Monday, May 9, 2011

401(k) versus Pension

The knock down battle of Defined Benefit Pension Plan verses the Self-Funded Retirement?  Who will win?  The 401(k) wins by default.   No one has defined benefit pensions anymore!

Our generation was sold on the 401(k) plan as a better alternative to the traditional defined-benefits pension plan.  The latter was a bit of Corporate Socialism, where our corporate overlords would guarantee to pay us in perpetuity in retirement.  Today it is "fend for yourself, buddy" - and yet the teabaggers claim we are sliding toward a Socialist State.  If anything, we are moving closer to anarchy, compared to the glory days of the 1960's.

And that is odd, to me, as many of these teabaggers are the kind of people who would have made out well under the Corporate Socialist State of that era - paid handsomely, provided with luxurious benefits, and provided with a guaranteed retirement.

But all of that has changed.  And while the 401(k) plan might be a poor substitute for the Cadilliac retirement plans of the past, there are some advantages to it.  And moreover, since most of us - even government workers - are on some sort of self-funded plan these days, the best thing we can do is fund these plans, rather than whine about them.

Problems with Pensions:  There are many problems with traditional pension plans, and for many of us, the 401(k) seemed like a solution to all of these problems.

1.  Vesting:  Pension plans usually required that you work for a certain number of years before you were vested in them.   Many plans required that you work for 5, 10, or even 20 years before you could get anything - and that meant if you were in a job where mobility was the key (Engineering, for example), you might never get a pension.  It also gave employers incentive to fire people in their 19th year.  The 401(k) plan provides you with a transportable retirement plan, regardless of how often you change jobs.

2.  Under-Funding:  Many companies promised lavish pension plans to their employees.  And that was it - just a promise.  The requisite money to fund those plans was never set aside - or not enough was set aside.  Like anything else, managers procrastinated and figured "We'll get to that later" - or they realized that they would be retired before then, and by underfunding the pension plan, they would increase profits, and get a nice bonus.   Usually, this unfunded liability ends up bankrupting the company later on (as it did GM) and the government has to step in to help out retirees, who end up with 40 cents on the dollar (if that) of their plans.

3.  Inflation:  Some pension plans have clauses to increase benefits to account for inflation.  But few do.  Most provide a fixed income for life, usually based on a percentage of the last year's salary.  But if inflation rises rampantly, this can dilute the value of the pension quickly.  Even mild inflation, over a couple of decades, can severely erode your earning power.

4.  Flexibility:  With your own money, you can spend it as you see fit.  Want to buy a retirement home?  You can do that if you have $500,000 in your 401(k) and pay cash.  But with a pension, you have to pay for everything in installments - unless you have savings.  And with a modest pension, you may not qualify to buy some items.

5.  Discourages Savings:  Many salary slaves (or hourly slaves) don't bother to save, figuring that their pension, plus Social Security, will carry them through retirement.  As a result, they live the debt lifestyle, constantly borrowing to buy cars and jet skis and motorhomes - throughout their lives.  Not being in debt is an alien concept to them and many retire with debt and mortgages.  A self-funded retirement plan gets a person thinking in terms of net worth - or at least it shold.

Problems with 401(k) and other self-funded retirement plans:  While the self-funded retirement plan has the potential to cure the problems of the defined pension plan, it has a host of problems all its own.  And these problems can be catastrophic for the average person.

1.  Failure to Save:  A self-funded retirement plan only works if you fund it.  And like the managers of the defined pension plans of yore, individuals often rob Peter to pay Paul, putting off saving for tomorrow in favor of spending today.  But Peter and Paul are, of course, the same person, just separated by 30 years in time.

2.  Market Volatility/Lack of Training:  The self-funded retirement plan only works if you know how to invest and don't do really stupid things.  The distribution curve and the law of probability (as well as an understanding of human nature and psychology) dictate that there will be some people who make horrible investments and lose all their money.  We are expecting everyone to become a financial expert, including the not-so-bright people at the bottom of the economic totem pole.  So the Secretary at Enron believes Kenneth Lay and puts her entire 401(k) plan into company stock - and loses it all.  This is not an anomaly, but a predictable outcome for a certain percentage of the population.  Others will panic when the market tanks and "sell it all".  And still others will invest wisely, but retire at an unfortunate time when the market is low.

3.  Spending Too Fast in Retirement:  Even if a person saves up enough for a comfortable retirement, it can all still go horribly wrong, if they live like drunken sailors and spend it all on bling and shiny-shiny and drain their 401(k) account within five years of retirement.

