The future of retirement should be Individual Retirement Accounts. We should be phasing out pensions in public sector jobs and making pension accounts available to more people rather than expanding social security.
There are two basic ways to finance retirement. You can save for yourself in your own account — like a 401(k) — where you decide how much to set aside, take all the investment risk, and then figure out how much you can spend each year when you retire. The amount of your retirement income depends on how much you have saved, how generous your employer is in matching contributions, and how well your investments perform. Anything you don’t spend is left to your heirs.
Or you may receive a pension from your employer, where someone else saves for you. You don’t have your own account, but you do have a claim on a future stream of income that someone else will pay for until you die, however long. Either of these types of savings vehicles can be sponsored by a private company or the government.
You can see why the defined benefit pension sounds better – someone else who supposedly knows what they’re doing assumes all the risk and gives you the money. It also seems more efficient. Risk can be diversified across generations; if a cohort retires when the market is up, it can subsidize a cohort that retires when the market is down.
But individual retirement accounts aren’t necessarily a worse deal. Often they are better.
First of all, pensions are not free. If an employer sets aside money for your pension, it is money that could otherwise be used to increase your salary. Rising pension costs are one of the main reasons teachers’ salaries have remained so low; as interest rates fell over the years, funding pensions became more expensive, resulting in less money being available for paying workers.
And pensions carry their own risks. They are much less valuable if you change jobs because the benefits are tied to seniority. And poorly managed pension funds can run out of money for payouts. Defined benefit pensions are funded in two ways: There is the funded model where the sponsor can set money aside for each person each year, pool it and invest it, then pay a fixed amount to the retirement. Or there’s the pay-as-you-go model, where little or no money is set aside and current workers pay for retirees.
If you have a pay-as-you-go model and an aging population with a low birth rate, you’ll eventually run out of money to pay the full benefits. This is exactly the problem that social security faces in America, and that European government pensions also face.
With a funded model, there is always an incentive to set aside less money than is needed to pay for future benefits, often in the hope that a risky investment will succeed and make up the difference. Private companies and the government prefer to use their money for other purposes rather than setting it aside to pay benefits 50 years from now. This is why there is a long history of private companies underfunding pensions.
It is telling that once companies were forced to fully account for the cost of pensions – after the Employees Retirement Income Security Act was passed in 1974 – most companies stopped offering them. . Today, most pensioners are in public sector jobs, where shoddy accounting standards allow them to be underfunded and overexposed to risky investments. Unlike a 401(k), workers have no say in this risk. As a result, public pensions are chronically underfunded and suffer even more from the current market downturn.
If your pension fund runs out of money, your promised retirement payout could be significantly reduced. Or, as often happens, there is a government bailout, which means higher taxes or reduced funding for other services such as libraries or schools. The biggest problem with pensions is that it is very difficult to create the incentives to fully fund them and invest them responsibly. And when it comes to government pensions, where politicians tend to be myopic, it’s particularly difficult.
Alternatively, individual retirement accounts such as 401(k) are by definition always fully funded because there is no promise of future payments. They have their problems: Left to their own devices, many people don’t save enough in their retirement accounts. People can make ill-informed investment decisions for their accounts and are exposed to market risk as a result.
Determining how much you need to save and how much you can spend in retirement is a very difficult problem because you don’t know how long you will live.
The reason people think Individual Retirement Accounts are a worse deal is because they reveal the truth we’d rather not face: Retirement is very expensive no matter how you fund it. Chile had one of the most successful retirement account programs, but it will likely be abandoned because savings rates – around 10% – were not enough to fund an adequate retirement for most people. Yet pensions have the same problem. American workers and their employers together pay 12.4% of their annual earnings for Social Security retirement benefits, and the program still faces financial difficulties. The same is true for most countries that offer pensions. The difference is that 401(k) accounts make the underfunding problem clear to everyone. It’s no wonder, then, that the Chilean system is facing an overhaul and calls are being made to extend pensions to other countries. These calls will become louder if there is a recession and the market pulls back further. But the increased use of defined-benefit pensions would be a mistake; These are just another form of debt that is unfunded.
Transparency is what makes 401(k) accounts so unpopular, but it’s also what makes them better. With all the uncertainty we face today, that 401(k) is always a better bet in the long run because they expose something we’d rather not face: it takes a lot of money to retire. . At least with a 401(k) we know what to expect and can act on the information.
More other writers at Bloomberg Opinion:
Wall Street is failing retired women: Alexis Leondis
Free trade isn’t really free, and that’s fine: Jared Dillian
Defense stocks are more than a refuge for recession: Thomas Black
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Allison Schrager is a Bloomberg Opinion columnist covering the economy. A senior fellow at the Manhattan Institute, she is the author of “An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk”.
More stories like this are available at bloomberg.com/opinion