Challenges to the private retirement system

The private pension system in the U.S. is in transition. The shift is from defined benefit pension plans wholly controlled by employers to defined-contribution 401(k) plans that are partially controlled by the employees enrolled in them. This is happening largely because 401(k) plans provide greater flexibility to employers, avoiding the large balance-sheet liability generated by the employer’s commitment to provide defined benefits over an indefinite future period.

From a retiree perspective, however, defined-contribution plans have two major weaknesses. The weakness that has generated the most attention is that employees have not been saving enough in their 401(k) to assure a comfortable retirement. Some of the reasons for this, along with initiatives aimed at encouraging higher 401(k) saving rates, were noted in a recent article by Anne Tergesen in the Wall Street Journal. She cited the following measures aimed at raising saving rates, which either have been adopted or are pending in legislative proposals:

— Systems that enroll employees into 401(k) plans automatically, requiring laggards and procrastinators to opt out.

— Authorization of multiple employer plans for small firms that have no plans of their own.

— More convenient methods that employees who are changing employers can use to transfer their accounts to the new employers, avoiding cash-outs that can result in spending splurges.

— Emergency funds that would co-exist alongside 401(k) accounts so employees do not raid their 401(k)s to meet emergencies.

— An option for investing 401(k) funds in an annuity.

The second major weakness of 401(k) plans, which has not generated much if any attention, is that they do not include any way for the individual retiree to manage mortality risk. Such management is an integral feature of defined-benefit plans because the employer delivers pensions for life to a group of employees with markedly different lifespans. In contrast, employees with 401(k)s are on their own.

While allowing retirees to purchase annuities might be viewed as a step in that direction, the wisdom of purchasing annuities before to retirement is highly questionable. In my view, the retirees’ objective during working years ought to be to accumulate as large a nest egg of financial assets as possible. Annuities do not fit that objective.

After retirement, however, when financial assets begin to be drawn down to meet living expenses, that judgment flips. If there is any likelihood that the retiree could outlive the assets, some of the assets should be allocated to the purchase of a deferred annuity. But doing that makes sense only within the framework of a financial plan that integrates the annuity with a scheme for drawing down financial assets over time. Further, if the retiree is a homeowner, the plan can also include a reverse mortgage.

Jack Guttentag is professor emeritus of finance at the Wharton School of the University of Pennsylvania. Comments and questions can be left at http://www.mtgprofessor.com

2018 Jack Guttentag Distributed by Tribune Content Agency,