Socialized Retirement Planning Is Out And Individual Plans Are In. Nobody Wants Responsibility For Your Retirement So They Are Passing The Buck To You. Do You Know How To Benefit From These Changes?
Eliminating poverty and providing security for the elderly used to be part of the American Dream. It began with Social Security and gathered momentum after World War II with corporate pension plans. The implied promise was that decades of service bought you a financial safety net during retirement.
But not anymore…
The paternalistic days of employers and government providing a guaranteed retirement income for life are coming to an end. Social Security and defined-benefit retirement plans are fast becoming relics of the past to be replaced with individual savings accounts and defined-contribution plans.
Retirement planning for the masses has proved to be a hot-potato too big to handle. The government and many employers mismanaged the responsibility so now they want to pass it off to you. Their mistake is now your responsibility. Are you ready? Do you know what to do? Do you understand the implications?
More than ever a huge premium has been placed on your developing the necessary skills and knowledge to invest and build wealth reliably and securely. As one coaching client told me “it is time to get religion about this situation” and own responsibility for your retirement security.
Nobody else is going to do it for you. You are solely responsible.
How Retirement Planning Became Your Problem
Let’s begin with some facts to bring perspective to this issue before we explain how this turn of events occurred:
(Editors note: Some studies and data in this article may be dated but none of the principles are. All trends cited are current and fully in force.)
- Traditional defined-benefit pension plans, which provide a fixed income for life based on ending salary and years of service, peaked in 1985 with 112,000 plans covering roughly 40% of American workers.
- As of 2006 the number of defined-benefit pension plans has declined more than 70% to under 30,000 plans according to the U.S. Department of Labor. That number continues to decline.
- In the brief 4 year period from 2001 to 2004 nearly 20% of the Fortune 1000 froze or closed down their defined-benefit retirement plans. That trend continues today.
- According to an October 31, 2005 Time magazine article the percentage of employers with 200 or more workers offering retiree health insurance declined from 66% in 1988 to 36% in 2004. Again, another benefit expected to vanish given current trends.
“This is a watershed event. There has been a steady decline in traditional pensions for two decades, but the trend is really accelerating, and it’s going to accelerate even more.”
Jack Van der Hei
- The reason corporations are cutting pension and health benefits is to reduces costs, reduce risks, and control under-funded liabilities. The total amount that pension plans are under-funded has steadily risen since 2000 to exceed $450 billion in 2005 (that number is far worse today).
- At the same time pension under-funded liabilities have escalated, the governmental agency that guarantees pension benefits has grown a deficit in excess of $23 billion as more corporations turn to government bailouts as a solution for their pension funding problems (again, a worsening problem).
- While on the subject of government, the Social Security system is unfunded and based on flawed actuarial assumptions. As the baby boom generation grays and people live longer it is already reducing benefits by increasing the minimum age requirement. You should reasonably expect additional benefit reductions and means testing as the system fights off financial insolvency.
- Over the same time period that defined benefit retirement plans, retiree health insurance, and Social Security have been declining, defined contribution and individual retirement plans have been booming. According to the Employee Benefit Research Institute the number of defined contribution plans has grown from 12 million in 1974 to nearly 64 million in 2005.
- According to Ibbotson, defined contribution retirement plans and IRAs had grown to make up nearly half of the $14.5 trillion in total retirement assets by 2005. Considering these plans hardly existed a generation earlier that represents a colossal shift that is only accelerating.
Those are the facts, and they paint a clear picture: the days when corporations and government took care of your retirement planning are ending. They want out of the retirement planning business so they are passing the buck to you. They are doing this by getting rid of defined-benefit plans and replacing them with defined contribution plans. The trend is clear: you are now responsible for your retirement security. Let’s see what that means to you…
Why You Should Care That Defined-Benefit Retirement Plans Are Being Replaced With Defined Contribution Plans
It is important to understand that changing from defined-benefit to defined contribution plans is more than just words or semantics: it is a fundamental shift in how retirement planning is done. It is a totally different ballgame. You must fully understand these differences so that you can profit from this changing environment.
