Tag Archives: Defined Contribution

Revised: Should Social Security Switch to a Defined Contribution Plan?

Just recently, I had the opportunity to have dinner with my dad.  Given our mutual interests, our conversation naturally drifted towards finance.  My dad playfully joked how excited he is to start receiving pension checks in just a few years.  Even though these checks will be small, I responded jealously; when I start working this fall, there will be no pension program waiting.

This shift away from pension programs is not unique to my father and me.  Over the last 40 years, many employers have switched away from pension retirement plans (more generally called defined benefit (DB) plans), for defined contribution (DC) plans (like 401K’s).  Under DB plans, employers pay a predetermined amount of cash to former employees after those employees reach retirement age.  Under DC plans, employers set aside a certain amount of money each year to assist employees in developing a retirement savings account.  As the graph below shows, the shift away from DB plans to DC plans has been staggering.  Since 1979, for employees lucky enough to have corporate-sponsored retirement plans, enrollment in DB plans has dropped 57% while enrollment in DC plans has grown 55%.

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This transition to DC plans is largely due to an increase in life expectancy rendering DB plans unsustainable (ie: as people live longer they collect benefits longer, increasing the onus placed on firms and requiring progressively more cash to fund DB plans).  This year, the Society of Actuaries released new life expectancies for the first time since 2000.  In the last 14 years, men’s life expectancy has grown from 82.6 years to 86.6 and women’s has grown from 85.2 years to 88.8.  Driven by increases in technology and better health care, this upward trend is only expected to increase.  Prior to this revision of life expectancy, outstanding private sector liabilities related to DB plans hovered around $2 trillion.  After this revision, these liabilities are expected to grow at least another 7%, bringing outstanding liabilities to $2.14 trillion, which represents over 13% of US GDP!

As anyone familiar with a balance sheet knows, liabilities must be paid, and doing so is no easy task.  Considering that life expectancy is expected to grow further, it’s not surprising that firms are switching to DC plans from DB, as doing so helps reduce total liabilities.  Specifically, the switch to DC from DB helps reduce liabilities by shifting investment risk away from firms and to retirees.  Under a DB plan, firms are responsible for paying a set amount of retirement income in the future.  To generate this future outflow, firms invest cash now, hoping it will grow enough to fund the promised pension payments.  Unfortunately, very few firms invest enough to meet the entire defined benefit payment, as most firms assume unrealistically high returns when making investments.  Doing so causes many firms to drastically underfund their DB plans, generating enormous liabilities (with potentially crippling consequences) in the process.  In contrast, a DC plan is much more sustainable because it does not promise any future cash payments, and therefore does not create any liabilities.  Rather, a DC plan only requires firms to presently invest cash on behalf of its employees, with the future retiree bearing the investment risk.

Does this mean that the switch from DB to DC is a bad thing for retirees?  After research, I believe it’s a wash.  That said, I did find some strong evidence suggesting that, under the right circumstances, DC plans can offer higher returns than DB.  A study by Dartmouth College found that the typical DC 401K-retirement plan, “provides an expected annuitized retirement income that is higher across nearly every point in the probability distribution than the typical defined benefit plan.”

If you check my sources, however, you’ll see that this study was performed before the Great Recession, when the market collapse took a huge toll on many nest eggs.  But even with such a dramatic downturn, DB and DC plans still perform similarly; over the last ten years, DB benefits have only outperformed DC plans by 0.86%.  Furthermore, most of this underperformance is due to a failure of individuals to make maximum contributions to their plan.

Based on this data, I should be indifferent between DB and DC plans because I know my retirement income will be similar under both options.  However, I am largely in favor of DC plans because they eliminate the liabilities associated with DB payments.  So how is this conclusion relevant to social security?  Personally, I believe a gradual shift from government-sponsored DB payments (ie: social security payments) to government-mandated DC contributions could help solve social security’s sustainability issue.

According to the Heritage Foundation, the expected insolvency date of social security is approaching faster and faster; in the last five years, this date has declined 8 years and is currently set at 2033.  However, given current conditions, the Heritage Foundation predicts that insolvency could come as early as 2024 (when originally started, social security was designed to remain solvent until 2058).  Given that social security represents 22% of the US federal budget, insolvency is no trivial issue, and reform is needed sooner rather than later.

I propose that this reform should include a switch from a DB plan to a DC plan.  While social security payments should remain intact for current and soon-to-be beneficiaries, I believe that social security tax should gradually be replaced with a social security “withholding.”  For example, if social security tax is currently 10% of income, I propose it should be reduced to 5% of income in, let’s say, ten years.  In those ten years, the social security withholding should grow to 5% of income.  Eventually, social security tax should fall to 0% of income and be replaced entirely by the withholding (Personally, because I think savings is so important, I think that this withholding should ultimately represent a higher percentage of income than social security tax ever has or will).

