Over the past 40 years or so, we willingly switched retirement plan types; employers willingly eliminated pension plans in favor of 401(k) Plans and Profit-Sharing Plans, and employees willingly accepted the change. Seldom would employers and employees agree on something this personal, so why did this transition go so amicably? The answers (there are more than one) lie in the analysis of risk, the perception of wealth, and, unfortunately for many people, financial naiveté.
The technical name for traditional pension plans is “defined benefit plans.” They work exactly like the name implies; they offer a predetermined benefit, and for an indeterminate period of time. The technical name for 401(k) Plans is “defined contribution plans.” Again, as the name implies, the contributions are defined, but the eventual benefit is not known.
Back in the 70’s, when your intrepid reporter was a young entrepreneur in search of the pathway to success, I had the good fortune to work in environments where financial learning was a constantly accelerating process. The world was changing quickly, and I was in it, thanks to my father-in-law, who had a small consulting firm. He offered me a job in 1974, and in his words, the offer was, “I can’t pay you much, and there are no fringe benefits (how could a young guy turn that down?), but I will give you 10 years of experience for every year you stay with me.” Needless to say, I jumped at the chance. Aside from getting married and having a family, it was the best move I ever made, because he was right. About all three things.
In those years, companies generally had pension plans for their employees’ retirement. Especially if unions were involved, because one of their causes was retirement income. Good for them, I say! Their members were otherwise poorly equipped to provide for anything beyond Social Security, and we all know what that means for your future lifestyle. But trouble lurked around the corner.
The business cycle is a fact of life, despite Bill Clinton’s claim in the 90’s to have repealed this classic law of economics. Recessions happen. Period. And when they do, bankruptcies increase, companies go under, and pension plans were too-often underfunded, leaving retirees penniless after long company service. I saw it; I didn’t like it. My father was a union guy, my mother a manager for the telephone company, and both had pensions from sources that were viable. How would I have felt if their companies had gone under, and no pension benefits were paid?
In 1974, Congress realized the severity of the problem, and produced ERISA, the “Employee Retirement Income Security Act of 1974.” It was the first day of my consulting career, and the boss handed me a small book explaining the Act. His very words were, “Read it; memorize it.” I did. That was the day I realized that there were so many things that interested me about business, finance, politics, and all the related topics, that it started my path to sitting here today.
But this is not about me. It is about the way the retirement planning process evolved, and how it affects you today.
More about the transition. ERISA established a Government Agency, the Pension Benefit Guarantee Corporation (PBGC), to help employee victims of failed pension funds. It has worked, but only to a limited degree, and it has helped many pensioners, though many not at 100% of their former guaranteed income benefits. Probably the best part of ERISA is the funding standards imposed for pensions. Pension plans with insufficient funds were required to beef up their contributions over time, which has helped. Under George W. Bush, the Pension Protection Act further strengthened funding standards. Apparently, the City of Jacksonville got the word late. But I digress.
Back to the story. Companies that didn’t have a traditional pension plan often had a profit sharing plan, where company funds would be contributed to a fund, and employees would be entitled to their portion of the fund at retirement. About the time ERISA was passed, the U.S. Tax Code was amended to include Section 401(k) – yes, that 401(k)! This provision allowed participants in a profit sharing plan to also contribute their own money, pre-tax, to the retirement fund that was kept in their name. After a slow start, the 401(k) provision eventually became ubiquitous. How?
Here is where the risk control portion starts – at the company level. With a pension plan, companies are responsible for lifetime payments to the retired employees, and often the spouses as well. This was somewhat unpredictable and often burdensome, but the risk was all on the Company to continue those payments. When the 401(k) Plan appeared, employers saw the opportunity to know exactly what the Plan would cost, and upon retirement of any employee, their obligation to that family ended. Employers loved it, as their risk level was reduced.
From a wealth perception standpoint, employees thought it was great. With a pension, there is no separate account in the employee’s name, containing actual funds, and no one could watch it grow. You had a promise of a future benefit, and nothing else. Along came the 401(k), and the employee’s own account was there, it was tangible, and everyone could watch it grow. Employees loved it. But the true risk to the employee involved was not well understood. Making the eventual account balance grow was probably fun, but making it last to the end of your unknown life span was, shall we say, more challenging.
And there is no PBGC to guarantee the 401(k) accounts. The risk belongs to the employee, both for the investments, at least to a degree, and for the lifetime income those investments must produce in retirement. This situation highlighted the naiveté of the average American, which was hardly the fault of people raised in a system where financial literacy was not taught in schools, and not stressed in the outside world. In other words, we were under-prepared to accept the responsibility of the sea change in retirement funding.
Nature abhors a vacuum, it is said. We had, and to a lesser degree still have, a vacuum of money management knowledge. Two primary groups rushed in to fill the void for the newly-wealthy retirees; the annuity industry and the brokerage industry. Both were eager to get their hands on this new pile of cash as people reached retirement age with a 401(k). Our industry, the Registered Investment Advisors, or RIAs, grew out of the brokerage industry, due to the conflicts of interest that were (correctly) perceived in the brokerage houses.
Make no mistake about the magnitude of the change in retirement planning. The days of receiving a pension payment for life are, for the most part, fading away. Today, the children of pensioners are extremely unlikely to have pensions for themselves. This is where trouble starts. We see it frequently in the young people who watch their parents live well in retirement, and without a great deal of money. That is why we teach the concept of “equivalent net worth,” which is a term I coined several years ago to describe the pension generation.
The most common industry standard today is the 4% withdrawal rate, which means that your “safe” income level is reached by only withdrawing 4% of your nest egg annually. If you have $500,000, that means $20,000 income to stay reasonably safe. Therefore, a pensioner with a $40,000 annual pension stream has an equivalent net worth of $1 Million, the amount of money required to produce $40,000 using a 4% withdrawal rate. They may not actually have the money, but the effect is the same – a lifetime $40,000 income flow.
The problem comes when the pensioner dies, and there is no longer the equivalent pile of money. There is, quite literally, no money in the account. The children inherit nothing from the pension, including the parents’ lifestyle. Too many are left high and dry, as they didn’t understand the system that was keeping their parents in the style to which they had become accustomed. There is no “helping hand” for the next generation following the final pensioners.
The good news for the offspring of the 401(k) generation is that inheritance is now common. When there is an account, such as an IRA, that has been well-managed, with a reasonable rate of withdrawal over the years, there is generally money left that can be passed on to the next generation.
That does not absolve the next generation of financial responsibility! After all, parents have a tendency to spend a great deal of money in their final months, especially in medical costs. This is unlikely to change, and makes relying on an inheritance very dangerous. We always tell people that it is good to plan for an inheritance, but it is never good to plan on an inheritance. Too many things can go wrong, and when it is too late, it is too late.
Part of sound financial planning today is understanding that it is more likely that a person will not have a pension than to have even a small one. Only certain careers, including military and government service, result in lifetime pensions, and even those are drying up as risk-averse employers change over to defined contribution accounts. That means that the risk is being shifted to the workers, and they are far too often ill-equipped and under-informed as to the management of that risk.
The Certified Financial Planner program developed out of the need for people to have trusted and knowledgeable financial advisors to guide them down life’s path, financially speaking. Always look for the fee-only and CFP marks when considering an advisor. These will guarantee that your advisor is truly on your side, and that decisions will be made with your best interests at heart. While you are at it, listen to our radio show, read the blogs, and pay attention to what you read and hear around you. Naiveté is temporary, and can be vanquished by learning. Taking control of your own retirement will allow you to retire in a manner similar to your parents, but you will be likely to leave a better legacy.