There is a crisis in defined contribution retirement plans. In addition to devastating market losses, employers are ceasing their matches. Many target date funds, designed to protect participants' plan balances as they approach retirement, have lost more than 30% of their value.
To fix the problem, Congress is considering everything from nationalization to simple fee disclosure. The Department of Labor has been proposing regulations covering participant advice rules, transparency of costs and disclosure of conflicts of interest.
Will these fixes work? More important, can 401(k) plans be fixed or is the vehicle itself the problem?
To answer those questions, let's go back a bit. The driving force behind "fixing" 401(k) plans is securing the retirement income of future retirees. And talk of secure retirement income inevitably conjures a longing for the safety and security of old-fashioned defined benefit pension plans. In the good old days, as seen through the golden haze of nostalgia, most people worked at one employer until they were 65 and then received a comfortable pension for the rest of their lives. But that blissful memory is not entirely accurate, especially since the problems of defined benefit plans drove the popularity of 401(k) plans in the first place.
The chief problem of defined benefit plans is that its safety came at a price. Participants had no material control over their benefit, no choice in delaying funding if that made sense and no option to increase funding to provide higher benefits beyond what an employer "gave" to its workers. As a participant, you were stuck taking what was offered.
Also, the safety and security of defined benefit plans are something of a myth. Most DB plans permit lump sum distributions at retirement, enabling participants to day-trade away what was intended to be secure retirement income. And as far as safety is concerned, just ask an airline pilot or a United Auto Worker if the benefits "guaranteed" to them 20 years ago are the same (and as secure) as they falsely believed back then.
Just as participants in defined benefit plans received the safety and security of future benefits — however compromised — in exchange for giving up certain choices, 401(k) plan participants can make the same trade-offs if they so choose. They can give up control of their benefit at retirement to an insurance company annuity, morphing the proceeds into a defined benefit plan. Of course, doing so is an irrevocable decision, and the insurance company is not a benevolent donor of wealth, so in most cases, that income safety comes at a price. If you are willing to pay the price of safety, the choice is yours.
The stability of defined benefit plans also can be duplicated. Defined benefit plans invest money in much the same way as 401(k) fund managers do, albeit usually at significantly less cost despite the actuarial burden they bear. Their balances declined last year too. So why are they safer than defined contribution plans? The difference is simple math and freedom of choice. When pension plans lose money and become underfunded, they must increase contributions, increase investment risk to attempt a higher return or change benefit accruals that the plan will be obligated pay. The trustees make these choices, and participants are left with no choice but to accept it.
Today we have the technology to graft the stability of defined benefit plans onto defined contribution plans. I call the result a bionic retirement plan. The funding-level calculations that actuaries do for DB plan participants in the aggregate now can be handled more quickly and easily, one participant at a time, using Monte Carlo simulations. The resulting personalized benefit calculations are far more accurate and realistic than a simple actuarial assumption.
If a participant is willing to receive a smaller benefit, they may choose to contribute less now. If they prefer to increase contributions to accrue a larger benefit, the choice is theirs. If a personalized plan becomes overfunded, a participant may choose to reduce risk, increase the benefit or offer himself or herself an early retirement package. The calculations for these choices are the same whether the calculations are run for a plan, for an individual participant or for an aggregation of numerous participants in a DB plan.
In planning for their clients' retirement, it's time for advisers to focus on the choices within the 401(k) framework that will make retirement more secure, instead of on product advice.
David B. Loeper is the chief executive and founder of Richmond, Va.-based Financeware Inc., which does business as Wealthcare Capital Management.
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