By Patrick Appel
A wonky e-mail from a reader:
I’m an ERISA employee benefits attorney who started out working for Nebraska’s state pension plans. I’ve thought a lot about the "defined contribution" (e.g. 401(k)) versus "defined benefit" (e.g. traditional state pension) debate. I tend to agree with most of the criticisms of 401(k) plans that you cited — But I think you need to think more about the actual state of large state defined benefit pension plans.
You mention that the states have vastly underfunded the public pensions. First, many (although not all) public pension plans were originally established (like Social Security) as a pay-as-you go type plan — although the vast majority of state plans are now pre-funded plans. The idea of the pre-funded plan is that enough money has been put aside during a worker’s career, that there are sufficient funds to pay the pension checks of that worker for the rest of the worker’s lifetime. In a sense, the traditional defined benefit pension plans work like giant insurance policies, with the risk of some workers outliving their money offset by other workers who die prematurely.
To work successfully, a big state pension plan has to have two things going for it: (1) workers who spend the majority of their careers within the same system, and (2) realistic actuarial assumptions regarding mortality and investment return.
These two things explain why the current state pension plans are less successful than they should be in theory.
(1) Workers don’t usually spend their full careers in the same pension plan — and therefore don’t earn full benefits. This is good for the plans, but bad for the workers.
(2) The actuarial assumptions are easy to manipulate, and there are many reasons why political leaders yield to the manipulation temptation. The real difficulty is that human nature doesn’t like to set aside a pot of money for the future. States are continually fiddling with the actuarial assumptions, so they don’t have to contribute to the plan. Since it is an inexact science, the actuaries can only do so much to prevent undue manipulation. Also, whenever the plans are "overfunded," policy makers see using the overfunded-plans as a way to grant enhanced benefits to their workers without having to actually spend money — they juice up the benefits with the "surplus," get praise from the workers, and don’t have to raise taxes. In bad times, political leaders like to staunch holes in their budgets by making unrealistic assumptions — then the actuarial model allows them to lower their contributions, and they have "instant money" for other state priorities.
Then there is the question of how the media reports on state pension plans — Short-term volatility in the financial markets may make a state pension plan look "underfunded" this year, but "overfunded" in three years. (Go back and read news articles, and you will see these see-saw reports on the same state pension funds — they are in "crisis" for a few years, then they are in "good shape.") Many of the criticisms about their funding are aimed either at those that are still recovering from starting as a pay-as-you-go system (where the current benefits are being paid from revenues generated by current contributions), or are made at a time when the current actuarial projections are grim. . . . Media-types never seem to notice that these actuarial projections usually have a rolling 30-year time horizon, so they are sort of like weather forecasts — not implausible, but notoriously changeable and often inaccurate.
Moreover, I liken the big pension plans to "wholesale" for the financial industry, whereas the 401(k) plans are more like "retail." A big state pension plan has a huge pot of money and therefore negotiating power with the financial industry. You and I have a small pot of money and basically have to take or leave the fee structures we’ve given. And large employers (where most 401(k) plans locate) pass many of the fees on to their individual participants. Therefore, the financial industry has incentive to discourage pension plans and encourage 401(k) plans.
An example (hypothetical) helps make this point. If a financial provider has (for example) a $1,000,000,000 pot of pension money, they can charge (for example) 30 basis points to manage the money (wholesale) — this generates a fee of $3,000,000. If that same financial company is managing $1,000,000,000 in 401(k) money, they can charge 175 basis points (retail) — this generates a fee of $17,500,000. For a financial company, the difference between the two pots of money is $14,500,000 in gross revenue. Of course, the infrastructure needed to service the money will be much more complex for the 401(k) plan, and therefore their costs would be higher. Still, one might question whether the costs are really $14.5 million higher for the 401(k) plan.
The bottom line is that we don’t have retirement product in the United States that prudently and efficiently sets aside money for a mobile workforce. Social Security is inadequate, and is funded on a "pay as you go" model. Traditional defined benefit pension plans don’t work for the mobile work force, if they are sponsored by single employers. 401(k)-type plans put too much risk and expense on the individual, who is ill-equipped to handle it.
The Dish 