The most obvious difference is evidenced by their names: defined-benefit plans specify the monthly payment you will receive (the benefit). Defined contribution plans specify the amount of contribution you must make to your retirement account. One is based on a fixed benefit and the other is based on a fixed contribution.
But what does that mean and what do you do with it? Below are some explanations of the implications:
- Defined benefit plans “guarantee” a certain monthly benefit for the rest of your life based on final average pay and years of service. Defined contribution plans have no guarantee: the amount you can withdraw each month during retirement may be higher or lower than a defined benefit plan depending on how much you saved, how much your assets earned, how long you expect to live, and how much risk you can live with.
- Defined benefit plans protect participants from market risk by shifting that risk to the employer. Whether the stock market crashes or interest rates go to the moon is the employer’s problem – not the employee’s – because the employee gets the same benefit regardless. Defined contribution plans place all the market risk squarely on the shoulders of the plan participant … you. If the market tanks and takes your account with it then you lose. Nobody is going to pick up the pieces for you.
- Defined benefit plans offer some protection from inflation until retirement day by calculating benefits based on final average pay. What happens to inflation after you retire is your problem because your benefit is fixed unless your plan includes cost of living adjustments. Defined contribution plans offer no protection from inflation which can significantly erode the purchasing power of the account assets. The only way you can protect yourself is to invest competently so that your assets grow fast enough to offset the effects of inflation.
- Defined benefit plans require no personal contribution from the plan participant nor do they require any investment skill or financial experience. Your employer takes care of everything, and you are a passive participant. With defined contribution plans you are responsible for making contributions (with some employer matching) and you are responsible for all financial and investment decisions. You are an active participant who will succeed or fail based on his actions.
- If investment mistakes or funding shortfalls occur in a defined benefit plan it is your employer’s problem to solve: they are responsible. If investment mistakes or funding shortfalls occur in a defined contribution retirement plan it is your problem to solve: you are responsible.
- Defined benefit plans penalize workers who change jobs regularly by requiring vesting. Defined contribution plans are completely portable and can travel with an employee from job to job. There are no vesting requirements.
- Defined benefit plans are little more than a promise that can be broken under certain circumstances … and often is. No personal ownership of a specific asset or account occurs in a defined benefit plan because the plan assets remain the property of the company. Defined contribution plans are owned directly by the employee and placed in the employee’s name. You own it.
- Because defined contribution retirement plans are your property they can be passed on to your heirs. Defined benefit plans die when you and your spouse cease to exist. They are not your property – they are just promises from your employer.
The underlying message coming out of this sea change in retirement planning is about ownership and responsibility. The old plans were just promises and weren’t owned by you. They were the property and responsibility of your employer. You were a passive participant so you didn’t have to know anything or do anything. As long as you were covered by the plan everything was taken care of.
“You cannot escape the responsibility of tomorrow by evading it today.”
With a defined contribution plan everything is up to you. You are the owner of the plan and you are responsible. You must decide to participate, how much to contribute, where to invest, and how much to withdraw every month after you retire. Nobody is going to do it for you. All the market risks, inflation risks, actuarial risks, and management risks have been transferred on to your shoulders. You are solely responsible and your retirement security hinges on your ability to make the right decisions.
In other words, the responsibility for retirement planning has been shifted from the company to the employee. This change was sold to the masses under the typical American bravado of independence, freedom and self-actualization, when in fact it was a deliberate effort on the part of corporations to transfer the risk and expense for funding retirement off their balance sheet and on to the back of the employee.
Let’s look deeper into what drove this change…
What Caused Pension Reform?
There are two primary reasons corporate America has jettisoned the defined-benefit retirement plan in favor of defined contribution plans – to lower risk and increase profit.
Funding retirement has become increasingly expensive because people are living longer. The average lifespan in 1950 was 69: today, at least one partner in a couple retiring has even odds of living to over 90. With rapid advances in biotechnology the true life expectancy for people retiring today is anybody’s guess because it is an expanding, moving target growing at an average of 110 days per year for the last century.
