TaxProf Blog

Editor: Paul L. Caron, Dean
Pepperdine University School of Law

Saturday, April 11, 2009

Zelinsky: Obama Embraces Defined Contribution Paradigm

Oxford University Press Blog:  President Obama Embraces the Defined Contribution Paradigm, by Edward A. Zelinsky (Cardozo):

Many important decisions are embedded in the federal budget proposed by President Obama. Among these are the President’s embrace of the defined contribution paradigm. That paradigm promotes retirement savings through individual accounts such as IRAs and 401(k) accounts. ...

This decision puts President Obama in potential conflict with his allies in the union movement. Today, the last bastions of the traditional defined benefit plan are the unionized work forces of state and local governments. Taxpayers thus find themselves paying taxes for lucrative defined benefit plans for unionized state and local employees. And now the Obama budget makes clear to these taxpayers that their retirement savings future is financing their own 401(k) accounts — even as these taxpayers fund often rich defined benefit pensions for government employees.

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In my opinion, defined benefit plans were always a bit of a scam.

First, there was the game of Survivor, in which only the minority who managed to survive layoffs and all other career risks managed to collect. Everyone else got nada. This "breakage" was essential to allow companies to pay rich benefits to the few surviors.

Second, in the 1980s many large companies terminated their defined benefit plans before 50-year-olds could take advantage of very rapid accrual of benefits in the decade before retirement. For some reason, defined benefit plans all seem to have that feature, which provides an economic incentive for the employer to get rid of older employees or otherwise avoid the obligation.

Third, defined benefit plans do not have inflation-adjusted benefits. If they did, they would not be affordable. (Government employee plans have inflation adjustment, and they are definitely not affordable for governments!) Without inflation adjustment, the benefits are good when inflation is low, as it has been recently. But under those same conditions employers will find that funding the plans is very expensive (because the discount rate is low). If inflation is high, the plans are affordable for the employees but they fail to provide reasonable security for the employees.

In my opinion, the defined benefit approach is inherently defective. The only secure retirement approach is to build up a store of actual value and spend 3% to 4% of it per year. Even that provides no protection from losing everything to a medical disaster or a lawsuit where the plaintiff only has to convince a handful of people that he deserves your money. There is no panacea, and defined benefit plans are worse than the other options.

Posted by: AMTbuff | Apr 11, 2009 11:50:14 AM

With pension plans dropping like wall street firms, the remaining defined benefit plan is social security. Instead of trying to eliminate social security, why not enhance it and create more of a true pension plan for everyone by building on the existing infrastructure of social security?

Posted by: Stephanie | Apr 12, 2009 9:51:55 AM