THE BLOG
12/28/2014 08:11 pm ET | Updated Feb 27, 2015

Why 401(k)s Shouldn't Replace Pensions

It's not just basic finance, it's common sense: A large pool of money invested by professionals will yield far greater returns than small, separate accounts managed by individuals with no professional training in finance.

So why do some think that ending Illinois' defined benefit pension system and moving workers into privatized, 401(k)-style accounts is a good idea?

In an effort to get investment risk off their backs, corporate America made a wholesale switch from traditional pensions to 401(k) plans over the last 30 years. Since these inadequate retirement vehicles are accepted as the only choice for the majority of workers, their inefficiencies in comparison to a traditional pension are little understood.

But new data from the National Institute for Retirement Security shows just how much Illinois taxpayers stand to lose if we switch to privatized accounts. To provide workers with the same modest retirement benefits, traditional pensions are 48 percent less expensive than 401(k)-style plans. That's a 48 percent savings to Illinois taxpayers.

According to NIRS, there are a few key reasons why defined benefit pensions are more cost effective:

  • Pension plans enjoy higher investment returns and lower fees than individual accounts, generating a 27 percent cost savings.

  • Unlike individual investors who generally enjoy high-risk, high-reward investment strategies when they're young but switch to lower-risk portfolios that yield far lower returns as they age, pension plans can maintain a balanced portfolio that yields consistently high returns, generating an 11 percent cost savings.

  • Pension plans pool longevity risk, meaning that they only have to save for the average life expectancy of a group of individuals. Workers in a 401(k) plan need an investment strategy that provides for the event that they live a longer than average life. Longevity risk pooling generates a 10 percent cost savings.

What's more, cutting public workers' retirement security by transitioning them to a 401(k) has its own set of unforeseen costs.

The average Illinois public employee makes a salary that is 13.5 percent less than their similarly educated counterparts in the private sector, trading front-end benefits like salary for back-end benefits like pension payments. With pension benefits gone, the state of Illinois may have to drastically increase public sector salaries or risk losing teachers, police officers, firefighters, and thousands of other critical workers.

In addition, some 80 percent of Illinois public employees (including teachers, police, fire fighters and university employees, among others) are ineligible for Social Security due to old laws that exempt workers who have a public pension. Switching to a 401(k) system could require Illinois workers to participate in the national program, forcing cities, school districts and universities to begin paying Social Security taxes, now 6.2 percent of each workers' salary.

Lastly, moving public workers to 401(k)-style accounts will not fix the unfunded liability problem Illinois faces. In fact, such a move will likely increase the state's pension debt, as it will reduce revenue in the form of employee contributions going into the pension funds and lower investment returns due to the change in the makeup of participants.

The problem with pensions in Illinois is a creation of politicians who spent years underfunding the system, essentially using the retirement savings of public workers as a credit card to pay for other priorities while ratcheting up state debt.

But it makes no sense to use the past misdeeds of politicians as an excuse to switch public employees to an inferior, less cost-effective retirement plan. Instead, we need to find ways to strengthen Illinois pensions for future generations.