When 401(k) Is Not OK – Why Defined Contribution Plans Aren’t a Good Idea

It’s increasingly common these days for members of city councils to consider changing police, fire and municipal employee pension plans from Defined Benefits (DB) to Defined Contributions (DC), those similar to private sector 401(k)s.

The council members – usually the newer ones making a name for themselves early in their political career – offer many reasons for proposing this change but key among them is that most taxpayers don’t have defined benefit plans themselves. It’s a ‘level the playing field’ sort of politically-charged approach.

It’s also rash and ill-advised. There’s a significant body of evidence that show DC plans aren’t a good idea for employees, for many reasons. Key among the concerns right now is the fact that 401(k)s aren’t working out very well for private sector employees. If the goal of private and sector employers is to improve retirement security for all workers, 401(k)s aren’t getting the job done.

Take for instance the findings of a recent study on 401(k)s and the real-life evidence from a state that tried such a switch in 1991.

A Deloitte study, the “Annual 401(k) Benchmarking Survey: 2009 Edition,” reported that 19% (up 2 percentage points from the previous year) of private sector plan sponsors believe "very few" of their employees will be financially prepared to retire. As a result, more than 60% of the employers are considering adding features such as re-enrollment to help increase deferral rates while others plan to conduct a retirement readiness assessment. If the 401(k) is the way to go, then why are employers taking such strident measures to make it work?

In West Virginia, the Teachers' Retirement System (TRS) closed their DB plan to new members in 1991. All new hires were offered a DC plan. This decision resulted in the loss of new members, making it more difficult to finance their unfunded obligations. Because the DC plan was not reducing employer costs nor providing an adequate level of retirement income, West Virginia Legislature reopened the DB plan for public school teachers. In June 2008, when given the choice to return to the DB plan, 78% of those in the DC plan chose to switch.

As the issues of converting to a DC plan continue to surface, hopefully more public employers will realize that a DC plan may not be the solution. We’re going to touch on this issue in many future blogs, but 401(k)s aren’t okay for public employee retirement security.