This one falls into the category of, “if this book can get published, why can’t I write a book, too?” Because I don’t have the resume and the connections, of course. The author is a sociology professor, with eight prior publications in his actual field of expertise, but with no particular expertise in the field of retirement except his own personal experiences as an activist who sued the state for violating their fiduciary duties in the course of their management of the retirement plan for university teachers. And his basic premise is that the replacement of the Defined Benefit plan with 401(k)s, in the U.S., and the development of contribution-based Social Security systems elsewhere, is due to the nefarious scheming of the greedy financial services industry.
And I don’t want to turn into the blogger who always criticizes everything she reads. So here’s a quick reminder: I really, really like the idea of pooled retirement plans, as proposed by Senator Harkin (though I’d modify the bill in various ways), although the specific legislation doesn’t seem to be going anywhere, and wrote about it at length back in February.
In any case, I figure that summarizing his book gives me an organizing framework for something of The Truth in 401(k) history.
He starts with “Before the Swindle,” in which he portrays the pre-401(k) days as a golden period. Social Security saved the elderly from poverty — though he mentions the initial 1% payroll tax and fails to mention that, as benefits grew over time, the tax rate did, too. And Defined Benefit plans — well, they were basically a foolproof method of providing retirement benefits, with public employers “taking the lead” in retirement benefits.
He says, “until 1980, most public- and private-sector retirement plans, as well as Social Security, were techinically defined benefit plans. In those plans, plans, participants pay into a collective pool from which benefits to retirees are paid.” Benefits were funded on a pay-as-you-go basis in private plans, until ERISA established minimum funding requirements in 1974, but even underfunded plans are OK because incoming contributions will fund current benefits.
Need I say that this is very simplistic? The first odd thing is that he refers to “participant” contributions but virtually no private-sector plans require employee contributions, because, unlike 401(k) contributions, they are taxed rather than being made pre-tax. Second, he mentions the Studebaker bankruptcy which was part of the impetus of the funding requirements in ERISA, but fails to truly recognize that, unlike state pensions where, let’s face it, the state government isn’t going anywhere, unfunded private-sector plans are not a trivial issue. The PBGC protects pension participants but no one’s particularly happy with the prospect of the government assuming large liabilities. And it’s not the magic of “pooled” funds that kept DB plans going, but employers who were required to pay benefits no matter what.
And Social Security and employer-sponsored plans both benefitted from the growth in the economy and the population in their heyday. There are quotes from Social Security policymakers from its early days praising it as a “good” pyramid scheme, and in the early days of employer-sponsored DB plans, they were seen as basically free money — promising benefits to workers that would be paid far into the future, to save on pay increases in the present, and expecting that the company would continue to grow, so that when benefits came due, they would be a trivial expense.
Little did people imagine at the time that GM would one day be called a pension plan which makes cars, due to the size of its pension liabilities relative to the company itself!
Chapter 2, A Fix for What Wasn’t Broken, starts with a detour into Milton Friedman and his devotees, then moves onto the advent of 401(k)s. “When the Republicans came into national office in 1981, 59 percent of people who had private employer-based retirement plans had defined benefit plans. Section 401(k) had been part of Internal Revenue Code for just over two years. In 1978, Ted Benna, a benefits consultant, convinced the Internal Revenue Service to add subsection (k) to section 401 of the code. . . by 2010 . . . only 19 percent [of private-sector workers with retirement plans] had defined benefit plans, while 81 percent had defined contribution ones.”
Why did this happen? Quite simply, because companies were greedy; they saw an opportunity to get rid of risk and to reduce their total compensation costs (by funding 401(k)s less generously than they previously had their DB plans), and they took it, deceiving their employees into believing they were getting a better deal than they actually were.
Let’s start with the fact that Benna did not “convince” the IRS of anything. The IRS code is law, passed by Congress. Section 401(k) already existed. What Benna did was realize that this existing provision could be used to allow employees to save money for retirement on a pre-tax basis — and, to clarify, the 401(k) plan refers to an employee’s ability to defer compensation; employer contributions are a different story altogether, and various forms of “DC” plans had been around pre-401(k), including Money Purchase Pension Plans (a form of DC in which the employer commits to a fixed percent of pay contribution each year, and the default benefit form is an annuity), and more generic “capital accumulation” plans.
There are also two reasons for the shift from 59/41 to 19/81: existing employers freezing DB plans, and newly established companies, or companies offering retirement plans for the first time, choosing a 401(k).
