There are two major types of retirement plans: defined contribution plans like 401(k)s, and defined benefit plans like pensions.
Both have flaws and advantages. Pensions are supposed to guarantee a level of income during retirement, but they make kicking the can down the road incredibly easy, creating underfunded obligations that have helped cripple companies like General Motors (NYSE:GM). Defined contribution plans are much more transparent -- what you see is what you get -- but given low levels of median household income growth and meager savings rates, they leave most participants ill-prepared for retirement.
So, simple question: Which is better?
Two weeks ago, I posed that question to Joseph Dear, chief investment officer of CalPERS, the nation's largest pension fund. Here's what he had to say (transcript follows):
Morgan Housel: Do you think defined benefit plans like pensions have done a better job at preparing America for retirement than defined contributions like 401(k)s?
Joseph Dear: Defined benefit plans have some incredibly significant advantages over defined contribution plans. CalPERS runs a huge defined benefit plan, but we also run a defined contribution plan that's a supplement and you can see other states with hybrid systems, so I don't know if it's always only one thing or another.
I think one of the things that not recognized in defined benefit plans that's really important is that we're one of the largest sources of long-term patient capital in the economy. We can invest in companies and not sell out tomorrow or in the next five seconds, that we can buy and hold. That's why private equity investment is important for us. We can do things like venture capital that are high risk and high return, but some of those venture capital firms become enormous. Somebody funded Google. Now it's a centerpiece of our economy. I think that's an important role.
The pension dollar that we pay out to the beneficiary is about two-thirds investment. That's a pretty good deal for taxpayers. You're getting a safe retirement, an economic security for public workers at a cost to the taxpayer of about 15 to 20 cents per dollar. That's a heck of a good value.
The critics of defined benefit plans say that all the risk is on the taxpayer and none of it is on the worker and then so they want to flip it over and let's have defined contribution plans be the answer where all of the risk is on the worker. Well risk transfer is a good public policy topic to talk about, but if you do it in defined contribution space and expect individual workers who in many instances are totally intimidated by the choices they have in investment, is that really the right way to handle it? And if you add on investment structures which are really designed for the advantage of investment managers, not of individuals. And here I'm talking about fees, you can end up with somebody making exactly the same contributions in a defined contribution plan and getting a much lower benefit than they would in a defined benefit plan simply because of how it's structured.
So if you want to talk about alternatives to defined benefit, I think they need to not look at defined contribution, but to look at systems that address that risk stance far differently, but make it possible for non-experts to be given a set of choices which they are capable of making and which will enable them to have adequate retirement when they decide to stop working.
Fool contributor Morgan Housel has no positions in the stocks mentioned above. The Motley Fool owns shares of Google. Motley Fool newsletter services recommend General Motors and Google. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.