“The quality, not the longevity, of one’s life is what is important.”
Martin Luther King Jr.
Longer life spans place a tremendous burden on retirement planning. The cost of funding retirement for someone expected to die at 69 is nothing compared to funding retirement for someone expected to live 30 or more years in retirement. (Get the complete story on how much money you need to retire here.) It means adding a zero to the savings required by raising it from six figures to seven figures. The ratio of years worked to years in retirement went from 12:1 just a few generations ago to less than 2:1 today. That means every year worked has a higher and higher savings burden placed on it to fund retirement.
The result of ever-expanding life spans is ever-expanding unfunded liabilities on the corporation’s balance sheet from their pension plans. More assets are required to fund longer lifetimes and increasing health care costs. Funding company pension plans just got too expensive. It doesn’t take a genius accountant to figure out that’s a bad thing, and that is why corporations are getting rid of the responsibility. They want to control costs.
According to the Department of Labor companies paid 89% of retirement contributions in 1974 and by 2000 workers were paying 51% and companies paying only 49%. This represents a 40% cost shifting from boss to worker. In addition to this cost shifting, additional savings result because fewer total dollars are contributed with direct contribution plans. The overall effect according to Brooks Hamilton in a 2006 PBS interview is companies have effectively reduced retirement contributions from 6-8% of payroll down to 1-2%.
The change to defined contribution plans is saving companies big money.
The other main factor causing the change is all the risk associated with managing a pension plan. Despite extensive education and training many retirement plan officials chose investments that radically underperformed expectations exacerbating unfunded liabilities. In other words, they screwed up. With defined benefit pension plans the responsibility to make up that shortfall rests squarely on the company’s and government’s shoulders and they don’t like it one bit. That is why they teamed up to give the problem back to you.
And if that risk wasn’t enough, there is always the risk of an unsavory character attracted to the large pool of retirement assets under the corporate umbrella. Corporate raiders buy companies and strip the money from the retirement plan (remember, it is the property of the company – not the employees) leaving the Pension Benefit Guarantee Corporation and employees holding the bag.
“Corporation, n. An ingenious device for obtaining individual profit without individual responsibility.”
Lawyers use legal shenanigans to bankrupt companies thus erasing pension and health benefit obligations – again, leaving retirees out in the cold. When a large pile of money is at stake there is no shortage of clever and unethical ways people devise to effectively steal those assets from the people who earned them and are relying on them for retirement. Breaking promises to retirees is an ugly but profitable business.
In short, American companies have learned a valuable lesson: funding and investing a massive pool of assets to pay retirement benefits to employees who are living longer is both expensive and risky. It is little more than a massive liability they no longer want. Like the game “hot potato” that kids play, they don’t want the retirement planning hot potato anymore so they are passing it to you.
Unfortunately, most employees don’t understand or appreciate the value of the pension and health benefits they are losing. This allows companies to lower risk and pocket huge cost savings with little backlash from employees. The actuarial and cost shifting issues are just too complicated and the negative implications are too far off in the future for most employees to protest about.
With the door wide open, corporations are passing the “hot potato” to you by freezing and closing down defined benefit pension plans and replacing them with defined contribution plans like 401(k)s. They shift the liability for retirement planning from their shoulders to yours. This trend is amply proven out by the statistics cited earlier. It is already reality and gaining momentum as you read these words.
Social Security Income Is Not Secure Either
You may want to believe Uncle Sam will rescue your retirement income needs from all those unfair corporations by offering government guaranteed Social Security benefits, but you would be deluding yourself with fantasy. Social Security is similar to a defined-benefit plan so it suffers from the same problems as corporate America’s version, but it is worse in other ways because it is unfunded with no real assets and based on flawed actuarial assumptions.
“We’ve gotten to the point where everybody’s got a right and nobody’s got a responsibility.”