And employers weren’t simply motivated by cost-cutting, and weren’t tricking their employees. Traditional defined benefit plans are designed to provide significant benefits to career employees, and much smaller benefits to job-hoppers, even if they stick around long enough to vest. Consider a worker who leaves a job after 10 years, at age 32, with a pay of 30,000, and receives a benefit of 1% of pay x years of service x final pay. His benefit for this period is 10% of 30,000 = 3,000 per year, at age 65. If he had stuck around, and had annual pay raises of, conservatively, 3% per year, he’d be getting, for just this 10-year period, about $8,000 per year. This means that a worker who expects to work at many different companies is much better off with a 401(k) plan than a DB plan, even if they had the same vesting requirements, and that when employers modelled changes to 401(k)s or “cash balance” pension plans, they had to take into account that the benefit at retirement for a full-career employee would be lower, but benefits for workers who leave at a younger age would be higher than before.
In the author’s case, he chose a 401(k) when he started what turned into his “lifetime” job, but he didn’t know at the time that he would make his career there; hindsight is 20/20.
Here’s another Fun Fact: in the UK, employers are moving to Defined Contribution plans at an even faster clip than in the U.S., and with the very clear intention of cutting costs. He cites DC plans as having contribution rates of 5.8% of pay, compared to 14.2% for DB plans. Well, guess what? Perfectly ordinary DB plans became increasingly expensive as the government added increasing layers of requirements: mandatory COLAs, spouses’ and orphans’ pensions, indexation of pensions for deferred vested employees, and more; and funding requirements became a lot stricter (including very conservative mortality assumptions projecting life expectancy improvement into the future) — so that pension costs grew out of control. He says 14%. My colleagues in the UK say it’s more like 25% — which is just not sustainable.
Next Chapter: Army Tanks and Think Tanks.
So he starts with the Pinochet coup in Chile. I get that Pinochet was a dictator, but I didn’t realize the prior context, that the overthrown president, Allende, was a socialist who was busily expropriating businesses. I haven’t really studied this whole history and I suspect it’s not as simple as the “Allende good, Pinochet evil” version that Russell tells (it’s my understanding that the economic reforms of this period helped Chile become a middle-income country — and, unlike many of its neighbors, we can actually set discount rates for actuarial valuations using corporate bond rates). In any event, Pinochet set about privatizing the Social Security system by replacing existing defined benefits with a 10% contribution to a pension fund, with a minimum benefit.
Later, the World Bank developed its multipillar model, in which the largest portion of retirement benefits are from individual accounts, and this system was adopted, with variations, by multiple Latin American and Eastern European countries.
But, he says, the World Bank is a bunch of hypocrites because World Bank officials themselves don’t have DC, but rather, DB plans.
So here’s the bottom line: the World Bank multipillar system was intended to meet dual purposes of providing retirement savings and to help countries which are trying to develop modern financial systems — especially Eastern European countries emerging from communism. Is the World Bank a bunch of hypocrites for having a DB plan? They never said that employers can’t offer DB plans, but the reality of the countries they worked with is that no such employer-sponsored plans existed in the first place, except perhaps for executives, so that creating an environment with any sort of voluntary employer retirement provision is a big step in the first place.
Next up: “Targeting Social Security and Public Worker Pensions”
In which he finally gets to a favorite liberal trope and references the Koch brothers to be sure we know how nefarious Social Security privatizers are, mentioning a publication by the “Koch brothers-financed Cato Institute” (page 54).
Russell starts with the Social Security proposals of David Stockman, which were too bitter a pill for the Soc Sec crisis of the early 80s and were thoroughly rejected, to be replaced by a mix of tax increases and benefit cuts, which he describes reasonably neutrally. He then moves to further proposals for Social Security privatization, which he attributes to the profit motive: “The more that Social Security can be privatized, the more new profit opportunities the financial services industry will have.”
Would any such privatization proposal have made any sense? Russell says no, but offers no other analysis than the fact that his annuitized TIAA-CREF benefit was lower, as a percent of contributions, than his Social Security benefit.
Conservative think tanks continued to publish Social Security privatization proposals, and President George W. Bush tried to use his political capital to push such a program but the public wasn’t buying it. Other proposals consisted of what Russell calls “add-on” privatization: “An add-on proposal, like the USA accounts, would continue the same revenue base for Social Security, while giving citizens government subsidies to open private accounts in addition . . . Add-ons . . . choke off the possibility of expanding hte defined benefit character of Social Security.”
Subsequent to this proposal, in 2010, the Simpson-Bowles commission on deficit reduction recommended significant cuts in Social Security, all of which Russell opposes. Raising the retirement age? It would hurt manual workers who are worn out from their work sooner than white-collar workers. Reducing the COLA? Squeezes the elderly. Reducing benefit accruals for upper earners? “The long-term effect, if not a stated goal, would be to reduce Social Security to an elderly poverty-reduction program only, eventually possibly even a means-tested one.”
