Defined-Contribution Plans (DC plans) are marketed as a tool to help workers save for retirement, but a close look at the results highlights a host of challenges. If you look past the marketing hype, you would be hard pressed to argue that the DC plan experiment has been a success.
The concept of employer-backed pensions dates back to 1875 when a firm in the railroad industry introduced the first one. AT&T joined the crowd in 1906, and by 1920 pension plans were a fairly standard benefit for American workers. In these pension plans, often referred to as defined benefit plans (DB), the employee receives a definite amount of benefit upon retirement regardless of the performance of the stock market, the bond market or any other investment. For more than 100 years, pensions were the light at the end of the tunnel that guaranteed a secure retirement for generations of workers.
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All of that started to change in 1974 when The Employee Retirement Income Security Act gave formal approval to employee-funded saving plans via a pronouncement that became the Internal Revenue Service Sec. 401(k). By 1981, regulations had been issued and the 401(k) plan formalized.
Johnson Companies quickly introduced the first 401(k) plan. It was designed to give employees another way to save. Theoretically, it would provide a way for workers to supplement their pensions with additional, tax-deferred personal savings. These plans differed from their predecessors, where employees received a defined benefit, and came to be known as defined contribution plans, because the amount put into the plan is defined but the amount that comes out is variable.
As time has passed, companies have replaced their defined benefit plans with defined contribution plans. It saves money for the companies, as they are no longer responsible for providing income to retired employees. Today, many younger workers have been taught to refer to their defined contribution plans as "pension plans," but real pension plans come with a guarantee. So what is the result of the DC plan experiment?
A Pay Cut for Workers
Yes, DC plans do provide a vehicle to help workers save, but DC plans are worker funded. Assuming you have enough money left over on payday to put some away for the future, it's your own money that is being saved. If you don't put any money away, you have no retirement savings plan. If you choose to save, some companies offer a match, but only if you contribute first, and the company match can be stopped at any time.
Consider this as an example, the paychecks of two employees. Employee No. 1 has an employer-funded DB plan (and the secure retirement that came with it back in the mid-1900s). Employee No. 2 has a self-funded DC plan (and stock market roulette that comes with it).
If both employees earn the same amount of money, the net pay of employee No. 1 is higher than the net pay of employee No. 2. Plain and simple, the DB plan participant gets more money on payday and a guaranteed check at retirement. That extra money in the paycheck can be spent for fun or invested for the future.
Now let's look at employee No. 2. This employee took a pay cut to participate in the plan, as DC plan participants are on the "self-funded" savings plan. If the employer provides a matching contribution and if the stock market goes up, things might work out just fine for employee number No. 2.
On the other hand, the story for employee No. 2 may not work out well at all. Employee No. 2 and other DC plan participants dutifully save a little bit of money from each paycheck, forsaking the opportunity to spend today in hopes of a secure retirement in the future. They do this for decades.
If the securities they purchased fall in value or don't grow quickly enough, these workers may be unable to afford retirement and may need to continue working. And the threat doesn't end there.
Even if everything goes well and the employees' investments rise in value, financial market gyrations after these employee retire will remain a threat to savings and income for the rest of the employees lives. Bottom line: DC plans don't come with a guarantee.
DC plan participants face another, perhaps even greater challenge. They are responsible for choosing their investments. While plan sponsors may argue that this empowers employees and gives them a choice, the truth is that most investors aren't good at choosing investments.
This truth is borne out at every level from a professional to an amateur. Using the results generated by stock indexes such as the S&P 500 as a benchmark of success, it is clear that investors don't make good decisions. Take, for example, the performance of the professionals who seek to replicate the performance of the unmanaged indexes. The Vanguard S&P 500 fund is perhaps one of the most famous index funds in the United States marketplace. As of Dec. 31, 2011, it failed to match the performance of the benchmark index over the one-year, three-year, fiver-year and 10-year time periods. All the fund's managers needed to do was to add just enough value to cover the cost of their legendarily low fees, and yet, they were unable to do it. Their famous competitor, Fidelity Investments, fared no better with their S&P 500 index funds. Not only does the math refute the idea that index funds deliver performance that matches the indexes they seek to track but it also reveals the truth that even index funds aren't passive investments, as fund managers engage in active management in attempt to cover the cost of their fees.
Now, take a look at professional investment managers who unabashedly choose securities in an effort to exceed the benchmark's results. They don't fare so well either. In any given year, more than half of them fail at their objectives. Considering the failure rate for the professionals, it would be unrealistic to expect the general public to do any better, and they don't.
Dalbar, an independent research firm that evaluates mutual fund investor returns, has consistently shown that both equity and fixed income investors underperform the broad indexes. In Dalbar's 2011 survey, equity investors lagged the S&P 500 by almost 1.5%, and fixed-income investors lagged the Barclays Aggregate bond index by more than 3.5%. In the end, if you are DC plan participant, the foundation of your retirement savings efforts rests on a platform with track record of failure.
Profits over People
What benefit do the mutual fund provider, the custodian, the clearing firm, the transfer agency and a host of other unseen functionaries have that investors do not? They get paid even if the stock market falls.
From the fees investors pay to mutual fund providers to rebates fund companies, they pay the plan sponsors, the trading costs, the clearing and custody costs and a host of other fees, the underlying flow of assets is often invisible to investors. At the end of the day, the fund families and other industry functionaries get paid no matter what.
Timing Is Everything
Is the DC plan completely worthless? No, but luck and timing play as much or more of a role in determining success rather than skill. Stock picking acumen aside, securities markets rise and fall. If they fall when a DC plan participant needs money, the participant is out of luck even if the participant beats the odds and chose good investments. Similarly, if the plan participant is saving to reach a certain dollar amount, and doesn't reach that goal in time to move to more conservative investments, a stock market crash can be devastating. If a bear market hits at the wrong time, DC plan participant's dreams of retirement disappear. On the other hand, if the participant is lucky enough to be in the markets when they are rising, fortunate enough to make enough money to cover all of the expenses associated with retirement and smart enough to pull all that money out of the market before it crashes, the DC plan would indeed help to cover the costs of retirement.
Based on how things have worked out for the average investor, the defined contribution plan pales in comparison to the original pension plans. Look at the results of the stock market over the past decade. Look at your friends and neighbors. Your grandparents knew a lot of happy pensioners. How many people do you know who are happily retired from their DC plan profits? The reality is that many DC plan participants are unable to retire or must find a way to generate additional income because their investments failed to meet their needs. A recent study by Fidelity Investments revealed that workers 55 and older had an average 401(k) plan balance of $233,800 in 2011. If those investors retired and put all of their money into high-risk investments (the only way to generate decent returns), they might be able to generate 6% per year. That's about $14,000 in income. If those investors stuck with conservative investments, they would be lucky to generate 1% per year. That comes to $2,338 in income per year.
Sadly, true pension plan participants haven't fared so well in recent years either. Corporations have been permitted to renege on their defined benefit plan obligations. After a career marked by loyalty to the firm, the promised pension plan benefits aren't materializing for many DB plan participants. If you are an American worker, you're on your own. In the meantime, Wall Street rumbles on, making money at every step.
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