The only reason Social Security exists at all is because of the taxing authority of the United States government to force current workers to pay retired workers their benefits. However, there is a dwindling percentage of the population working and paying into the system, and a growing percentage of the population in retirement drawing benefits from the system. The years worked to years retired equation has changed over the last few generations from 12:1 to 2:1 so you have fewer and fewer workers paying for more and more retirees. It is a bad situation that is getting worse.
As it stands now, most studies show someone living an average lifespan can expect a return on their Social Security investment ranging between 1-3% a year. That’s pathetic. Treasury bills, money market funds and passbook savings accounts would have paid you better. Worse yet, if you die before you can collect benefits you get nothing nor do you have an account value that you can pass to your heirs because there are no assets and you own nothing – it is just another promise to pay.
That promise continues to get weaker and weaker because as the baby boomers retire and live longer the proportion of working Americans paying into the system versus those drawing on the system will force a reduction in benefits. That means the pathetic return on “investment” for Social Security is only going to get worse.
The politically expedient solution to date has been to restrict benefits by raising the age limit for qualification. This measure effectively lowers the total lifetime benefit; however, many more remedies will be needed to stop the red ink. It is reasonable for you to assume additional qualification restrictions and means testing as the baby boom grays and retires because reducing actual pay rates or raising tax rates have both proven politically difficult to implement.
With that said, don’t expect the Social Security system to vanish as many doomsayers claim. It will more likely just wither away and become less relevant to your retirement planning. If you were born before 1960 it is reasonable to factor some diminished form of expected Social Security benefits into your retirement income planning with confidence. Those born after 1960 should be more cautious because the government will be in a very difficult position by the time you want to collect a benefit check.
Again, the end result is you are solely responsible for planning your retirement income needs. Nobody else is going to take care of it for you.
The Only Pension Plan That Remains Secure…
The world of pension reform is not gloomy for all segments of the economy. If you are a public employee working in state or local government then you can plan for your golden years with a higher degree of confidence … at least for now.
The relative security of public employee pension plans is a confusing fact to consider at first glance given a study by Barclays Global Investors in San Francisco estimating the unfunded liabilities for public employee pension plans at an astronomical $700 billion. This is all the more amazing when you realize this unfunded liability exceeds their entire annual revenue stream. A separate study by Wilshire Associates found 54 out of 64 state pension funds were under-funded to the tune of $175 billion.
In short, public sector pension plan assets are every bit as mismanaged and under-funded as in the private sector because they are faced with the exact same problems the private sector faces … but there is a key difference. The public sector has the commitment, taxing authority, and legal support to pay the bill. The private sector does not.
“If men were angels, no government would be necessary.”
What do I mean by this? When judges and legislators make rulings in cases regarding promised pension and health benefits for public employees it should come as no surprise they tend to rule in favor of the plan participants … after all, they are one of them. Hmmm… History has shown they don’t tend to rule against their own self-interests on these matters. However, that has not been the case for legislation effecting private pension plans.
So while public pensions face many of the same problems that the private sector faces, they have one ace in the whole. Those who determine the future of the plan are part of the plan, and that makes all the difference (so far).
Why You Need Retirement Planning Help
The new reality of retirement planning is your role and responsibility has shifted from passive to active. You either get in the driver’s seat to secure your retirement income needs or face an insecure retirement as a consequence. Corporations are washing their hands of the responsibility by eliminating defined-benefit plans and the Social Security system is hopelessly flawed. The institutions and bureaucrats botched up the retirement planning process and have passed the buck to you whether you want it or not. Are you ready? Do you know what to do?
“You can delegate authority, but not responsibility.”
Stephen W. Comiskey
To answer “yes” to the above question you must have the personal financial management skills to take advantage of today’s retirement planning alternatives, the commitment and discipline to follow through, and you must also possess the investment skills to manage the wealth wisely.
So let me try again, are you ready to take advantage of this change? Unfortunately, the statistics show most individuals are not ready:
- Watson Wyatt analyzed 503 employers sponsoring both a 401(k) and defined benefit retirement plan from 1990-95. The result was the employee determined investments in the 401(k) averaged 1.9 percent lower annual return than the professionally managed pension plan.