Time to jump in again.
The key idea behind any privatization proposal is that a funded Social Security system has more stability than an unfunded one, and that having a clear relationship between benefits and contributions minimizes political trickery. When Social Security was taking in more in taxes than it was paying out, the money just went to offset deficits in the federal budget. If there had been funded accounts, the excess contributions wouldn’t have been “lost.” of course, the same goal could have been accomplished by a “Sovereign Wealth”-type fund, in which the Social Security Administration invests in the private market, but there was a quite reasonable fear that pressure would be too great for such a fund to truly be run in an apolitical way, vs. investing in favored industries.
Next item: his claim that Social Security is the better deal based on contributions vs. annuities. I can’t check his math, but he refers to the “total accumulation” in the TIAA-CREF statement, and it’s not clear to me whether he truly differentiates between the account balance and the split between contributions and investment earnings; he also fails to recognize that, as an older worker, he’s benefitted greatly from the fact that Social Security contributions were originally much lower than now. There are plenty of studies that discuss the actuarial “fairness” or lack thereof, of Social Security vs. private plans, but he doesn’t cite any of them in his text except to make a blanket claim that any projection that makes private accounts look good uses unrealistic assumptions.
But it becomes clear at this point that he rejects any manner of private saving for retirement. He’s also now beginning to speak quite contradictorily: Social Security functions on individual contributions, and everybody pays their own way (though he acknowledges this isn’t really true), but yet there’s nothing about Social Security’s actuarial position that a nice healthy tax increase won’t solve, especially by removing caps on taxable income (which would, of course, make this a “welfare” program for the middle class, and whether Russell gets this and doesn’t want to acknowledge it, or not, I’m not sure).
Finally, a lengthy section on public pensions. He discusses campaigns to move state workers to 401(k)s , and claims that this is wholly unnecessary because public pensions are, on average, well-funded, and, even those that aren’t, are not in any real danger because they can continue to pay benefits on a pay-as-you-go fashion.
He doesn’t really get it. The issue with public pensions isn’t their funding level. It’s the corruption — legislators increasing benefit levels beyond all reason, with early retirement ages, substantial pay replacement, and full COLAs, because they’ll get union support without the bill coming due until long after they’ve left power. Pensions which are generally untouchable for existing employees, even for future accruals. Local officials and administrators who can play games with pension spiking to maximize benefits, with fat raises just before retirement for teachers, for instance.
What’s more, whether pension plans are “fully funded” means something different for public vs. private plans; for accounting purposes, a state plan’s actuarial valuation is based on a discount rate derived from their expected asset return (invest in risky assets and magically your liabilities drop) where a private plan is required to use a high-quality corporate bond rate.
Fundamentally, a 401(k) or any similar plan ensures that the State can’t cheat but has to pay its obligations to its employees when they are earned, rather than deferring them to far in the future.
Chapter 5, How 401(k)s are supposed to work and why they don’t
This is taking forever, and I’m only halfway through is book, so I’ll summarize this chapter very briefly: 401(k)s aren’t an adequate replacement for pensions because the financial services industry charges too much in fees. That’s his bottom line.
There’s more to it than that in his story — participants spend their balances between jobs rather than rolling them over (which is no different than participants spending their small-amount lump sums from DB plans), and employers don’t contribute as much to DC plans as they had to DB plans. But that’s basically it.
I don’t have the data in front of me to directly address his statement about investment fees in DC accounts. He is certainly correct that DC accounts earn less and are more expensive, fee-wise, than a proportional share of an employer’s pension fund. His discussion of the price-gouging of annuity providers misunderstands how insurance annuities work, though, and I’ll address that later because he returns to the subject.
Chapter 6, A Model Unravels
Was the Chilean model the solution to everything? People discovered that it wasn’t providing returns as high as hoped, and that many Chileans would be receiving very low incomes from their accounts. The solution was not to return to a traditional DB system, but to top-up the DC accounts.
Russell then discusses the private accounts in Argentina, and praises the Kirchner nationalization of these accounts in 2008, 15 years after the private account system was begun. Was it an expropriation of private funds to shore up a struggling (to put it nicely) government? In Russell’s view, this was nothing other than the government “protect[ing] victims of a financial swindle.”