3.  Running out of Money:  #1 and #2 and #3 lead to #4 - the possibility of running out of money at a time in your life when you cannot earn more and are most vulnerable.

The problem with the 401(k) plan is that the consumer ends up worrying his whole life whether he has funded enough, and then worrying in retirement whether they will run out.  It clearly is a more stressful situation and nursing at the corporate teat.

Of course, the defined-pension plan maybe was a fool's paradise.  Ask any retired Eastern Airlines pilot how their pension worked out - at 40 cents on the dollar from the Pension Resolution Trust Authority.  They probably wished they had a 401(k) plan, at this point.

Or ask any Engineer from the 1960's about it.  Back then, you got hired to do a job for maybe five years and then were laid off.  No one stayed at a company long enough to get a vested pension plan.  For folks like us, the 401(k) was a Godsend - finally, we got to keep the money!

And the 401(k) does have some advantages over a Pension - you can spend money at the rate you want to.  Need a new roof?  You can pay cash in retirement for it, rather than have to borrow and make payments from your Pension income.  The 401(k) can also be borrowed against and even cashed in for education or for a down payment on a home, in limited circumstances.  However, there are economic consequences of such actions.

Regardless, the 401(k) does make a person more liquid and forced all of us to become savers and investors.  The only problem is, it is liquidity you cannot spend, if you want to have a comfortable retirement.  The 401(k) also means you can leave money to your heirs and descendents, who hopefully will use the money to fund their retirements as well.  It provides the average person the opportunity to create dynastic wealth, which was formerly something only the very rich could do.

But the problem is, many people are under-funding their 401(k) plans.

• 30% of employees eligable for 401(k) plans elect not to participate.  Thirty Percent!

• Many start too late and their rate of saving is too low.   According to the Federal Reserve, the average family's account balance in a 401(k) is only $29,000.

• Half the people with 401(k)s cash them out when they change jobs instead of rolling the money into an IRA or another 401(k).
 This is a freight train headed off the tracks, and we can see this from a decade out.  And no one is saying anything, other than to shake their heads and say "Gee, that's too bad".

In addition, for many participants, the rates of return on their plans are not as great as they should be.  Fund management fees eat up a big portion of the profits.  And people either put all their money into "safe" low-yield investments, or they put them all in high-risk stocks.  And when they see their investments not doing well, they panic and cash it in, or churn their own accounts to death.  Very few diversify.

How much is a defined pension plan worth, versus a 401(k)?  As I noted in an earlier post, if you were to buy an annuity, it would fall along the lines of the 4% rule, perhaps a little closer to 5%.  So, if you have a pension that pays $50,000 a year in retirement, that would be worth about a million dollars, if you were to purchase it as an annuity.

And yet, many, if not most people in this country have far less than that saved up for retirement, but yet live on over $100,000 a year at the present time.  They will find retirement to be less than they expected, as they are used to spending a hundred grand a year, but will have to live on less than half that during their retirement years - or run out of money, or both.

The self-funded retirement plan is here to stay, like it or not.   It wins the debate by default.  If you are one of the vanishing breed with a defined benefit pension, good for you, and let's all pray it was properly funded and your company doesn't go bankrupt during your retirement.

But if you are a 401(k) kid, you have to start saving - saving consistently, saving early, and saving always.  Because you'll need to have a lot of money in your 401(k) to fund even a modest retirement - a million dollars or more.  And very damn few of us are Millionaires in America these days - not nearly enough to provide for the coming retirement debacle.

And I have written about this before, at length.  We are all-so-concerned about the death of Osama Bin Laden, or who got booted off Dancing With the Stars, but the fact that about 1/4 of the population will be retiring in the next ten years, a large percentage with little saved, many with nothing saved, is never talked about.

Slow moving trends and events are never commented on by the idiot media.  It is only when this retirement debacle reaches catastrophic proportions that anyone will even notice.  And then it will be a "Gee, what happened?" kind of thing, with the government and the "fat cat bankers" being blamed.

But we still have time to turn this ship around, or at least your personal ship!  It is never too late to make thing better.

Some Interesting (but scary) links:

The flaws in the 401(k) plans and Mutual Funds illustrate why it is so important to pay down debt, not take on debt, and be debt-free.  It also illustrates why it is important to invest in a panoply of investment vehicles (diversify) - everything from a CD, Savings Account, Money Market, Savings Bonds, Treasury Bills, Whole Life Insurance, Annuities, Mutual Funds, Stocks, Corporate Bonds, Municipal Bonds, Real Estate, and wherever else you can think to invest!

More money is always better than less money.  Maybe the system is "unfair" - but not saving at all is not the answer, either.