The market is down, inflation is up and your retirement prospects aren't looking so good. It's tempting to pine for the old days, when employers provided defined pensions to workers, giving them more certainty in their golden years.
Except…. it wasn't quite like that, actually. 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 pensions in public sector jobs and make retirement accounts accessible to more people rather than enlarging Social Security.
There are two basic ways to finance retirement. You can save for yourself in your own account — such as a 401(k) — where you decide the amount 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 how much you saved, the generosity of your employer in matching contributions, and how much your investments returned. Whatever you don't spend is left for your heirs.
Or you can receive a pension from your employer, where someone else saves for you. You don't have your own account but you have a claim on a future stream of income that someone else pays until you die — not matter how long that is.
Either of these types of saving vehicles can be sponsored by a private company or the government.
You can see why the defined benefit pension sounds better — someone else who supposedly knows what they are doing takes on all the risk and gives you money. It also seems more efficient. Risk can be diversified across generations; if one cohort retires when the market is up they can subsidize a cohort who retires when the market is down.
But individual retirement accounts aren't necessarily a worse deal. Often they are better.
First of all, pensions aren't free. If an employer is putting aside money for your pension, that's money that might otherwise go toward a higher salary. Rising pension costs is one big reason why teacher salaries have stayed so low; as interest rates fell over the years, financing pensions got more expensive, and that adds up to less money available for paying workers.
And pensions carry their own risks. They're much less valuable if 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 financed in two ways: There's the funded model where the sponsor can put money aside for each person each year, pool it all together and invest it, and then pay a set amount upon retirement. Or there is the pay-as-you-go model, where little or no money is put aside and current workers pay for retirees.
If you have a pay-as-you-go model and an aging population with low birth rates, you will eventually run out of money to pay full benefits. That's exactly the problem Social Security faces in America, and that European government pensions are also confronting.
With a funded model, there's always an incentive to set aside less money than is needed to pay future benefits, often with the hope that some risky investment will succeed and make up the difference.
Private companies and the government would rather put their money to other uses than reserving it to pay benefits 50 years down the road. That's why there's a long history of private companies underfunding pensions.
It's telling that once corporations were forced to fully account for the cost of pensions — after the Employee Retirement Income Security Act passed in 1974 — most companies stopped offering them.
