Pensions and careers have changed. Ramesh Ponnuru thinks the retirement changes are for the better and we heartily agree. We will give an example and explain why it matters. Ramesh thinks Americans should stop mourning the loss of traditional (defined benefit) pensions concludes:
These are changes that would build on, rather than attempt to reverse, the last few decades of developments in the American retirement system. Those developments, especially the rise of the 401(k), have largely been for the better.
Sidebar One: Pensions can be divided into defined benefit and defined contribution. In a defined benefit plan you typically get a pension equal to then number of years worked * highest salary over three years * a percentage. So if you work 30 years and your percentage is 1.8 then you get 54 percent of your highest salary. A 401 (k) is an example of a defined contribution plan where a defined amount is invested and you get the result at retirement. We often think that the worker takes the risk in a defined contribution plan and the company takes the risk in a defined benefit plan. That is only true if the worker retires from that employer. We will show details later. End Sidebar One.
Sidebar Two: Risk is both upside and downside. If a worker spends his entire career with one employer then a defined contribution plan is more risky because he might get much more or much less than a defined benefit plan. End Sidebar Two.
The big reason for changing pensions is that the nature of careers have changed. Years ago it was bad to have a resume that indicated you were a job hopper. Now career advice is:
If you are changing jobs less than every three years, you are in the minority.
You may need to have a well-prepared explanation when you front up to your next job interview.
It also true that employers come and go. Both of these are reasons why we should cheer at the increasing number of defined contribution plans.
MWG has a defined benefit pension plan. It worked very well for us although it limited our opportunities, as it was intended to do, in the time close to retirement. It worked very well for us because we spent nearly 40 years with one employer. Thus, our paltry year salaries in the seventies and eighties were irrelevant and only the years mattered in the computation of benefits. If we had of switched employers it would have been bad for us because our salary was so low. Another benefit was sick days. In our case sick days accumulate and can be used to pay for medical insurance after retirement. The sick day benefit is based on your highest salary but you must retire in order to get it. Thus, because of both sick days and defined benefit, as retirement approached it was financial suicide for us to leave before retiring. When we became eligible for retirement, the sick days became a powerful incentive towards retirement because workers had to pay for part of the cost of health insurance but retirees, like us, with lots of sick days did not.
For us and our employer, the defined benefit plan worked. We got a nice retirement and they got us to work for less than market prices late in our career. We are not sure if the intent of the pension was to get us to retire. It was effective at that too. We retired because the tax on working was over 100 percent. That is, we had more disposable income in the first year of retirement then we would have had if we worked that year.
Defined contribution was a fair deal for us in another era. Even then we were a minority in staying with one organization so long. Now we would be a micro-minority. Defined contribution is the way to go in the new environment. We need to find incentives to increase them. We have three suggestions:
First make health insurance benefits taxable to the recipient.
Second, increase social security benefits for the needy by means testing benefits for high income individuals.
Third, increase the tax benefits of Roth IRAs. Make the contribution tax deductible and keep the returns not taxable.
The first would help by producing a bit of government revenue and focusing both employer and employee on the retirement issue. The second would provide a safety net to the really needy. The third would reduce complexity at retirement because everyone would go Roth and there wouldn’t be any taxes having an impact on decision making.
As Ramesh says, let us build on the success of 401 (k) plans. Folks are looking for freedom. The right incentives will help them make good choices.