Recently, a group of several dozen prominent economists got together at the annual meeting of the Financial Economists Roundtable. Among other topics, they discussed the problems surrounding the changing ways in which American workers choose to save for their retirement. Afterward, the FER released a statement (PDF file) with a number of recommendations on how employers should structure their retirement plans for the benefit of their employees.
The statement begins by citing the shift over the last 25 years from traditional defined benefit pension plans to defined contribution plans. With defined benefit plans, the employee is entitled to a fixed monthly payment at retirement, and the employer retains responsibility for setting aside and investing enough money to cover its pension obligations. With defined contribution plans, on the other hand, the employer merely provides a way in which employees can choose to set aside a portion of their salaries toward their retirement. Some employers also add money to their employees' defined contribution plan accounts through profit sharing and matching contributions. While the majority of employer-sponsored retirement plans were defined benefit plans in 1980, currently, defined contribution plans are in the majority, and continue to gain popularity among employers.
Shifting risk to workers
The FER's primary concern about defined contribution plans is that they shift a number of risks onto employees that were once borne by their employers. First, it's up to each employee to learn enough about investing to make good decisions about how much they choose to save, and what investments they pick with their savings. If an employee chooses a bad investment, or doesn't save enough to cover post-retirement expenses, the employer lacks any responsibility for bailing out the employee. Second, most defined benefit plans paid retirees in the form of monthly pension payments for the remainder of their lives. In some cases, the spouse of an employee could continue receiving those pension benefits even after the employee's death. In contrast, although many defined contribution plans allow participants to elect a monthly payment that will last for life, many retirees choose not to do so, thus assuming the risk that they will outlive their savings and become a burden on society.
But the statement only briefly mentions that changes in employment practices have greatly reduced the effectiveness of defined benefit plans for common workers. Because most defined benefit plans calculate an employee's monthly benefit based on salary and length of service with the company, such plans work well in situations in which workers keep the same job throughout their careers. However, given that many employees now change jobs numerous times over their careers, and may only work for a few years with any one employer, reliance on defined benefit plans would mislead such employees into thinking that their retirement needs would be met, while likely leaving most employees with thoroughly inadequate pension income.
In addition, participants of many defined benefit plans choose to take lump-sum distributions from their plans rather than monthly payments, leaving them vulnerable to the same longevity risk as participants in defined contribution plans. Moreover, the huge pension-funding deficits at large employers like Ford
Changes in plan practices
The FER statement also suggests that employers should take several steps to increase both participation in their retirement plans and the plans' effectiveness in helping employees save for retirement. According to the FER, retirement plans should automatically enroll new employees, pick a contribution percentage, and choose investments for the employee. Employees should not be allowed to use their retirement plans to invest in their employer's stock, although employers could make additional contributions to employee accounts in the form of shares of company stock. Employers should provide education on investments and financial management to employees. Finally, employers should use their better bargaining power to allow retiring employees to obtain favorable rates for annuities that will pay them monthly payments for the remainder of their lives. The recently passed Pension Protection Act of 2006 gives employers many of the tools they need in order to take these steps without infringing on their employees' rights.
It's hard to argue against making more education and distribution options available to employees. However, implicit within the FER statement is a disturbing thought: Employees can't be trusted with the responsibility to manage their own financial affairs. The FER recommendations unfortunately perpetuate the outdated idea that employers should be responsible for taking care of their employees. In the past, when labor unions held significantly more power and protected a much larger percentage of the workforce, it may have been reasonable to expect employers to look out for the best interests of their employees. In today's world, however, where layoffs and staff reductions are an everyday occurrence, suggesting to employees that their employer will take care of their retirement plan options for them is extremely dangerous.
True, statistics show that many people never participate in their employer's retirement plan, and that automatic enrollment would make sure that at least part of their salaries went toward retirement savings. Yet making enrollment, deduction, and investment all automatic processes runs the much greater risk of making employees believe that they can rely on automatic defaults, rather than doing their own specific retirement planning. Employees must know that they are responsible for their own finances, and they need the tools and knowledge to take that responsibility.
Learning about investing and financial planning isn't always easy, but it's part of being a responsible adult member of society. Workers owe it to themselves to take advantage of the numerous options at their disposal to help them make the most of their savings.
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Fool contributor Dan Caplinger likes having control over his retirement savings. He doesn't own shares of any companies mentioned in this article. The Fool's disclosure policy won't quit on you.