Chapter 7, Turmoil in the Land of Steady Habits
Here Russell tells his personal story. In 1986, he joined the faculty at Eastern Connecticut State University, and had the option to join the public pension plan or the TIAA-CREF 401(k); he chose the latter without much understanding of the difference between the two, and was shocked, when he reached retirement age, at how little a benefit this had earned him, so he asked nicely to be let back into the public DB plan, then found out that they had grounds for a lawsuit: “the state was guilty of wrongdoing by not providing ARP members with adequate inforamtion. Their officials had not told new employees that the ARP and SERS plans rendered unequal benefits. Nor had they told new employees that their decisions would be irrevocable.” As a result of their lawsuit and union negotiations, the DC participants were given the opportunity to return to the DB plan by transferring back their accrued balances, though he doesn’t detail the mechanics of the transfer.
Last Chapter, What We Can Do
In which he moves on to his prescriptions.
1. Strengthen and Expand Social Security
I mentioned before his twin statements that Social Security benefits are earned, fair and square, but at the same time, the cure for Social Security’s actuarial imbalance is to remove the cap on wage income and to begin to tax non-wage income; in other words, to make the Social Security “FICA contributions” into a component of ordinary income tax.
2. Supplementary Social Security Accounts
“Social Security could be expanded so that employers could begin eliminating their employee retirement plans and redirecting contributions into new supplementary Social Security accounts. The accounts would increase Social Security benefits for participants.”
Look, I get that he’s not an actuary. But he has no business proposing ideas such as this without any clue as to what this would mean in terms of the numbers or any mechanics of how it would work.
He also proposes supplementary IRAs which would allow participants to add to their average wage (by filling in years with low pay in the 35-year average) to increase their Social Security benefit at retirement.
3. Social Security Annuities
For existing DC accounts, mandate annuitization at retirement, and, because they are “unfairly” priced, set up Social Security as a public at-cost annuity provider. “Essentially, this would represent a nationalization of the annuity business – the creation of public options that would be so attractive that for-profit companies could not compete.”
This is where is failure to understand annuity pricing really comes into play. A public retirement plan is able to offer annuities that are a “better deal” than an insurance company for a number of reasons:
The insurance company bears full responsibility for the payment of annuities years into the future, and accordingly needs to invest conservatively, in fixed-income securities. A public provider such as the state faces no such need. Likewise a private employer can make up shortfalls over time from its own funds, or from the PBGC in the worst case. Private and public pension funds also don’t face the sort of reserve requirements as an annuity provider.
The insurance company is generally much more conservative in its assumptions about life expectancy, assuming a fair amount of improvement in the future; pension plans use the current government-mandated table which, while it is becoming more conservative, is still more of a “best estimate” of current life expectancy, with no margin for conservatism.
A retirement plan which uses annuity factors as a conversion factor for mandatory annuitization doesn’t have the same issue with adverse selection as annuities purchased in the individual market (that is, sickly old people are less likely to buy annuities). Here Russell is right that mandatory annuitization would be cheaper, in the same way as, when large employers like GM have been making the news lately by buying annuities for all their retirees, they get a better deal than an individual would. But Russell had better think long and hard about whether he really wants to mandate that the 65-year-old construction worker be required to annuitize his benefit with the same terms as a white-collar worker.
4. Take Control of Your Retirement Plan
This is less interesting because it’s the same generic information about maximizing benefits at retirement on a personal level. yadda, yadda, yadda.
But he says this, “If, as in my case, your employer has a defined benefit plan, you should try to get into it. If your employer does not have such a plan, you could suggest it switch to one” — or work with your union to achieve this.
Here’s the bottom line:
Employers are not going to switch back to DB plans. Yes, pooled investments professionally managed improve outcomes, and some of the consulting my firm does is around helping employers find low-fee funds, and encouraging them to set up and standardize target-date funds, in an effort to improve investment outcomes for employees. But employers want out — in none of our consulting around improving employees’ retirement funds is it even a consideration for employers to increase their contributions.
What’s more, DB plans were such a great deal for employees (or, more narrowly, full-career employees) because the employer bore all the risk. Employers are much more risk-conscious, and the particular watchword now is, “don’t take risks without quantifying them” and “don’t take risks in areas that are outside your core business expertise.” With few exceptions, private sector employers aren’t going to continue to shoulder the risk of pension plans any longer, and that’s just a simple fact.
That’s why I support pooled pension plans, which aim to recreate some of the advantages of the traditional DB plan in our changed world. But one has to understand that risk doesn’t disappear here, either — in various models, participants ultimately bear the risk that their benefits could drop, and there may be a role for a PBGC-like entity guaranteeing pensions, with a need for a very careful balancing of risk while allowing funds to be return-seeking.
Sigh. . . . I could write a book about it.