- Even employees of companies whose business is investment advice underperformed market indexes by 3.2 to 10.5 percentage points according to the National Center for Policy Analysis. Can you imagine? Employees in the investment advice business under-perform passive indexes. Hmmm…
- Anecdotal studies of finance professors’ 401(k) investment choices show surprising contradictions between the optimal portfolio theories they teach and the investment choices they actually make. These are the very finance professors who teach future financial advisors – makes you think twice, eh?
- Multiple studies show employees not participating in company offered defined contribution plans, failing to maximize employer matching contributions, and not saving enough to fund their retirement income needs. In short, they are making the same mistakes their employers made with the earlier defined benefit plans.
- Finally, a 2001 study by John Hancock Financial Services found a severe lack of financial literacy among 401(k) participants. For example, employees perceived company stock as less risky than a diversified portfolio. 44 percent thought money market funds included stocks, 20 percent didn’t know they could lose money in equities, and 65 percent didn’t know they could lose money in a bond fund.
This is a difficult situation. Most people are not financial experts, yet they are required to be one because they are responsible for their retirement plan. When highly paid, highly educated, corporate experts botch the retirement planning job miserably, what can we reasonably expect from the average American worker with little formal training and a few hours a month to dedicate to the task?
This is not a good situation…
“If stock market experts were so expert, they would be buying stock, not selling advice.”
The sad truth is many employees have limited financial skills and experience. Even those who are employed in the finance industry and should know better have demonstrated less than expected ability to put their knowledge into practice. This situation is further aggravated by a legal system that makes companies reticent to offer investment advice to help their employees for fear it will expose them to liability if the employee loses money or comes up short at retirement.
Given the facts, your only reasonable choice is to take the bull by the horns and prioritize your financial education. I know you need another thing to do like a hole in the head, but you must learn about investing and finance or you will be putting your retirement security at risk. There is really no other choice.
If you would like the support and guidance of your own personal financial coach to help you then consider our coaching services. Also, steps 5 and 6 of the Seven Steps To Seven Figures course series are specifically designed to educate you about investing. It is important to further your financial education so that you make smart choices with your retirement plan investments. Financial Mentor is here to help.
Three Steps To Take Now So That You Can Secure Your Retirement Income
There are three clear action steps every employee should take regardless of their investment experience.
“The price of greatness is responsibility.”
Sir Winston Churchill
1) First, you must recognize that you are ultimately responsible for your financial security. No corporation or government is going to take care of your retirement planning and investment decisions for you. Your financial advisor can help but ultimately you must possess enough knowledge to personally know whether his advice is accurate or not. There are varying qualities of financial advice and even the best advisors make mistakes as evidenced by the highly paid corporate advisors who created the under-funded liabilities that caused this mess in the first place. If these high profile experts can botch it up, it might make sense to question your own experts.
Until you become committed to your retirement security and own responsibility nothing is going to happen. It is the necessary first step for you to prioritize the actions necessary to get results. Remember, to know but not act is to not know at all – commitment comes first.
2) The second step is to maximize your contributions to every available tax-deferred investment vehicle you can. Begin by maximizing your 401(k) to take advantage of employer matching programs and then look into any other plans you may qualify for. IRAs, Roth IRAs, SEPs, HSAs and any other tax deferred saving vehicle is worth considering. Check with your accountant or financial advisor for current contribution limits and qualification rules that apply to your personal financial situation. Also, consider including alternative assets such as income producing real estate or business ownership as potential long-term retirement income vehicles.
3) Make your investment education a priority. You must learn how to make your assets earn. When it comes to investing what you don’t know can hurt you. A few decisions can make the difference between a secure retirement and flipping burgers at your local fast food restaurant during your “golden years”.
“I believe that every right implies a responsibility; every opportunity an obligation; every possession a duty.”
John D. Rockefeller Jr.
Investing and personal finance are arguably two of the most important skills you can develop, and there is no time better than now to get started. FinancialMentor is here to help you with education and retirement coaching services you need to succeed without the conflicts of interest and bias created by selling investment products.
Let us know how we can help you.