Replacing Defined Contributions

I think that it is pretty certain that defined contribution [DC] plans 401(k)s, 403(b)s, 457s, much as they have grown to be dominant, have been a failure.  Many, though not all people like the illusion of control, and seeing their cash balance — makes the pension plan tangible, even if they don’t get what they will really need at retirement.

Pension plan reform has to face three realities.  The first is people don’t know how much to put away for retirement.  I’ll give you a hint: for almost all people, it should be over 10% of your gross pay.  The second is that people don’t know how to invest, so hand it off to advisors who will do it for them, and cheaply.  The third is silent, and leaves a lot of money on the table — most people would be better off taking an annuity from their pension plan than a third party, or trying to manage a lump sum on their own.  This is usually an option only for defined benefit [DB] plans.

On the last point, annuities from insurance companies will almost always be inferior to those from DB plans — the investment policy of the DB plan will likely yield more than the investments of the life insurance company.  The DB plan has more ability to take risk, and its expenses are lower.

And speaking of lower expenses, that’s another reason to replace DC plans.  Not only do DB plans provide better security, they have lower expenses.

But employers don’t want to fund expensive DB plans, particularly in a low interest rate environment.   Fine, that’s not what I am arguing for.  I am suggesting an odd sort of DC plan:

  • Participants can contribute what they wish
  • Employers can contribute what they wish
  • Professionals manage the assets; no asset management by participants.
  • During active employment, the cash balance can transfer with a change of employment.
  • At retirement, it converts to a DB plan, and an annuity is granted, more generous than could be obtained privately.  The retiree does not get the agony of managing a lump sum.

I think this would lead to much better results for plan participants.  The case would have to be made to participants that they have not done well managing their own funds — they will underperform by less through third party managers.  Also, few are good at managing lump sums for income.

This is the sort of plan that would yield better results for most, given that DB plans are out of favor, and participant-directed DC plans lead to high expense lousy results.  Best to have a hybrid plan.  Trustee-directed DC plan for accumulation.  DB plan for distribution.

That’s how I would structure it at present.  Better ideas are welcomed.  Thoughts?

8 Comments

  • You’re not replacing voluntary defined contributions, just restricting choice within that model.

    The problem most people have with saving for retirement is the saving-enough part, not the asset management part. Save enough, and the rest isn’t that important. Don’t save enough, and the rest won’t matter.

    If you’re talking about society-wide, I’d worry about impacting the ‘saving-enough’ part before I’d focus on the asset-mangement part.

    If a person is saving enough, but not capable of optimally investing those savings, I’m not sure how to encourage them to manage better while not making them feel that someone is taking away control.

    And if a person isn’t saving enough, your plan won’t help that.

    Net-net, your plan seems the same as current voluntary-contribution 401k plans, only you remove two choices currently in the individual’s control: asset management, distributions. Your proposed options already exist (target-date or conservative/moderate allocation funds; private annuities), you just want to make them mandatory.

    I agree with you that most people will not make the best choices, but people’s desire for control of ‘what’s theirs’, coupled with current distrust for financial institutions as a trusted fiduciary, means your plan faces an uphill battle.

    From one perspective, Social Security is not too dissimilar from what you propose (although non-voluntary-but-lower contributions, with lower investment returns and distributions), and there was a serious movement to loosen SS up and allow beneficiaries to have MORE say in managing that plan. So you are fighting against one political party’s platform, and depending on the polling, against the stated preference of a significant percentage of the participants. WE WANT MORE CONTROL cries the crowd.

    The sales pitch is going to be hard. One could argue that the PPACA (“ObamaRomneyCare”) is similar: there are ways to go about increasing overall outcomes/returns on average, but that might impact the choices (or how choices are felt) of some, and distributional affects of others, so we accept a compromise between maximum population-wide outcomes and maximum personal choice. Even if that compromise is provably sub-optimal for most of the participants.

    Most people THINK they will do better than average because most people think they’re special. Lake Wobegon…

  • John says:

    How different is your proposal from Nebraska’s cash balance plan for public employees?

    • After some research, not that different. My ideas are my own, I did not know what Nebraska was up to.

      I only tried to react to what works best among DB & DC plans in a time where each is having difficulty.

