I think that it is pretty certain that defined contribution [DC] plans 401(k)s, 403(b)s, 457s, much as they have grown to be dominant, have been a failure. Many, though not all people like the illusion of control, and seeing their cash balance — makes the pension plan tangible, even if they don’t get what they will really need at retirement.
Pension plan reform has to face three realities. The first is people don’t know how much to put away for retirement. I’ll give you a hint: for almost all people, it should be over 10% of your gross pay. The second is that people don’t know how to invest, so hand it off to advisors who will do it for them, and cheaply. The third is silent, and leaves a lot of money on the table — most people would be better off taking an annuity from their pension plan than a third party, or trying to manage a lump sum on their own. This is usually an option only for defined benefit [DB] plans.
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On the last point, annuities from insurance companies will almost always be inferior to those from DB plans — the investment policy of the DB plan will likely yield more than the investments of the life insurance company. The DB plan has more ability to take risk, and its expenses are lower.
And speaking of lower expenses, that’s another reason to replace DC plans. Not only do DB plans provide better security, they have lower expenses.
But employers don’t want to fund expensive DB plans, particularly in a low interest rate environment. Fine, that’s not what I am arguing for. I am suggesting an odd sort of DC plan:
- Participants can contribute what they wish
- Employers can contribute what they wish
- Professionals manage the assets; no asset management by participants.
- During active employment, the cash balance can transfer with a change of employment.
- At retirement, it converts to a DB plan, and an annuity is granted, more generous than could be obtained privately. The retiree does not get the agony of managing a lump sum.
I think this would lead to much better results for plan participants. The case would have to be made to participants that they have not done well managing their own funds — they will underperform by less through third party managers. Also, few are good at managing lump sums for income.
This is the sort of plan that would yield better results for most, given that DB plans are out of favor, and participant-directed DC plans lead to high expense lousy results. Best to have a hybrid plan. Trustee-directed DC plan for accumulation. DB plan for distribution.
That’s how I would structure it at present. Better ideas are welcomed. Thoughts?
By David Merkel, CFA of Alephblog