Over the last twenty-five years there has been a major shift by employers away from defined benefit pension plans and towards 401(k)s. This shift has major implications for preparing for retirement. In this blog I discuss some of the philosophical and practical implications of this shift.
One profound change is that individuals now shoulder the responsibility of saving for retirement. With a defined benefit pension plan the employer typically decided on the amount contributed by both the employer and the employee to the plan. Employees generally had no say in the matter other than through a union negotiation. The idea was that the combination of the pension and social security would keep an employee’s retirement income in line with their pre-retirement income so no adjustment in lifestyle was required.
One reason this was financially feasible for employers was that pension payments ended at the death of the employee or the employee’s spouse. Employers were able to pool the risk of all the participants in the plan so that employees who died early helped fund the employees who lived very long lives. In effect, longevity risk, the risk of an individual living longer and outlasting their retirement savings, was managed by the employer, not by the individual.
With a 401(k), managing longevity risk shifts to the individual. There is no pooling risk with other employees. An individual is not only responsible for saving enough on their own to fund their retirement (beyond Social Security and a relatively small company match), but also ensuring that the amount lasts their entire lifetime no matter how long they live or what stock market conditions they encounter. The employee must draw down the portfolio conservatively enough such that money will be there even if they live to a very old age and/or experience significant negative market conditions during retirement. For those individuals who do not live to a very old age or experience significant negative market conditions there will likely be a large portfolio left at the end—in most instances greater than the portfolio size at retirement, which is not what most people expect.
This calculation is further complicated by a big unknown in retirement planning: what amount might be needed to cover long-term care expenses incurred near the end of life? Long-term care insurance is often not an appealing option. This means that retirees will want to set aside a significant sum to cover potential long-term care expenses. I typically recommend $500,000 per person. If that amount is not needed for long-term care expenses, the ending value of the portfolio will be even higher.
This leads to another profound change. The shift to 401(k)s will lead to a massive generational transfer of wealth that would not have occurred in the world of defined benefit pension plans. With a traditional pension the income stops at death and there is nothing to pass on. But in the case of 401(k)s, the remaining investment portfolio will typically be passed on to the next generation.
Retirees will thus find themselves grappling with finding the balance between spending on themselves during retirement and setting money aside for contingencies, which if they don’t materialize will mean a significant inheritance for their heirs.
Many folks come to me with the notion that they want to spend their last dime on their deathbed, but that is nearly impossible to accomplish. The one tool that might help with that are annuities, but purchasing an annuity often becomes less appealing once you work through he math.
My fear is that the shift we’ve experienced from defined pension benefits to 401(k)s will exacerbate the divide between the haves and the have nots. Those fortunate enough to have a good income and diligent enough to plan and save what is needed will be rewarded with a comfortable retirement and a large sum to pass on to their heirs. Many others who do not accumulate adequate retirement savings will struggle getting by on what they collect from social security. With nothing to pass on, the divide in the next generation will be even greater.
With more responsibility now on an individual to save for their retirement and manage the investment risks of a portfolio, it is critical to have in place a long-term financial plan and, most important, to start saving for retirement at an early age, as hard as that may seem at the time.