Could New DB Plan Designs Solve for Retirement Savings Inadequacy and Inequality?

Recent studies find 401(k)s have increased retirement savings gaps among demographic groups, and those in 401(k)s have not met their savings potential, while DB plans offer more equality.

The Economic Policy Institute’s (EPI) report, “The State of American Retirement Savings,” contends that the shift from defined benefit (DB) plans to 401(k)s has increased gaps in retirement preparedness based on income, race, ethnicity, education, and marital status.

Using data from the Federal Reserve Board’s Survey of Consumer Finances, the EPI found the share of prime-age families with retirement account savings rose in the 1990s as employers replaced traditional pensions with 401(k)s. But it contracted after the 2001 and the 2007–2009 recessions, and remains below the 2001 and 2007 peaks. “This drop-off reflects the fact that retirement account contributions are voluntary and funds may be tapped before retirement, making retirement savings more vulnerable than traditional pension benefits to economic downturns,” EPI says.

According to the study, retirement savings have stagnated in the new millennium, and nearly half of families have no retirement account savings at all. That makes median (50th percentile) values low for all age groups, ranging from $1,000 for families headed by people in their mid-30s to $21,000 for families approaching retirement in 2016. For most age groups, median account balances in 2016 were lower than at the start of the new millennium.

Nearly half of working-age families have nothing saved in retirement accounts, and the median working-age family had only $7,800 saved in 2016. Meanwhile, the 90th percentile family had $320,000 and the top 1% of families had $1,663,000 or more (not shown on chart). “These huge disparities reflect a growing gap between haves and have-nots since the Great Recession as accounts with smaller balances have stagnated while larger ones rebounded,” the EPI states.

High-income families are seven times as likely to have retirement account savings as low-income families, the study found. Most black and Hispanic families have no retirement account savings. Racial and ethnic gaps are large even among families with retirement savings. College-educated families are much more likely to have retirement savings and have much larger retirement account balances. Single people are less likely to have retirement savings.

The EPI points out that net worth declined across the board after the Great Recession, leaving the bottom 60% of working-age families with less wealth in 2016 than their counterparts had in 1989—a devastating setback. The bottom 10% have had negative net worth since the Great Recession. The top 10%, meanwhile, are the only group that has recovered from the downturn. Thus, wealth inequality has continued to grow. The EPI contends 401(k)s magnify inequality. The bottom 60% of working-age families receive 23% of total income but hold 13% of retirement account balances. Meanwhile, the top 20% receive 59% of income and hold 70% of retirement account balances. Retirement inequality is greater than income inequality even in peak earning years, it says.

The National Institute on Retirement Security (NIRS) has published an Issue Brief that contends financial asset inequality is exacerbated by regressive tax incentives for retirement savings and unequal access to employer-provided retirement plans.

401(k) savings not meeting potential

An Issue Brief released by the Center for Retirement Research at Boston College examines why 401(k) and IRA balances are substantially below potential. “These accounts can generate significant wealth if workers contribute consistently from a young age, keep their money in their accounts, and minimize their investment fees. However, most workers have 401(k)/IRA balances at retirement that are substantially below their potential,” researchers contend. As an example, the Center finds a 25-year-old median earner in 1981 who contributed regularly would have accumulated about $364,000 by age 60, but the typical 60-year-old with a 401(k) in 2016 had less than $100,000.

The researchers identify four factors—immaturity of the 401(k) system, lack of universal coverage, leakages, and fees—that might explain why 401(k)/IRA balances fall below their potential. Results of their analysis show that the immaturity of the system and the lack of universal coverage are the main culprits, followed by leakages, and finally fees.

They conclude that, without a significant effort to cover the uncovered, a large gap between potential and actual accumulations will persist even after the system matures.

DB plans are more equal

An interesting finding from the EPI study is that more people have 401(k)s, but participation in traditional defined benefit (DB) pensions is more equal. For example, across five income segments, starting with the lowest to the highest, the percentage who have 401(k)s is 10%, 33%, 48%, 62% and 70%, respectively. The percentage who have pensions is 6%, 14%, 19%, 32% and 25%, respectively.

Likewise, 51% of white, non-Hispanics have 401(k)s, versus 33% of Blacks and 28% of Hispanics. But, 21% of white, non-Hispanics have DB plans, as do 17% of Blacks and 13% of Hispanics. Fifty-nine percent of those with a college degree or more have a 401(k), compared to 43% of those with some college, 37% with a high school diploma or GED and 19% of those with no high school diploma or GED. The percentages that have a DB plan are 24%, 21%, 17% and 8%, respectively.

In a blog post, John Lowell, Atlanta-based partner and actuary for October Three, notes some of the arguments against offering DB plans: employees don’t spend their careers at one company, so they need something account-based and or portable; companies can’t stand volatility in accounting charges and in cash contribution requirements; nobody understands them; and they are difficult to administer.

According to Lowell, the Pension Protection Act (PPA) took a step toward solving all of those problems, sanctioning new pension designs—most notably, a market-rate-of-return cash balance plan—that address all four of the arguments listed.

Companies have been slow to adopt these solutions. So, Lowell suggests three pushes:

  • “A cry from employees that they want a modern pension in order to provide them with usable lifetime income solutions.
  • “A recognition from Congress and from the regulating agencies that such plans will be inherently appropriately funded and therefore (so long as companies do make required contributions on a timely basis) do not pose undue risk to companies, to the government, to employees, or to the Pension Benefit Guaranty Corporation (PBGC) (the governmental corporation that insures corporate pensions) and therefore should be encouraged not discouraged.
  • “Recognition from the accounting profession in the form of the Financial Accounting Standards Board (FASB) that plans that have an appropriate match between benefit obligations and plan assets do not need to be subjected to volatile swings in profit and loss.”
“Give us those three things and the pensions sanctioned by the Pension Protection Act can fix retirement for the future,” Lowell contends.