Like a 401K contribution, I propose that this withholding should be invested, tax-free, in a retirement account on an individual basis.  Essentially, this withholding is equivalent to automatic-enrollment in a government-mandated 401K plan.  As individuals continue to work, instead of paying taxes to fund social security, they will pay withholdings to help fund their own retirement.

With respect to investment decisions, the government should have a default option requiring individuals to purchase relatively safe, well-diversified indexes (like a global fund).  If individuals would like, they should be allowed to invest up to half of their withholdings on indexes of their choice (I limit investment to indexes because, as Malkiel makes obvious in A Random Walk Down Wall Street, indexes are the safest way to make money.  On average, even professional money mangers cannot outperform indexes that track the aggregate market).  Once individuals reach retirement age (ie: the age they would have qualified for social security) they can begin making withdrawals from this retirement account.

My proposed plan has some similarities to George W. Bush’s proposal of private savings accounts in early 2000.  Under the most successful of Bush’s privatization proposals, taxpayers could divert 4% of taxable wages or a maximum of $1000 from FICA payments to fund personally managed retirement accounts.  These contributions would not replace, but rather would offset, social security’s existing DB payments.  Workers would then have the option to invest their private accounts in 5 different funds.

The key difference between my proposal and Bush’s proposal is the long-term implications for social security.  Bush’s proposal aimed to prolong, not eliminate, the insolvency date of social security by offsetting social security’s DB payments with some DC payments.  In contrast, my plan proposes a gradual but complete transition of social security from a DB plan to a DC plan, thereby rendering insolvency irrelevant.

While my plan is not perfect, I believe it effectively addresses the sustainability of social security by gradually eliminating government-paid DB benefits.  Furthermore, it forces individuals to save for retirement by replacing a significant portion of their taxable income with government-mandated savings.  I believe this system, by eliminating the liabilities related to DB retirement plans, is much more sustainable than social security, and it has the double-benefit of encouraging savings and investment literacy.  As always, I welcome any and all suggestions as we collectively try to address the issue of social security sustainability.

Should Social Security Switch to a Defined Contribution Plan?

After discussing defined benefit (DB) and defined contribution (DC) retirement plans in class yesterday, I was  intrigued to explore the issue further.  Professor Kimball mentioned that DC plans are starting to replace DB plans, but what is motivating this switch?  And are there any implications for social security?  After a little research, I’ve concluded that, given the growth in life expectancies, DB plans are unsustainable.  As such, firms are necessarily switching to DC plans to avoid insolvency.

This year, the Society of Actuaries released new life expectancies for the first time since 2000.  Since 2000, men’s life expectancy has grown from 82.6 years to 86.6 and women’s has grown from 85.2 years to 88.8.  Driven by increases in technology and better health care, this upward trend is only expected to increase (Professor Kimball joked that we may be one of the last generations to die).  Prior to this revision of life expectancy, outstanding private sector liabilities related to DB plans hovered around $2 trillion.  After this revision, these outstanding liabilities are expected to grow at least another 7%, bringing outstanding liabilities to $2.14 trillion, which represents over 13% of US GDP!

As anyone familiar with a balance sheet knows, liabilities must be paid, and paying down the above mentioned DB liabilities is no easy task.  Considering that life expectancy, and in turn outstanding DB liabilities, is expected to grow further, it’s not surprising that firms are switching to DC plans from DB.  Indeed, while some 60 million Americans are still covered by DB plans, since 1979, DB enrollment has fallen from 38% of Americans to 14%.  In the past decade alone, enrollment in DC plans has more than doubled to include over 40% of Americans.  Given the magnitude of outstanding DB-related liabilities, firms have had little choice but to initiate this switch.

But is the switch from DB to DC a bad thing?  After research, I believe it’s a wash.  That said, did find some strong evidence suggesting that, under the right circumstances, DC plans can offer higher returns than DB.  A study by Dartmouth College found that the typical DC 401K-retirement plan, “provide an expected annuitized retirement income that is higher across nearly every point in the probability distribution than the typical defined benefit plan.”  

That said, if you check my sources, you’ll see that this study was performed before the Great Recession, when the market collapse took a huge toll on many nest eggs.  But even with such a dramatic downturn, DB and DC plans still perform similarly; over the last 10 years, DB benefits have only outperformed DC plans by 0.86%, with most of this underperformance caused by a failure of individuals to make maximum contributions to their plan.

Based on this data, I should be indifferent between DB and DC plans because I know my retirement income will likely be similar under both options.  That said, I am in largely in favor of DC plans because they eliminate the liabilities associated with DB plans.  So how is this relevant to social security?  Personally, I believe a gradual shift from government-sponsored DB payments (ie: social security payments) to government-mandated DC contributions will solve social security’s sustainability issue.

