Financing Retirement: The Private Sector; the Shift from Defined Benefit Pensions to Personal Retirement Accounts Is Likely to Benefit Retirees

Article excerpt

Since 1980, there has been a rapid shift from employer-based, defined benefit pensions to employee-controlled personal retirement accounts. This paper documents the shift and explores the conventional wisdom that this shift increases risk for retirees and will result in lower accumulation of retirement assets. In particular, it focuses on personal retirement accounts and considers the options available for retirees to contain risk and assess the likely outcomes over alternative options, including life cycle allocations. It concludes that personal retirement accounts are likely to lead to higher retirement accumulations that are also less risky than would be the case under defined benefit plans.

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Over the past two and a half decades there has been a fundamental change in saving for retirement in the United States, with a rapid shift from saving through employer-managed defined benefit pensions to defined contribution saving plans that are largely controlled by employees. In 1980, 92 percent of private retirement saving contributions went to employer-based plans; 64 percent of these contributions were to defined benefit plans. By 1999, about 88 percent of private contributions were to plans in which individuals decide how much to contribute to the plan, how to invest plan assets, and how and when to withdraw money from the plan. The most important type of personal retirement account is a 401(k), but personal plans also include 403(b), 457(b), traditional and Roth Individual Retirement Accounts (IRAs), and other plans. (1) In the subsequent discussion, "401(k)" includes all of these personal retirement plans.

I will first review the spread and current role of 401(k) plans and then consider the future role of 401(k) plans in retirement saving. I will then comment on the risk of such plans and how retirees may evaluate the risk of alternative investment options. There has been a great deal of comment in the press and elsewhere about the risk of personal retirement plans, perhaps especially following the Enron collapse. The comments often emphasize the market risk of personal plans. Risk compared to what? The implicit assumption is often that employees bear the risk under personal accounts, while under defined benefit plans the risk is born by employers, and there is no risk to employees. However, the bankruptcy of United Airlines and other airlines, for example, makes clear that employees can also be at risk under defined benefit plans. More important, however, the job change risk to employees under defined benefit plans is very substantial. I will not discuss further in this paper the risk under defined benefit plans. (2) Rather, I will consider evidence on how retirees may value uncertain wealth accumulations under alternative investment allocations options in 401(k) plans. I will also consider how risk in such plans might be reduced by life cycle funds and other means and how much employees might gain from such investment strategies.

The spread of 401(k) plans

Figure 1 is a cohort representation of the rapid increase in eligibility for a 401(k) plan since 1984. The figure shows data for nine cohorts, five years apart, denoted by the age of the cohort in 1984. These cohort data were calculated from several waves of the Survey of Income and Program Participation (SIPP). Data are available for seven years noted by the markers--1984, 1987, 1991, 1993, 1995, 1998, and 2003. Each line shows the increase in family eligibility as the cohort ages. Consider cohort C25 that was 25 years old in 1984. In 1984, about six percent of the C25 cohort families were eligible for a 401(k) plan. (3) By 1987, when the cohort was age 28, the percent that was eligible had risen to about 17 percent. By 2003, when the cohort was age 44, eligibility was almost 70 percent. The most important feature of the figure is the increase in eligibility over time for families of a given age. For example, the dashed vertical line highlights the increase in the eligibility of families in cohorts that attained age 40 in successively later years. …