In the December 13, 2008 article by Anne Tergesen (journalist for The Wall Street Journal), published in the in the Wall Street Journal the author suggests that “[t]he financial meltdown has fueled a call to change – or replace – [401k] retirement accounts.”
Well here’s my thinking. I say, Start Over!!!
The best way to fix 401k plans is with a hammer. 401k plans have little practical use when planning for retirement. Basically, the problem is that 401k plans are not capable of aligning pre-retirement wealth accumulation with post-retirement income needs. Combining voluntary contributions with lack of investment expertise and “timing risk” results in the situation we have today where 401k account balances are very low, and aging employees can’t retire simply because there is not enough money.
Let’s take a closer look:
First of all, retirement plans are, more than anything else, attrition tools, intended to optimize the orderly turnover of a work force. Older workers give way to younger workers because they can afford to maintain their standard of living after retirement. There was a time when a retiree could live comfortably on about 65% of pay. The mortgage was paid off (ha), the kids were grown up and out of the house (ha ha), medical care was covered by your employer (ha ha ha), and you were in a lower tax bracket (ha ha ha ha!). Nowadays, the “replacement ratio” as it is called is closer to 80% of pay. Defined benefit pension plans are designed to target a replacement ratio, and the benefits are typically described as a percentage of final average pay. So with a defined benefit pension plan, any participant knows how close he is to his desired “replacement ratio”. Add in Social Security and personal savings and you have essentially an inflation proof retirement model. 401k plans on their own cannot accomplish this.
Second, 401k plans became the prevalent form of retirement plan for reasons unrelated to benefits adequacy. Their growth began in the 1980’s concurrent with the increasing foreign ownership of American companies. From the foreign owner’s perspective, pension plans (and for that matter, retiree medical plans) are a long-term obligation that can impact the balance sheet way beyond the life span of a company. Not knowing how long a haul their American commitment was, they preferred the 401k’s because, from a balance sheet perspective, the assets always equal the liabilities.
Third, 401k’s cannot provide the same payout as pension plans even if employers contributed the same amount to each plan because in 401k plans employees are their own investment managers and have proven time and again that they do not do a very good job at this. Simply stated, employers are historically better investors in both good markets and bad.
Fourth, employers believed that employees liked 401k plans more than pensions since they were “easier to understand”. This might be true as far as contributions accumulations are concerned, but employees clearly do not understand how to invest their contributions in order to achieve real wealth accumulation in 401k plans. Baby boomers, who were the first to embrace 401k plans imagined that they would have both personal savings through 401k and retirement security through pension plans, but that’s not the case in many companies. 401k plans have replaced traditional pension plans and now with the decline in account balances, the aging boomers can’t afford to quit. Employers will soon come to learn that it costs about three times as much to provide medical benefits to a 65 year old worker than to a 65 year old retiree, for whom Medicare is the primary payor.
So what might replace 401ks?
Maybe a return to pension plans and retiree medical plans? I suspect you’ll sooner see the discontinuance of 401k plans and medical benefits altogether (not as far fetched as it once seemed.) Maybe with the advent of massive public works programs companies should just liquidate, fire everyone, and invest the leftover funds in government bonds. I would have suggested CDs but since the government now owns all the banks I’m not sure there is a difference anymore. Email Robert Cirkiel at firstname.lastname@example.org