big conglomerates making everything from canned soup to cosmetics, aerospace companies, railroads, airlines, defense companies, and big local companies like paper mills and such. Collectively they employed a much larger fraction of the workforce than you might imagine. At the beginning of that period there were also vast numbers in the army, which pays a pension to those who stay in long enough (and that service also counted toward a pension if the person went on to work for the Federal government in some other capacity). And, of course, state and local governments, universities, hospitals, and so on still offer pensions.

People talk a lot about how small businesses "create most of the new jobs," which is sort of true, but also misleading. Business that stay small don't employ very many people. It's the occasional small business that succeeds and becomes a big business that creates lots of jobs.

So, lots of the people who have already retired did have a pension plan of some sort. It's only been since the late 1970s that retirement plans really started being phased out--and lots of those companies kept their retirement plans for people who were already in them, at least for a while.

The upshot is that we're only now just starting to see the beginning of the period where these people--the ones whose pension options were sharply curtailed in the middle of their career--are starting to retire. The article I mentioned at the beginning talks about them.

Soon, though--in just a few years--we're going to be starting to see people who never had a shot at even a modest pension reaching retirement age. A lot of those people are going to be in big trouble.