      • John says:

        Not many people have heard about the Nebraska plan. I only learned of it a few weeks ago while doing a consulting project. Also saw this piece from Towers Watson, which might interest you. It gives historical statistics on the prevalence of different types of retirement plans among Fortune 100 companies.

  • Greg says:

    Defined contribution plans like 401Ks are legally restricted to $15K per year contributions (and much lower in the past). Those contributions come directly from the beneficiary (deducted from paycheck).

    Defined benefits plans have essentially no legal limit on contributions — and those contributions are made by “someone else” (bankrupt companies and/or younger taxpayers who never made the promises in the first place). Any coward can promise someone else will make the contributions.

    Claiming that DC plans don’t measure up is an unfair comparison.

    Retroactively change the public sector scams — impose the same contribution limits that “we the people” have. Force the “workers” to make the contributions to their DB plan, instead of getting it made for them.

    That would at least be an apples to apples comparison.

    Defined benefits plans were no better than the defined contribution plans. They just created a false appearance of working by use of accounting tricks.

    Plenty of private sector companies went bankrupt when the DB accounting games stopped working (see AMR Corp most recently). The same will happen to public sector scams in the next decade (see NJ, CA, etc as merely the leading edge). Defined benefits plans never actually worked.

    If you want to retire at 65 (or any age), ***YOU*** must save enough to fund an annuity at current market rates. It is cowardly and lazy to assume someone else (or some later generation) is going to save for you.

    Baby boomers are deadbeats who (as a group) did not save enough to fund their hoped for retirements. That is the problem, and it has nothing to do with DB versus DC plans.

  • maynardGkeynes says:

    @ Greg: I think you make a good point about the low contribution limits on defined contribution plans and the apples to oranges comparison. I had not thought about that before. However, I do think that the comments about the Baby Boomers are not quite on the mark. First, the Boomers funded their Social Security retirement quite well. There is a minor shortfall, but that is largely attributable to the present high unemployment due to a severe recession. I also think that Boomers were victims of the system. There is no one in government or business who did not have a vested interest in telling the Boomers to spend every extra dime they made — it was good for the economy, for business, blah blah blah. Now, Bernanke is simply trying to reignite the bubble. I think you expect way too much from most people if you think they can resist institutionalized consumption binging that has been promoted by the alliance of business, government, and Madison Avenue for the last 60 years. It is still going on, and it is very troubling.

    • Greg says:

      1) Social security always was, and still is, a ponzi scheme. It is not funded — the “trust fund” is literally a file drawer in Ohio with IOUs. The system is a transfer system, not a pension scheme.

      2) If you are dumb enough to trust Congress / politicians to save money for you, I have bridges and swampland you may be interested in purchasing as well.

      3) The post is about defined contribution (DC) and defined benefit (DB) plans — it is not about social security ponzi schemes.

      The baby boomers lived way beyond their means — and yes, they need to take responsibility for their actions instead of blaming “the man” or “the system” or whatever other woodstock vernacular. Your life, your retirement, your responsibility.

      “Madison Avenue made me do it” ??? that is your excuse for living beyond your means? You don’t have any ability to think for yourself?

      I am not in the first 1000 people to point out that the national savings rate *WAS* 6-7% a generation ago, and as the baby boomers reached their peak earnings age (45-65), the national savings rate is ZERO (and negative at times).

      Life expectancy increased, but savings rates dropped to zero. That is why retirement plans don’t work for boomers.

      There is no retirement system that will work with a zero savings rate.

  • maynardGkeynes says:

    Greg, what I have discovered is that ranting about human behavior, whether about individuals or their elected representatives, as you do, is an unproductive exercise. It’s a question of incentives, which need to be changed. I don’t see any solutions offered in what you are saying. Perhaps you could offer some. Also, I don’t agree that Social Security is a Ponzi scheme. How many Ponzi schemes do you know of that are fully funded through 2037, and at least 80% funded beyond that for the next 75 years. David’s post addressed the failure of defined contribution plans, and he is right. Thank god we still have the defined benefits of Social Security, because as even you point out, most people lack the discipline to save for retirement, for whatever reasons one could name.

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