401(k) is bad option for any worker

Robert Hiltonsmith is a policy analyst for Demos, a public policy organization in Manhattan, and the author of the report "The Failure of the 401(k): How Individual Retirement Plans are a Costly Gamble for American Workers."

Lurking just below the surface of the recently concluded budget battle in Albany is perhaps an even bigger fight: a push to reform the state's pension systems. One of Gov. Andrew M. Cuomo's major campaign promises was to reduce pension costs, and Mayor Mike Bloomberg promised in his January State of the City address to make pension reform his "number one priority in Albany."

Though reform of the state's pension system is both inevitable and warranted, the governor's likely proposal for another new retirement tier and a clampdown on overtime will assuredly trigger renewed pressure to implement a much more radical, and dangerous, proposal: privatizing public employees' pension systems by converting them to individual 401(k)-type plans.

Five other states -- Florida, Kansas, North Dakota, Oklahoma and Virginia -- are considering the move to a 401(k)-only retirement system for their public employees, and six more -- Alaska, Colorado, Georgia, Michigan, Ohio and Utah -- have already done it. Their new systems haven't been in place long enough to determine how they are working.

But cheerleaders of shifting from the current defined-benefit public pension system to a defined-contribution plan argue that the former are unaffordable and that 401(k)-style systems are more efficient. They also argue that it's unfair for public-sector employees to get better retirement benefits than most private sector workers, who are picking up the tab with their taxes.

Claims of savings and fairness may sound right on the face of it. But privatizing state pension systems would be a disaster for both public employees and the citizens who pay their salaries. Pushing public workers into 401(k)s would just mean more citizens would face the likelihood of inadequate retirement income and future dependence on the social safety net.

Private sector firms began moving en masse to 401(k)s in the 1980s; the percentage of firms offering these plans as their sole retirement benefit tripled during that decade. Nowadays, for those workers who are lucky enough to receive retirement benefits at work, 70 percent have only a 401(k). This change had the effect of torpedoing retirement security for employees, whose retirement savings are generally only a fraction of what they need for a comfortable retirement.

So converting the state pension system to 401(k)-style plans would eviscerate retirement security for some of the few remaining workers who have any. Pension plans, in which contributions are pooled and invested in relatively safe, slow-growing funds, come with the state guarantee that a retired worker will maintain a certain income. And with the notable exception of the recent stock market decline, the state has been able to provide that guarantee without asking for extra contributions from municipalities.

In contrast, individual retirement-savings plans often come with inflated management fees and no protection from a sudden market downturn. They put workers' livelihoods in the hands of financial managers who, if the financial collapse is any indication, too often make risky bets for short-term gain.

Why are 401(k)-type plans such a bad idea for public and private employees alike? First, they're expensive. The exorbitant fees charged by firms that manage 401(k) accounts can cost private-sector workers a quarter or more of their retirement savings. Demos calculates that these fees can eat up more than $70,000 of an average private sector worker's lifetime earnings. For those lucky enough to get an employer contribution, additional fees can be applied.

These fees are over twice as high as those state pension managers pay firms to manage their own assets. Because pension funds have pooled assets, the funds can be invested with a much longer time horizon than individual accounts can be, reducing costs. Also, offering individualized investment options would leave the state with less bargaining power; the retirement contributions of the state and its employees would necessarily be spread out over a larger variety of funds, so the state would be less able to negotiate lower fees.

This means that if states switch to 401(k)-type plans, the taxes of their citizens, who pay state employees' salaries, would inflate the already astronomical profits of the mutual funds and securities brokerages who manage most assets in these plans.

401(k)s also place the burden of the multitude of risks that come with saving for retirement entirely on the backs of workers. Those forced into individual retirement plans risk losing their savings in a market crash, investing so conservatively that they receive anemic returns, contributing too little to their plans, outliving their savings and more.

These risks have added up to very shaky retirement prospects for private sector workers. Federal Reserve data show that only a quarter of all workers aged 55-64 have more than $85,000 saved for retirement. Most retirement advisers recommend a balance many times that amount. For example, if you make $100,000 a year, retirement experts believe you'll need about $75,000 per year in retirement to maintain the same standard of living. So you'd need to have nearly $1 million saved, on top of Social Security, to ensure you'll have that $75,000 no matter how long you live.

The other argument pension detractors make -- that public workers shouldn't get benefits that aren't available to most people in the private sector -- simply illuminates how terrible 401(k)s have been for private sector workers. Why should the solution be to move more workers into an inadequate system? Retirement should not be a race to the bottom. Instead, we should be looking at how to improve private-sector retirement benefits.

Universal retirement accounts, for instance, would combine the best features of traditional pensions and 401(k)s. As with traditional pensions, employers, employees and the government would all contribute, the accounts would guarantee a payout for life, and assets would be pooled to maximize returns and minimize individual risk. But like individual retirement plans, the accounts would move with employees from job to job and, most important, the accounts would be personal -- workers would own the assets in their own account. Given the country's struggles with health care reform, the political feasibility of such an approach is dubious. But these plans do work: the Netherlands and Switzerland, among other countries, have similar types of universal private retirement accounts.

State pension benefits are fairly modest: The National Institute on Retirement Security estimated that in 2006, the last year for which we have data, the average public employee's pension in New York was a very reasonable $24,263 per year. We should be fighting to ensure that everyone has the possibility of a secure, dignified retirement, rather than trying to bring down some of the last workers who do.

In the wake of the worst recession in memory, the state and municipalities are facing a host of real budgetary issues. Sensible reforms to the state's pension system -- eliminating rules that allow excessive overtime to inflate pensions and, in some cases, increasing retirement ages -- are both fair and will help to control pension costs in the long run. But before the next round of the pension reform debate begins, let's agree that switching public sector workers to 401(k)-type plans should be off the table.