Friday, October 10, 2008

Time for a return to defined benefit plans

Lost in this past bearish week (US stocks are down ~20% since Monday morning) is a recent debate about retirement plans: defined benefits vs. defined contributions.

Defined benefits is the old system. After a certain number of years of work, one's company will guarantee a certain amount of money each month during retirement. These disbursements are funded from current worker's paychecks, and managed either by the company itself or by a contractor. Social Security is, in effect, a giant government defined benefits plan.

Defined contributions is the new system. We can take a certain amount of money out of our paycheck each month, tax free, and invest it as we choose, letting it grow tax free until we retire and then draw funds out as we need it. This has been attractive for three reasons:

1. It creates a direct link between the money I'm putting aside versus the money I'm getting out, bypassing any potential pyramid schemes (as Social Security has been the past few decades, with more people paying into it and than getting money out of it).

2. It allows each individual to set his or her own risk tolerance and direct investment accordingly.

3. Finally, and most importantly, it shifts the risk from the employer to the employee. This is primary reason that employees have switched to these plans.

The problem with defined contribution plans has reared its head this week: panic. The massive sell off on Wall Street is in part a function of millions of individuals deciding that their retirement accounts have dropped low enough and must be liquidated before they decline further. This, of course, pushes stock prices even lower.

A defined benefits plan would not fall victim to such a panic routine, since defined benefit plans have much better and more accurate projections of future liquidity needed (i.e. payouts), and also (should) have access to both private and government insurance and hedging mechanism to protect themselves against downturns. Companies should certainly shift their allocations in times such as these. But they are far less likely than individuals to simply dump their holdings into a falling market.

Defined contributions plans were supposed to be the herald of a new ownership society. Instead, they are a mechanism for irrational risk taking and collective panic.

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