Will Replacing 401(k) Plans With Portable Pensions Fix Retirement Planning?

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Traditional Three Legged Stool of Retirement
(post, image via Michigan.gov)

Over the weekend, I finally got around to reading this Time magazine article about Why It’s Time to Retire the 401(k) which has been getting some buzz. The author promotes bringing back what I call “portable pensions” to replace the employee-controlled 401(k) plan, which would guarantee say 50% of your last year’s salary for the rest of your life. Sounds nice, but how will it work, and who’ll pay for it?

Take the Mr. Shively in the article, who is still working at 68. About 25 years ago, his employer dropped the pension and replaced it with a 401(k). Over those two and a half decades, he has managed to save $70,000 in a 401(k). Yet it is suggested that if only his company kept the pension, he would be getting $1,308 per month, or $15,700 a year. Such a lifetime of cashflow from age 65 would cost at least $200,000 according to ImmediateAnnuities.com ($250,000 if joint, covering a spouse also age 65). Where did the $130,000-$180,000 difference come from?

Pensions are more expensive to run than 401(k) plans. Let’s say you have average employees making $50,000 a year and you match 100% up to 5%. That costs $2,500 a year – bang, you’re done, and you don’t have to worry about investing the money to meet future liabilities. Where does the savings go? Either Shively got paid more (through higher salary or matching contributions) and didn’t save it, or his employer pocketed the savings, or likely a little of both.

This brings us to the other problems of the 401(k) system are, which were explored in this 2001 Barron’s article by William Bernstein after the last stock market crash. “The 401(k) is likely to turn out to be a defined-chaos
retirement plan.”

Employees are not saving enough. Will this be fixed by a portable pension? Only if employers are willing to pay higher total compensation, which is unlikely. Otherwise, will people really be okay with forced savings like an additional mandatory 5-10% contribution? Folks tend to see that as a tax, like Social Security.

Investors are depending on future market returns which will likely not be as high as in the past. The idea of gaining 8% per year, 5% after inflation, sounds nice but may not happen in the future. Current P/E ratios are still above average current. This means people will need to save even more than they thought. Again, where will this money come from?

401(k) expenses are too high, which reduces returns even further. Having a guaranteed income for life requires insurance companies. Which means instead of mutual fund expenses, you’ll have hidden insurance fees and guaranteed returns that will have to be significantly less that market returns. If more transparency and direct competition existed, perhaps the costs could be minimized.

Investors have poor investing knowledge. This is kind of an unsaid reason of why 401(k)s are bad, because there will always be those invested poorly. My concern is related to this recency bias. 401ks got traction initially because markets were hot at the time. Talk of pensions increase now because the recent performance was awful. What happens when the markets get hot again? Will people be happy with their 6% steady increases when others are gaining 30% in year?

I’d like to see what happens with this “portable pension” idea, but the practical realities concern me.

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Comments

  1. The Time article was an interesting read and definitely food for thought over my morning coffee. It’s true that not everybody a) has the income to max out a 401(k) or b) the investing knowledge to make sure they are making the right allocations as they get older, and as the article pointed out, the market conditions at the time they retire heavily affect their returns. I like the idea of a private portable pension plan as yet another option. The government has social security; let the portable pensions be run by private companies. For people who haven’t been contributing to some kind of investment retirement (be it 401(k) or IRA) and are getting close to retirement or who have limited investing knowledge, this would probably be a great option for them. Perhaps if you are in a portable pension, you can pay less into social security OR your employer can pay in some as well. This option would put my mind at ease regarding my parents who have worked for small businesses all their lives and had no retirement option with those employers. They have traditional IRAs that they have been funding for the past 10 years or so, but I haven’t yet had the talk with them about whether or not it’s going to be “enough” when they do retire.

  2. I agree. There is this principle called “money doesn’t grow on trees.” For the employees to receive more in pension, somebody has to put in more money. When the employer isn’t willing to pay as much as they did in the pension plan (that’s why they terminated the pension plan), the employees will have to contribute more.

    The risk does not magically go away in a pension plan. If the employees want to shift the market risk away from themselves, they will have to pay somebody to take that risk. That’s another added cost.

    Sure it would be nice if the employer continued to pay the cost, take the risk, and give the employees a pension. When the employer decided they weren’t going to do that, employees have to take up the slack.

  3. I never understood the hatred for annuities in PF Blogger world. Couldn’t the person in your example consistently invest in a variable annuity with some sort of guaranteed rider for income?

    Who cares if the fees equate 2%, 4% or 5% – if the insurance company (who you have to trust to be worthy of your money) is willing to provide you 4 or 5% gains for income purposes (in what is usually referred to as a ghost account) – then who cares about fees?

    Just a thought.

  4. Yes, I’ve read research about this topic, and employers with defined contribution plans usually contribute much less than employers with defined benefit plans.

    That said, I think it would be nice if there were some way to have a “portable pension,” even if it were largely employee-funded. I envision something like a fixed annuity, where each employee contribution increases the ultimate payout at retirement. Rather than building up a big 401(k) balance and then annuitizing it at the end, an employee could see at age 40 that he had already purchased, say, $500/mo. worth of retirement annuity, and adjust his contribution accordingly.

