The future of retirement should be individual retirement accounts. We should phase out pensions in public sector jobs and make retirement accounts accessible to more people rather than enlarging Social Security. There are two basic ways to finance retirement. You can save for yourself in your own account — such as a 401(k) — where you decide the amount to set aside, take all the investment risk and then figure out how much you can spend each year when you retire. How much income you have in retirement depends how much you saved, the generosity of your employer in matching contributions, and how much your investments returned. Whatever you don’t spend is left for your heirs. Or you can receive a pension from your employer, where someone else saves for you. You don’t have your own account but you have a claim on a future stream of income that someone else pays until you die — not matter how long that is.Either of these types of saving vehicles can be sponsored by a private company or the government. You can see why the defined benefit pension sounds better — someone else who supposedly knows what they are doing takes on all the risk and gives you money. It also seems more efficient. Risk can be diversified across generations; if one cohort retires when the market is up they can subsidize a cohort who retires when the market is down. But individual retirement accounts aren’t necessarily a worse deal. Often they are better. First of all, pensions aren’t free. If an employer is putting aside money for your pension, that’s money that might otherwise go toward a higher salary. Rising pension costs is one big reason why teacher salaries have stayed so low; as interest rates fell over the years, financing pensions got more expensive, and that adds up to less money available for paying workers. And pensions carry their own risks. They’re much less valuable if you change jobs because benefits are tied to tenure. And poorly managed pension funds can run out of money for payouts. Defined-benefit pensions are financed in two ways: There’s the funded model where the sponsor can put money aside for each person each year, pool it all together and invest it, and then pay a set amount upon retirement. Or there is the pay-as-you-go model, where little or no money is put aside and current workers pay for retirees. If you have a pay-as-you-go model and an aging population with low birth rates, you will eventually run out of money to pay full benefits. That’s exactly the problem Social Security faces in America, and that European government pensions are also confronting. With a funded model, there’s always an incentive to set aside less money than is needed to pay future benefits, often with the hope that some risky investment will succeed and make up the difference. Private companies and the government would rather put their money to other uses than reserving it to pay benefits 50 years down the road. That’s why there’s a long history of private companies underfunding pensions. It’s telling that once corporations were forced to fully account for the cost of pensions — after the Employee Retirement Income Security Act passed in 1974 — most companies stopped offering them. Now most pensions are found in public sector jobs, where shoddy accounting standards allow them to be underfunded and overexposed to risky investments. Unlike a 401(k), workers have no say over that risk. Hence, public pensions are chronically underfunded and suffering even more with the current market downturn. If your pension fund runs out of money, your promised retirement payout could be severely cut. Or, as often happens, there is a government bailout, which means higher taxes or reduced funding for other services such as libraries or schools. The biggest problem with pensions is that it’s very hard to create the incentives to fully fund and invest them responsibly. And when it comes to government pensions, where politicians tend to be short-sighted, it’s especially difficult. Alternatively, individual retirement accounts such as 401(k)s are by definition always fully funded because there is no promise of future payments. They do have their problems: Left to their own initiative, many people don’t save enough in their retirement accounts. People can make poorly informed investment decisions for their accounts and are exposed to the ensuing market risk. Figuring out how much you need to save and how much you can spend in retirement is a very hard problem because you don’t know how long you’ll live. The reason people think individual retirement accounts are a worse deal is that they reveal the truth we’d rather not face: Retirement is very expensive, no matter how you fund it. Chile had one of the more successful retirement account programs, but it will probably be scrapped because the saving rates — about 10% — weren’t enough to fund an adequate retirement for most people.Yet pensions have the same problem. American workers and their employers together pay a combined 12.4% of their annual earnings for Social Security retirement benefits, and the program is still facing financial strains. The same goes for most countries that provide pensions. The difference is that 401(k) accounts make the underfunding problem clear to everyone. So no wonder Chile’s system is facing an overhaul and there are calls to expand pensions in other countries. These calls will grow louder if there is a recession and the market retreats further. But increasing reliance on defined-benefit pensions would be a mistake; They’re just another form of debt that goes unfunded. Transparency is what makes 401(k)-type accounts so unpopular, but that’s also what makes them better. With all the uncertainty we face today, that 401(k) is still a better bet in the long run, because they expose something we’d rather not face: It takes a lot of money to retire. At least with a 401(k) we know what to expect and can act on the information. *This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners. Allison Schrager is a Bloomberg Opinion columnist covering economics. A senior fellow at the Manhattan Institute, she is author of “An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk.” This story has been published from a wire agency feed without modifications to the text. Catch all the Business News, Market News, Breaking News Events and Latest News Updates on Live Mint. Download The Mint News App to get Daily Market Updates. More Less Subscribe to Mint Newsletters * Enter a valid email * Thank you for subscribing to our newsletter. Post your comment First article Source link Share this:FacebookXLike this:Like Loading... Related Post navigation Upswing your Career in Finance Raoul Pal – What Is The Way Out From The Financial Crisis?