Over the past 30 years, a dramatic change has taken place in the use of retirement plans to help people save for their later years. In an earlier era, many people were covered by defined benefit pension plans, which promise a fixed benefit at retirement, often based on years of service and compensation levels. In recent years, 401(k) plans have become the dominant form of plan for accumulating retirement funds. This article looks at the pluses and minuses of each.
Defined benefit plans are generally a promise made by the employer, private or public, to provide a benefit at retirement. The employee may be called upon to contribute toward the benefit, but the responsibility is on the employer to make sure the funds are there at retirement. For many years, until the enactment of the Employee Retirement Income Security Act of 1974, ERISA, funding of defined benefit plans by employers was required at only a modest level. And many of them were poorly funded. The best-known example was the retirement plan for Studebaker, which made cars, in Indiana and elsewhere, for many years. When Studebaker went out of business, there was not enough in its retirement plan to fund all of the promised benefits. Employees who got less than they had expected had little or no recourse. ERISA changed that, requiring that plans be funded on a regular schedule. Contributions to such plans are deductible by private employers, which is a tax benefit, but they also reduce the bottom line and require the transfer of cash to the plan each year. Private employers have some funding leeway, but eventually have to fulfill their obligations to the plans. Or, they could terminate the plans, and move to another type of plan, which is what most employers did.
The upside of defined benefit pension plans, then, is that they offer a benefit that can be calculated well in advance, and aid in planning for retirement. The funds in the plan are invested by advisers chosen by the employer, who, presumably, are skilled in doing so. The downside is that the employer is responsible for the liability for such plans and must have a plan for defraying it. That liability would be reflected in financial statements, which could result in a drag on the employer's value. And if investments of the retirement funds do not do well, the employer has to put in more money to make up for the losses. And that responsibility placed on the employer, and the use of expert investment counsel, is the upside of such plans for those participating in them.
Governmental plans are not subject to ERISA, so they have more leeway when they fund retirement plans. The result in that situation has been that governments postponed payments into public plans, resulting in the very serious problems we find today throughout the country: public pension funds are woefully underfunded. How underfunded they are is a matter of statistical analysis, and seems to vary depending on whether a writer is a supporter or opponent of such plans. But the ability of governments to postpone funding retirement plans until a sunny day arrives is a serious defect of such plans.
The replacement for many private plans has been the 401(k) plan, a reference to the Internal Revenue Code section authorizing them. In this type of plan, the employee reduces his or her income, and the amount of the reduction is placed in the retirement plan. It is a voluntary decision on the part of the employee, who could contribute the full amount permitted by law, or a lesser amount. (The maximum annual contribution for 2013 is $17,500, plus an additional $5,500 for those who have reached age 50.) The employer could add to the plan, such as through a matching contribution, but matching rates, if there were any, could vary.
Once the funds are contributed to the plan, in almost every case the employee decides how to invest them. The plan administrator or an adviser to the plan offers a selection of investment vehicles, usually a range of mutual funds, and it is up to the employee to decide among those funds. At retirement, the employee receives the amount to which the investments had grown by that time. If the employee is skillful, and defers the maximum each year, it could be a very large amount. Both the benefit and risk of investments is shifted to the employee. In recent years, governments have also begun considering these types of plans as replacements for defined benefit plans. Proponents of defined benefit plans have suggested that there are constitutional limits on the ability to make such a change, at least for current employees. This process, and the questions it raises, are ongoing.
The upside of these plans is that they are usually less expensive for the employers. They rely on the forbearance and wisdom of the employee in selecting investments. The right decisions can be very beneficial to the employee. The idea of such a plan is to place the responsibility on the employee to create his or her own future, a sort of consumer-driven retirement planning.
The downside of these types of plans is easy to see. If the employee doesn't make the decision to defer income, there is nothing to invest. In addition, the idea that employees could choose their own investments from a menu of mutual fund choices and make the right decisions is, generally, false. Many studies have shown that if employees make their own investment decisions, they don't do well, because they are not experts at investing money. In recent years, many plans have offered more sources of investment advice through plans, which can be helpful. In some plans, so-called individually directed accounts, employees can use their own outside advisers.
But a more fundamental problem is this: For many people in higher income levels, a 401(k) plan does not permit large enough contributions that, with investment gains, can produce an adequate investment fund at retirement. A substantial level of employer-matching contributions can help, but experts in pension policy have concluded that the 401(k) structure is not designed or adequate for providing the needed amount of retirement income for higher income people. In an earlier era, people thought of retirement funding as a three-legged stool: Social Security, a defined benefit pension and personal savings. For higher income individuals, replacing the defined benefit plan with a 401(k) plan means the stool has one short leg, with the expected result.
It's unlikely that employers will go back to the days of widespread defined benefit plans, but it is important to understand that the 401(k) structure, with too much employee discretion to make decisions for which they are not trained and for which they often make the wrong choices, is not the solution. There are other types of plans, combining both the 401(k) voluntary aspect and some level of formula employer contribution, that might offer a solution. But the first step for employers is to understand the benefits and the drawbacks of the types of plans available, and decide what they want to achieve with retirement plans. This is especially true for law firms, where the provision of an adequate retirement account can be a useful part of the transition process for lawyers, and avoid the dangers inherent in providing unfunded promises of retirement income to retiring lawyers.
Robert H. Louis is a partner and co-chairman of the personal wealth, estates and trusts department at Saul Ewing. His practice includes estate, tax and retirement planning for individuals and closely held businesses. Louis can be reached at email@example.com and 215-972-7155.