According to the Heritage Foundation, the expected insolvency date of social security is approaching faster and faster; in the last five years, this date has declined 8 years and is currently set at 2033.  However, given current conditions, the Heritage Foundation predicts that insolvency could come as early as 2024 (when originally started, social security was designed to remain solvent until 2058).  Given that social security represents 22% of the US federal budget, insolvency is no trivial issue, and reform is needed sooner rather than later.

I propose that this reform should include a switch from a DB plan to a DCB plan.  While social security payments should remain intact for current and soon-to-be beneficiaries, I believe that social security tax should gradually be replaced with a social security “withholding.”  Like a 401K contribution, I propose that this withholding should be invested, tax-free, in a retirement account on an individual basis.  Essentially, this withholding is equivalent to automatic-enrollment in a government-mandated 401K plan.  As individuals continue to work,  instead of paying taxes to fund social security, they will pay witholdings to help fund their own retirement plan.

With respect to investment decisions, the government should have a default option requiring individuals to purchase relatively safe indexes (like the Russell 2000 or the S&P 500).  If individuals would like, they should be allowed to invest up to half of their withholdings on indexes of their choice (I limit investment to indexes because, as Malkiel makes obvious in A Random Walk Down Wall Street, indexes are the safest way to make money.  On average, even profession money mangers cannot outperform indexes tracking the market).  Once individuals reach retirement age (ie: the age they would have qualified for social security) they can begin making withdrawals from this retirement account.

I believe this plan effectively addresses the sustainability of social security.  It eliminates the need for the government to pay DB payments in the form of social security.  Furthermore, it forces individuals to save for retirement by replacing a significant portion of their taxed income with government-mandated savings.  While this is not a perfect system, I believe it is much more sustainable than social security, and it has the double-benefit of encouraging savings and investment literacy.  As always, I welcome any of your suggestions as we collectively try to address the issue of social security sustainability.

Social Security- Situation as bad as it seems?

According to Schieber and Biggs, the retirement situation in America is not as bad as it seems. Over the past 30 years, we have seen many employers switch from defined-benefit pensions to defined contribution savings plans (such as 401(k)s). This switch has lessened the income that is combined with the Social Security benefits that retired individuals receive.

Firstly, it is necessary to distinguish between a defined-benefit plan and a defined contribution savings plan. “A defined contribution plan is a retirement plan that requires that an individual “account” be set up for each participant in the plan — even if the only participant in the plan is you.” It is a “defined contribution” plan because you can only add a fixed maximum amount per year. The contributions are based on a percentage given in the plan. The most common type of defined contribution plan that we have all heard of is called the 401(k). Basically, in a defined contribution plan, a fixed percentage of your income is invested each year.

In contrast, “A defined benefit plan is a retirement plan set up to pay a fixed annual amount to eligible employees during their retirement years.” It is called a “defined benefit” because your quarterly or annual contribution is based on an actuarial calculation of what your benefits should be. At retirement, you receive your benefit. The actuarial calculation will be the smaller of the two options: 1) $180,000 or 2) Your average compensation from the three highest, consecutive years where you made the most money. A defined benefit pension plan is the most appealing option because with this option, a portion of your paycheck is not sacrificed. Your employer covers this cost. Whereas in a defined contribution plan, your own money is going into the 401(k).

Accordingly, this is precisely the reason why many companies have been switching from defined benefit to defined contribution; these plans are less costly to the employer. Some employers offer hybrid plans, which are harder to come across. But if the hybrid is offered, it is a good idea to participate in the defined contribution as well because it is likely that the newly refined pension plans will only allow you to ‘just get by’ in retirement.

The writer of the Wall Street Journal article (cited at the beginning) is a former chairman of the Social Security Advisory Board. A brief summary of his claim is that the perception that most retirees will be “poor” is an over exaggeration because retirement income ignores at least 60% of the money that retirees receive. The story that most Americans believe is based upon data from the Current Population Survey (CPS), ran by the U.S. Census Bureau. However, this survey fails to take into account the income that Americans derive from 401(k)s and IRAs (which is defined contribution, the direction in which most employers are pushing toward). This understatement of accounting for retirement funds will only increase as more employers switch to defined contribution plans.

In the article, you will find that there are other measures which the CPS fails to take into account- such as certain tax figures and DC plans, but even though the social security situation is not good (it’s currently operating in deficit), it is clear that the social security predictions are not as grim as they may seem on the surface. In order to make accurate predictions of how to advise successful future policy for social security, it will be necessary to include all measures of retirement incomes that Americans are currently receiving.