Pensions aren’t the answer to your retirement anxiety


The market is down, inflation is up and your retirement prospects are not looking too good. It’s tempting to think back to the old days when employers gave workers fixed pensions and gave them more security in their golden years. Except…. it wasn’t really like that. Defined benefit pensions are overrated. Even in this scary market, you should be grateful to have a retirement account like a 401(k).

The future of retirement should be individual retirement accounts. We should phase out public sector pensions and make retirement accounts accessible to more people, rather than expanding Social Security.

There are basically two ways to finance retirement. You can save for yourself in your own account – such as a 401(k) — where you set the amount you want to set aside, take all the investment risk, and then figure out how much you can spend each year when you retire. How much income you have in retirement depends on how much you’ve saved, how generous your employer is with top-ups, and how much returns you get on your investments. What you don’t spend stays with your heirs.

Or you receive a pension from your employer where someone else is saving for you. You don’t have an account of your own, but you are entitled to a future stream of income that someone else is paying until you die — no matter how long that’s government.

You can see why the defined benefit pension sounds better – someone else who supposedly knows what they’re doing takes all the risk and gives you money. It also seems to be more efficient. Risk can be diversified across generations; if a cohort retires when the market goes up, they can subsidize a cohort that retires when the market goes down.

But individual retirement accounts aren’t necessarily a bad deal. Often they are better.

First, pensions are not free. When an employer sets aside money for your pension, that money is that could otherwise be used for a higher salary. Rising pension costs are one of the main reasons teachers’ salaries have remained so low; As interest rates have fallen over the years, it has become more expensive to fund pensions, and that adds up to less money being available to pay workers.

And pensions carry their own risks. They’re much less valuable when you change jobs because benefits are tied to tenure. And poorly managed pension funds can run out of money for payouts. Defined benefit pensions are funded in two ways: first, the funded model, where the sponsor puts money aside for each person each year, pools and invests, and then pays out a set amount at 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 PAYG system and an aging population with low birth rates, you will eventually run out of money to pay full benefits. This is precisely the problem facing Social Security in America, and also facing European state pensions.

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 would rather use their money elsewhere than set aside it for paying welfare in 50 years. Because of this, there is a long history of private companies underfunding pensions.

It is significant that most companies stopped offering them after companies were forced to take full account of the cost of pensions – after the Employee Retirement Income Security Act 1974 was passed. Today, most pensions are found in the public sector, where shoddy accounting standards allow them to be underfunded and exposed to risky investments. Unlike a 401(k), employees have no say in this risk. As a result, public pensions are chronically underfunded and are suffering even more from the current market downturn.

If your pension fund runs out of money, your promised pension payment could be severely curtailed. Or, as often happens, there’s a government bailout, which means higher taxes or less funding for other services like libraries or schools. The biggest problem with pensions is that it is very difficult to incentivize them to fund them fully and invest them responsibly. And on the state pension, where politicians tend to be short-sighted, it’s particularly difficult.

Alternatively, by definition, individual retirement accounts such as 401(k)s are always fully funded since there is no prospect of future payments. They have their problems: Left to their own devices, many people do not save enough in their retirement account. People can make ill-informed investment decisions for their accounts and are exposed to the resulting market risk.

Figuring out how much to save and how much to 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 expose a truth we’d rather not face: Retirement is very expensive, no matter how you fund it. Chile had one of the more successful retirement account programs, but it is likely to be phased out because savings rates –– around 10% — were insufficient for most people to fund a decent retirement. Pensions, however, have the same problem. American workers and their employers together pay 12.4% of their annual income for Social Security retirement benefits, and the program still faces financial strains. The same applies to most countries that offer pensions. The difference is that 401(k) accounts make the underfunding issue clear to everyone. No wonder, then, that the Chilean system is about to undergo a general overhaul and that other countries are also calling for an increase in pensions. These calls will get louder when a recession hits and the market retreats further. However, it would be a mistake to increasingly rely on defined benefit pensions; They are just another form of debt that is unfunded.

Transparency is what makes 401(k) accounts so unpopular, but that also makes them better. With all the uncertainty we face today, 401(k) is still a better choice in the long run because they reveal something we’d rather not face: it costs a lot of money to retire . At least with a 401(k), we know what to expect and can act on the information.

More from other authors at Bloomberg Opinion:

Wall Street is failing retired women: Alexis Leondis

Free trade isn’t really free, and that’s okay: Jared Dillian

Defense Stocks Are More Than A Recession Haven: Thomas Black

This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.

Allison Schrager is a columnist for the Bloomberg Opinion on economics. She is a Senior Fellow at the Manhattan Institute and the author of An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk.

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