Mike the Mad Biologist

401(k) Plans, Pensions, and Some Tax History

One of the few advantages of getting older is that, as long as the memory remains good, you know where all the bodies are buried. This is sometimes called wisdom. A couple of weeks ago, the Wall Street Journal reported that 401(k) plans wouldn’t provide many soon-to-be retirees the income they needed for retirement:

The median household headed by a person aged 60 to 62 with a 401(k) account has less than one-quarter of what is needed in that account to maintain its standard of living in retirement, according to data compiled by the Federal Reserve and analyzed by the Center for Retirement Research at Boston College for The Wall Street Journal. Even counting Social Security and any pensions or other savings, most 401(k) participants appear to have insufficient savings. Data from other sources also show big gaps between savings and what people need, and the financial crisis has made things worse.

Felix Salmon notes this about the replacement of defined benefit pensions by 401(k) plans:

The more important answer is “I’m not an investor” — and neither are you. Just because you have a 401k plan does not, ipso facto, make you an investor. This is a serious problem with defined-contribution pensions in general: they place an onerous set of responsibilities onto individuals who are wholly unqualified to discharge them in a sensible manner. Already, such plans tend to have far too many choices, many of which are expensive long-only mutual funds which seem like a pretty bad idea for just about anybody. Trying to add alternative investments in private equity or hedge funds to the mix would almost certainly be disastrous — the dumb money coming in at just the wrong time, just like it always does.

So your 401k is going to be made up of stocks, bonds, and cash, just like it always has been. Those asset classes are, it’s true, only a subset of the full range of investment opportunities available to sophisticated investors. But you’re not a sophisticated investor, so there’s no point in feeling aggrieved. It’s possible that you might be able to invest some of your 401k funds in Pimco’s Total Return Fund, which is an active and sophisticated investor, and which happily uses very sophisticated derivatives on a regular basis to get extra return and to make money in down markets. But generally speaking, people with 401k plans should stop at big-picture asset-allocation decisions: beyond that, they’re way out of their depth.

But I think this misses the larger picture: 401(k) plans were not invented to help middle-class (or upper-middle class) people retire. A tax attorney (not Michele Bachmann) who also happens, according to tax historians (really, such people exist), to be one of the legal architects of the 1968 Tax Reform Bill and who knows his way around this stuff once explained to me what 401(k) plans were all about.

401(k) plans were a way to give rich people, who were already going to invest that money anyway, a tax break for doing so. This was a common theme of the Carter/Reagan* era for you young’uns. They were also a way for employers to avoid having to support fixed benefit pensions and thereby reduce compensation (i.e., retirement benefits) to employees (cutting back on retirement benefits was another theme of the late 70s and 80s). The advocates of these plans never even thought about middle class workers. They–you–didn’t enter into the calculations at all.

And now we have an entire generation of ‘citizen investors’ who have been played for suckers:

Traditional or defined benefit pension plans, properly administered, increase economic efficiency, while the newer defined contribution plans have high costs whether done one at a time through Individual Retirement Accounts or in group plans like 401(k)s.

Efficiency means that more of the money workers contribute to their pensions – - money that could have been taken as cash wages today – - ends up in the pockets of retirees, not securities dealers, trustees and others who administer and invest the money. Compared to defined benefit pension plans, 401(k) plans are vastly more expensive in investing, administration and other costs.

Individually managed accounts like 401(k)s violate a basic tenet of economics – specialization increases economic gains. That is why the average investor makes much less than the market return, studies by Morningstar show.

“Much less than the market return.” “Vastly more expensive in investing, administration and other costs.”

There you have it in black and white. Played for suckers. Fixed benefit pensions would require money managers to earn their salaries, as opposed to extracting it from the middle class.

*While Carter has been portrayed as a liberal, he massively deregulated the economy and slashed taxes. Reagan simply went further.

Comments

  1. #1 Kaleberg
    February 27, 2011

    In other words, 401k’s worked exactly as expected.

    It’s good that someone else remembers the Carter administration. Not only did he cut taxes and do a lot of deregulation, he also demonized the Soviet Union and got a lot of flack for it. He not only pulled us out of the Olympics, but he refused to sell them grain or support their natural gas pipeline since it was built by slave labor. On the other hand, he was a fiscal conservative, unlike wildly spending Reagan.

  2. #2 D. C. Sessions
    February 27, 2011

    The advocates of these plans never even thought about middle class workers. They–you–didn’t enter into the calculations at all.

    Not quite. The end of the 60s saw a number of incidents where people in defined-benefit plans got royally screwed after thirty years or more with one employer (GE comes to mind from one that was covered extensively in the electronics industry press). Laid off, they were handed a few hundred dollars as the present value of their pension plans. At fifty-something, there was no way they could build up another pension.

    Thus, a major movement for “portable pensions.” With lifelong employment being a thing of the past for most workers, defined benefit plans get really, really hard to make work.

    Of course Wall Street was tickled pink to have all of those extra money streams coming in [1]. Sure beat the way both government and the private sector “funded” their pension plans with nothing but IOUs; have a look at the automakers or the current flap over underfunded public pensions.

    Are 401(k) plans all goodness? Of course not. That doesn’t mean that they aren’t better than many of the alternatives.

    [1] Ever wonder what will happen when the Boomers accelerate their retirement and withdraw more than they’re putting in? Have a look at Japan and what happened to the WWII generation that had been propping up the economy with what amounted to no-interest loans for forty years.

  3. #3 Lyle
    February 27, 2011

    Just ask that the 401k include a total stock market index fund or an S&P 500 index fund. These essentially are bets on the the whole economy. You won’t make a killing but you won’t be slaughtered either. See Boogle for details (he invented the concept). Note that in addition these funds are low cost because little work is needed, and the investment advisor could almost be a computer. Historically since 1871 returns on the S&P 500 have been in the neighborhood of 6.7% adjusted for inflation, implying a doubling every 12 years or so. Trying to beat the market is a fools game.

  4. #4 Eric Lund
    February 28, 2011

    @DCS: But we do, in fact, have a portable defined-benefit pension plan in this country. It’s called Social Security. It’s hardly a perfect system, but it does a reasonably good job of keeping healthy seniors from starving.

    The bigger problem with defined-benefit pension plans is that the sociopaths who tend to run big corporations these days find it hard to resist the temptation to underfund, if not outright loot, the pensions.

  5. #5 Wow
    February 28, 2011

    (further #4, see the pensions scandal for Maxwell news corp)

  6. #6 Stephanie Z
    February 28, 2011

    Eric, you won’t catch me saying that there aren’t still plenty of underfunded DB pension plans, but the Pension Protection Act (2006?) has made it more difficult to quietly engage in significant underfunding. The “quietly” part has some impact, as that sort of thing signals economic weakness to investors. That means it hits stock prices, which tend to flow through to executive compensation.

    All of which doesn’t mean it doesn’t happen, but it does decrease the motivation.

  7. #7 Wow
    March 1, 2011

    Stephanie, the USA’s social security shortfall is a direct result of such “quiet defunding”.

    The result being that Republicans are saying that SS isn’t funded therefore the entitlements have to be cut, but the high tax cuts that were funded from this theft WERE funded in the past, therefore they should continue.

    And please ignore that they aren’t funded any more, m’kay?

  8. #8 Stephanie Z
    March 1, 2011

    Wow, funding for Social Security and private pensions are so completely noncomparable that your statement doesn’t make a lot of sense. Yes, arguments against Social Security rely on people’s inability to understand math and accounting, but no, Social Security is not unfunded and has not been defunded.