Why a 401(k) is No Replacement for a Pension
By Cindy Long
Longtime friends Brenda Brum and Dolores Townsend have a lot in common. They both like antiquing and poking around flea markets. They both care for an elderly parent. They both taught at the same school. And they both avoided a financial debacle that would have forced them to keep working well past retirement age.
Brum and Townsend live in West Virginia, the state that until a few years ago had the worst-funded pension plan in the entire country. By the early 1990s, the plan was on the verge of collapse with just 14 percent of the money needed to cover the pensions it owed teachers.
In 1990, then-Governor Gaston Caperton signed legislation to pay off the pension liabilities over a 40-year period. But it also changed the plan from a defined benefit (DB) pension to a defined contribution (DC) 401(k)-type plan.
Effective July of 1991, West Virginia’s new teacher hires were placed into the DC plan. Educators hired prior to that date were able to choose to enroll in the new 401(k)-type plan or to stay with the pension. Lured by the possibility of huge investment returns instead of a lower, but steady, pension income, many made the switch.
But not Brenda Brum or Dolores Townsend — they opted to stick with the pension, and now they’re counting their blessings rather than the number of years to retirement.
“I have colleagues who changed to the DC plan and they have to keep on working,” says Townsend, who retired in 2009. “They’ve been ready to retire, but they lost all their 401(k) savings in the crash of 2008, and now they can’t afford to retire.”
Turns out they wouldn’t have been able to afford to retire before the crash either.
By 2008, according to a study done by West Virginia’s Consolidated Public Retirement Board, most teachers age 60 or older who participated in the 401(k) had only $100,000 or less in their accounts – a fraction of what the pension would have provided them, and not nearly enough to retire on and remain self-sufficient.
“In West Virginia, a lot of people think $100,000 is a lot of money. Teacher salaries have always been so low, people have a distorted view about how much is enough to live on,” says Brum, who retired in 2011. “But most people live 18 to 20 years after they retire, and how can you stretch $100,000 over that time? The only option is not to live as long!”
According to West Virginia Education Association Executive Director David Haney, the DC plan “failed in every way, shape and form.”
He gives an example of a woman who retired on the pension plan at age 60 after 30 years of service. Over those 30 years, she’d contributed $51,604 to her pension (despite common misperceptions that taxpayers fund pensions, they’re actually a shared responsibility with employee contributions and investment earnings doing most of the work). The plan’s benefit formula is 2 percent of final average salary times years of employment. The woman’s final salary was about $45,000 a year, so her pension is $2,261 a month. To earn the same amount in the DC plan, she would have had to amass $323,400 in her 401(k) – a hefty sum compared to $51,604, and a long shot given the ups and downs of a volatile market.
401(k)s Weren’t Meant to Replace Pensions
Defined contribution 401(k) plans were never intended to be a pension replacement for employees. They were originally created as a perk for highly paid executives, and were originally called “salary reduction plans” before being renamed for the tax code that makes them possible. The thinking was, the more these executives were paid, the more they could afford to contribute from their paychecks, and the more they had for retirement – on top of the old stand-by pension and Social Security. Another perk was that DC plans are portable – convenient for executives who climb the corporate ladder from one company to another.
It all sounds pretty good when the markets are hot and delivering high returns, which is why so many working Americans – executives or not — clamored to get in on the 401(k) action starting in the 1980s. But what happens when the bottom falls out like it did in 2008?
People lose money. Lots of money. And moderately paid public employees like teachers who spent their entire careers serving the public in the classroom are suddenly unable to retire after their 401(k) has been decimated by a market crash.
For years, David Haney and WVEA members lobbied the West Virginia government to overhaul the plan and return to a pension system that provided secure retirement benefits and was managed – and funded — properly. They pointed out the discrepancies between the defined benefit and defined contribution plans, showing why the pension plan offered a much better retirement benefit for employees and major cost savings for the state.
Finally, the retirement board’s actuary provided some facts that backed them up.
The actuary discovered that savings rates in the DC plan did, in fact, lag far behind monthly benefits that the DB plan would pay. The DC plan members, including new hires and those who made the switch in 1991, had an average of $33,944 in their accounts by June of 2005. Those over age 60 had an average of just $23,193 – a trifling amount to spread out over the rest of their lives in retirement. On the other hand, teacher participants in the DB plan, earning the average salary after 30 years of service, would receive an annual pension of $27,000. They wouldn’t have to figure out how to make it last. They’d get that $27,000 each and every year of their retirement, whether they lived to be 68 or 108.
