October 29, 2017
An NYT article discussing Republican plans to sharply limit the tax deduction for 401(k)s noted how these retirement accounts have largely replaced traditional defined-benefit pensions and said that they were cheaper for employers. This is not entirely clear.
In principle, a payment for a retirement benefit is supposed to be a substitute for wages. If a worker gets $2,000 a year paid into a defined-benefit pension or a 401(k) plan, this is supposed to be offset by roughly a $2,000 reduction in wages. In the simple case, the retirement benefit is not costing the employer anything, since the worker is seeing a reduction in pay corresponding to the value of the benefit. (This is the same story economists tell about employer-provided health care insurance.)
As a practical matter, the offset is almost certainly not one to one. Many workers will view the contribution for retirement as worth more than the same amount of dollars in their paycheck while younger workers who are far from retirement might view the contribution as being worth less than the same amount of dollars in their paycheck.
But that aside, if we compare a tradition pension, with a guaranteed benefit, with a 401(k) type defined-contribution plan, a dollar in the former should be worth much more to workers than a dollar in the latter. The reason is that the employer is agreeing to take on the market risk with a defined-benefit plan. The actual value of this guarantee can be debated (Andrew Biggs, of the American Enterprise Institute, calculated that a dollar in a defined-benefit plan is worth on average three dollars in a defined-contribution plan), but there is no doubt that the willingness of employers to accept market risk is of considerable value to workers.
This has historically been the reason that large companies offered defined-benefit pensions. It matters little to a company like GE whether the market is up or down in the year a particular worker retirees; however, it matters hugely to the retiring worker. If GE agreed to accept this risk, then they could presumably offer a pay package with a reduction in pay that was larger than the amount they were actually contributing to the pension. In this case, a defined-benefit plan would actually be cheaper than a 401(k) plan.
However, this story would change if workers became less tied to firms so that most workers would not expect to stay with their current employer until retirement. In that case, they may not stay with the company long enough to qualify for its pension. This would mean the contributions to the pension would not be particularly valuable to workers. Also, if companies chose to downsize and layoff large numbers of workers, the existence of large pension obligations could make the layoffs more complicated.
The decline of defined-benefit pensions is more likely tied to the changing pattern of worker-employer relations rather than simply in order to save money, although it is almost certainly the case that employers offering defined-benefit plans on average make larger contributions to the workers’ retirement than those just offering 401(k)s.
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