    This would have to done with private insurance companies, not the government, so that the money would actually exist and be invested somewhere!

  5. Of course to readers of Time, pensions sound like a good deal. Who wouldn’t want something (i.e. a pension) without having to pay for it? Oh yeah, everyone in America who keeps voting for deficit-spending politicians every election. I guess that’s, what, 99% of the population?

    Think for a minute about how ridiculous of a concept pensions are. (Your “Where does the $$$ come from?” question is exactly right!) How can a company promise to pay an employee a certain % of their salary for the rest of their lives? American companies in particular are on the lookout for quarterly performance with some basic long-term planning, but to assume you can meet an obligation to workers 40-50 years in the future makes no sense when you consider that there are probably zero companies in the US that have a 40-year plan. The basis for that payment is based on unknowns… future returns, whether the company will exist in the future, whether the pension will remain fully funded… the entire concept is the same as social security or any other pyramid scheme. Why should a company take on those kinds of risks with so many unknowns?

    CalPers is example #1 of this. If you want to see what is wrong with everything about pensions, just look at how California manages its own public employee fund.

  6. I take issue with the way a few things are characterized in the linked article:

    * The author states that the accounts are particularly bad for those close to retirement. He makes no mention of asset allocation or other strategies to manage this. You can even purchase annuities in many 401(k) Plans, which would alleviate much of this concern.

    * He cites the average balance in the 401(k), but this doesn’t measure the funds that people have in total across more than one account. I have a modest 401(k) balance in one account, but it hardly shows the whole picture. If he means to say that people aren’t saving enough, I agree entirely, but this isn’t the best way to illustrate the point.

    * Coming off of the second deepest recession in history makes it pretty easy to show how pensions would out perform a 401(k), but it leaves out a critical detail. Pensions themselves are invested in the market. The real difference is that pensions must be invested in more traditional assets while the 401(k) permits the account holder to seek more risk. The fact that most people choose to be weighted in equities in their 401(k) overlooks the fact they could choose largely the same conservative strategy of a pension.

    This ultimately comes down to choice. A portable pension is a good option for many but I fail to see why it should be achieved by limiting the breadth of choice that people presently have with the 401(k) route.

  7. In 20-30 years, the same people who have been complaining about “inner city poor” sucking at the government teet will probably be at the government’s doorstep as they are unable to work but need income.

    There is not enough money for a safety net. The social security system was a brilliant idea. It’s too bad it was abused.

    Personally, I hear all the time from my peers, “I’ll never be able to retire.” We’ll see if that acceptance still sticks at the age of 70. Many in my age group, late-20s, blew a large chunk of their 401K on a downpayment in 2006 and haven’t recovered from either the housing market or the stock market. Now they just talk about gold.

    In additon, many are saving just 3% of their annual salary. Sorry, that’s just not going to cut it.

  8. How about giving me a private SS account instead of making me pay into the current system?

  9. Ugh. Pension systems are also rife with underfunding, etc.

    I mean, I am in business. It’s common practice for actuaries to ask what you want to put away into retirement funds (pensions). They’ll make it work – whatever you want. They can assume unreal rates of returns and low inflation, etc., etc.

    I’ll take a 401k, ANY DAY. But I am happy to take responsibility for my retirement. Heck, I prefer to control it myself.

    I know the average American is not saving enough. But let’s face it, if they want their employer to take care of it, then they trust their employer to be good stewards of their retirement. They don’t realize that their compensation will decrease by however much their employer has to pay to administer and fund a pension. (The whole money doesn’t grow on trees thing, as mentioned – people don’t understand it has to come from somewhere).

    I’ll agree – 401ks are a failure. Thing is, pensions are too.

  10. Half of all babies born in America in 2007 will live to be 104 – http://www.nytimes.com/interactive/2009/09/08/opinion/20091019_opart.html – the experiment of privatizing retirement planning is a social experiment we will all be a part of.

    There’s a really interesting post on this topic at dshort.com – http://dshort.com/articles/2009/retire-the-401k.html

  11. I get Time magazine, and I read that article. I was unimpressed. I refuse to have pity for those that retired right when the market was low. The market is just a lottery. Some people win and some people lose. However anybody that put in 40 years of working and invested properly should have done fine no matter when you go in and when you go out as long as they weren’t gambling along the way. Some people *did* get screwed when their pensions were cut, but that’s not an argument to get rid of 401K’s…just an argument that pensions shouldn’t have been taken away.
    Another error in the article was when it talked to about the later years being more market controlled. Well if you wisely start moving your money out of stocks as you grow closer to retirement that becomes a nonissue.
    The key to it all is education. This should be taught in high school and before. I work at a school and I use Vanguard for my 403B. I’m amazed how people choose other companies besides Vanguard even though they charge about 2% more for the same funds. That money really adds up! If they knew what they were doing was more or less the equivalent of going to a car dealership and buying a car for 80,000 that they could get elsewhere for 20,000, I think they would act differently.