The government saw the red ink writing on the wall, and in 2008, West Virginia agreed to switch back to a DB plan.
Here’s why they made the switch and why other states should follow suit.
DB Plan Investments Are Managed By Financial Experts
Over a 30-year period, according to a study by the National Institute for Retirement Security and consulting firm Milliman Inc., defined benefit plans delivered an almost 25 percent greater return to participants than defined contribution plans.
One reason for the higher returns is because DB plans ’ investments are professionally managed day-to-day by investment experts rather than individually managed by people whose investment tools consist of little more than a crystal ball and a lot of luck – which is all West Virginia investors had to rely on.
“The DC plan participants received absolutely no education on how to manage their investments,” says Haney.
Like many public employees in states with DC plans, the West Virginia educators received no web-based courses, no seminars, no written materials, and no access to consultants. They couldn’t even get reports on how their investments were doing more than once a quarter, and then had only a very short window in which to change their allocations.
“Do most classroom teachers, bus drivers, and cafeteria workers know what their risk tolerance is, or about their time horizons? Do they know the difference between fixed securities and equity securities, or max cap versus mid cap? Do they know whether they should they invest internationally, or in growth stocks, or derivatives?,” asks Haney.
We can’t reasonably expect the average employee to effectively manage her savings with absolutely no training when even some winners of the Nobel Prize in Economics admit to making mistakes, either by not paying enough attention to their own retirement arrangements or by making bad decisions when they do.
“I think very little about my retirement savings, because I know that thinking could make me poorer or more miserable or both,” 2002 Economics Nobel Prize winner Daniel Kahneman of Princeton University told the Los Angeles Times .
DB Plans Lower Costs With Pooled Risks
DB plans are pooled and therefore have “built-in” savings that allow them to deliver retirement benefits at a lower cost to the employer as well as the employee.
First, they average risks over a large number of participants. Instead of requiring contributions substantial enough to provide retirement income through a person’s maximum life expectancy, which, with the miracle of modern medicine, could be upwards of age 90 or even 100, defined benefit plans only need to fund benefits through the average life expectancy of the group. So when a pension member or their designated beneficiary dies prematurely, the assets that have been accumulated on their behalf are used to provide benefits to the remaining employees.
Also, with pooled funds, the management fees are lower than maintaining hundreds or thousands of individual accounts, which result in a 26 percent cost savings, according to the National Institute on Retirement Security.
Also, unlike defined contribution plans, pension assets can be diversified for optimal returns throughout an employee’s lifetime. People with 401(k)s, on the other hand, are advised to move their investments into safer, lower-returning assets as they age and approach retirement. But because DB plans pool the risks of losses, they can maintain an investment mix that is diversified among stocks, bonds, and other investments, increasing the investment returns and lowering required contributions.
DB Plans Boost the Economy
According to an analysis of 20 million 401(k) participants conducted by the Employee Benefit Research Institute and the Investment Company Institute, the median account balance of a worker in his or her 60?s, making between $40,000 and $60,000 a year was $97,588 at the end of 2006. That amount would generate about $8,000 a year in retirement income.
“How can someone live on that amount,” asks Haney. “They’d struggle just to pay utilities and to put food on the table. They’d probably become wards of the state.”
In fact, research shows that when older Americans can’t be self-sufficient in retirement, taxpayers face higher public assistance costs.
But when they’re on a fixed income pension, retirees represent a vital, continuous source of spending. A National Institute for Retirement Security study shows that public employee retirees pump $358 billion into local economies and help to create 2.5 million jobs.
They can afford home maintenance , they can buy a new car, or, like West Virginia retired educator Dolores Townsend, they can go on a vacation.
“I don’t have to scrimp and save because I’m worried my retirement benefit will run out,” says Townsend. “When everything else fluctuates, like gas, groceries, and prescriptions, it’s nice to know my paycheck won’t, so I can plan for my expenses and then spend what’s left on the fun stuff, like a new pair of shoes or a ski trip with my nephews.”
Haney says the rest of the country can benefit from what West Virginia learned the hard way – that individual 401(k) accounts. which were only intended to supplement pensions, have proven to be an insufficient primary source of retirement income, that pensions are more economically efficient, and can provide the same retirement benefit at half the cost.
“Given the growing level of retirement insecurity, our nation should be looking at ways to get back to basics and ensure that all Americans have access to adequate and secure pensions,” he says. “Part of the American dream is that after a life of hard work and playing by the rules, people should be able to retire with dignity and security.”
Top Photo: Michele Coleman