  12. I’ve never understood why private employees let companies get rid of their pension plans. I wish someone would explain that to me. Code section 401k was never written to be the retirement plan for the entire private workforce of America, and it should come as no surprise that people are now wondering if it was a good idea.

  13. 1. Raise the SS retirement age to 70.

    2. Make all income subject to payroll taxes.

    This will ensure that SS will be there for everyone who needs it so that old people will not live in poverty. As for the rest, let people save a certain amount in their IRAs and 401ks tax-free if they so choose, and stop tinkering with it. We can’t guarantee every retiree a beach house.

  14. Great article, interesting read.

    Only comment really:

    “401(k) expenses are too high, which reduces returns even further. Having a guaranteed income for life requires insurance companies.”

    Shouldn’t it read Pension fund expenses are too high? If not, I misunderstood something.

    Best,
    PLA

  15. These days it’s tempting to get a bigger mattress! I only wish there was a way to go strictly portable on our 401k(s). Being stuck in a place with poor choices for managers is just plain un-American in my view.

  16. BlueCollarDollar.com says

    Based on the fact that 401(k)’s are essentially tax events, the wrong agencies are stepping in to try and fix an IRS problem.

    Here is what I suggest: Consider making the tax deferred deduction on the 401(k) contribution twice what it currently is and you will, in essence, give the employee a raise. You could force a minimum contribution and surprisingly, it might not even be noticed. As many of you already know, 5% barely changes your take home pay. But getting an additional deduction would.

    The IRS could take it one step further by then fixing the withdrawal tax table. Many of us don’t know what we will be taxed when we retire because we don’t know what we will be able to withdraw. The IRS could place a 5% cap on anything under $20,000 a year, 15% for all additional annual draw-downs. Upper tier investors would want to pile in and this would have the net effect of raising all investor boats. (To recover much of this lost taxable revenue, reducing the contribution limit by a thousand dollars to $15,500 would force those who could invest that sort of money to pay the taxes and put the money in a Roth. My roughest calculations show that it would add $10 billion a year to the coffers, offsetting the increased dedcutions.)

    The IRS could also penalize those tax returns (in the nicest way possible) and tax any over payments in excess of $500. This would be directed to a group 401(k) that would be directed towards a state sponsored target date fund (even though I don’t like them much, for this purpose, they may be custom made). When the person applies for retirement benefits, this fund would be added to their benefits and because it was already taxed, it would could not be taxed again. Applicable tax rates for 401(k)s would also apply on any interest gained.

    Harsh medicine? Perhaps. But the end result would be more money to spend now, more money to spend later and more money that many would not have. All by changing the tax code.

  17. Abolish SS tax and Federal Income taxes. Return to sound money. Tell people they will have to take care of themselves. I’m sick of all this government control of my money.

  18. “There is this principle called “money doesn’t grow on trees.” For the employees to receive more in pension, somebody has to put in more money.”

    Exactly. I work for the company that used to have a really nice pension plan. I am actually going to get a small part of it: the plan was changed a couple of times (for the worse) than frozen at end of 2007 level.

    Yep, it was nice…. But it was all great when my employer had virtually no competition. But when the competition increased and a lot of smaller companies didn’t provide pensions, pensions and a lot of other nice things (like medical care in retirement or full employment policy) went out the window. Now, with our collegues in other countries willing to work for less, we should really be lucky we have a job.

    The old pensions aren’t coming back. With people living longer, with outsourcing, they are a nice dream.

    401K is just an ability to put money in a tax deferred account. It doesn’t have to be in stocks – most 401K have stable value, for example, that actually have had pretty nice average return in the last 10 years. It is also not the only way to save. One can still save after tax money and not just in Roth. Nobody said that savings have to be labeled specifically “for retirement” to be used in retirement. All saving and investment accounts that aren’t spent are going to be there in retirement.

    @BlueCollarDollar.com:
    “You could force a minimum contribution and surprisingly, it might not even be noticed.”

    This would penalize people who have no employer match and very bad choices in 401K. Shouldn’t somebody whose employer has only employer stock in 401K be able to opt out and just stash the money elsewhere?

    As to the rest of your post: fixing max 401K contribution at $15500 would mean eliminating inflation adjustment. This is why we have higher limit today than 2 years ago – adjustment for inflation. Eliminate the adjustment, and in a few years the contributions amount would be ridiculously low. Also, your idea of taxing people who save more is essentially penalizing savers for spenders. One doesn’t need to be very rich to contribute the max. Plus, since most people’s salaries rise with time as are their contributions, you’ll be penalizing older people. Like me for example: when I was younger and earning less, I could only contribute up to company match. Now that I am older, have higher salary and am closer to retirement, why shouldn’t I be able to contribute “this kind of money”. Your post, actually reeks of envy to people “who can contribute this kind of money”. 20 years from now you may be one of these people.

    Y

  19. Ugly American says

    This is a tax to replace the fact that nobody with any choice wants to buy our worthless government bonds any more.

    The government will force us all to ‘contribute’ to the new system which they will then continue to squander on corporate hand outs and wars.

    The government will continue to lie about inflation and tax back the benefits as it pays them out in monopoly money.

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