Defined benefit, defined contribution and the hierarchy of needs

We are in a secular bear market. What this means for many pensioners or for many about to become pensioners is great uncertainty about the quality of their retirement. I expect this uncertainty to translate into anger regarding the move from defined benefit pensions to defined contribution pensions. Whether a policy response results depends on how stocks do over the next few years. Nevertheless, in my estimation, we are about to understand that human psychology and defined contribution plans are at loggerheads.

My thinking on this subject is influenced by my familiarity with the theory called Maslow’s hierarchy of needs. If you recall, the Great Depression left many feeling insecure and it illuminated the lack of a social safety net in the United States in particular. A basic “safety need” was going unmet. I see the present period of economic uncertainty ending in the same kind of angst as the realization that many have not provided adequately for retirement sinks in.

The following Wikipedia explanation of this hierarchy fills in the salient points (I have bolded the most important sections:

800px-maslows_hierarchy_of_needssvgMaslow’s hierarchy of needs is predetermined in order of importance. It is often depicted as a pyramid consisting of five levels: the first lower level is being associated with Physiological needs, while the top levels are termed growth needs associated with psychological needs. Deficiency needs must be met first. Once these are met, seeking to satisfy growth needs drives personal growth. The higher needs in this hierarchy only come into focus when the lower needs in the pyramid are met. Once an individual has moved upwards to the next level, needs in the lower level will no longer be prioritized. If a lower set of needs is no longer being met, the individual will temporarily re-prioritize those needs by focusing attention on the unfulfilled needs, but will not permanently regress to the lower level. For instance, a businessman at the esteem level who is diagnosed with cancer will spend a great deal of time concentrating on his health (physiological needs), but will continue to value his work performance (esteem needs) and will likely return to work during periods of remission.

The crux of Maslow’s theory is that human beings become nearly incapable of focusing on higher level needs when basic needs like financial security are wanting. A bear market and severe recession, as we are now experiencing today, create huge levels of financial insecurity that did not previously exist. And that is going to mean a sea change in the way people behave.

We are seeing house prices decimated and stock prices have fallen by half for many. These events will put finances into focus for baby boomers, the first of whom will retire in two years. In my view, the switch from defined benefit to defined contribution will be seen as a major reason for the lack of security. The following snippet from an MSN Money article brings this point home.

After watching her account drop 44% last year, Kristine Gardner, a 35-year-old information-technology project manager in Longview, Wash., feels no sense of security.

“There’s just no guarantee that when you’re ready to retire you’re going to have the money,” she says. “You either put it in a money market which pays 1%, which isn’t enough to retire, or you expose yourself to huge market risk and you can lose half your retirement in one year.”

Many retirement experts have come to a similar conclusion: The 401(k) system, which has turned countless amateurs like Gardner into their own pension-fund managers, has serious shortcomings.

“This is the biggest test that the 401(k) plan has seen to date, and it has failed,” says Robyn Credico, the head of defined-contribution consulting at Watson Wyatt Worldwide, noting that many baby boomers are ready to retire. “We’ve put people close to retirement in a very challenging position.”

The most obvious pitfall is that 401(k) plans shift all retirement-planning risks — not saving enough, making poor investment choices, outliving savings — to untrained individuals, who often don’t have the time, inclination or know-how to manage them.

These are issues that 35 year-olds have time to deal with. But, if you are 58, things look a lot different. Now, during the past bull market, employers in the G-7 often switched from defined benefit to defined contribution pension plans, effectively giving individuals both the responsibility and risk of investing for their future. The timing could not have been worse for those 58 year-olds; they came of age in a time when markets rose and an illusion of adequate retirement savings was created by a bull market. What should be clear is that bull markets and defined contribution don’t mix. Basic human psychology (the recency effect) will see a never-ending bull market, leaving individuals short of savings. And, that’s where Maslow’s hierarchy steps in.

Not saving enough has always been a big problem for 401(k) participants. The tough economic times are exacerbating that tendency. In 2007, the median account balance for 55- to 64-year-olds in defined-contribution plans such as 401(k)s administered by Vanguard was just $60,740, and only 10% of all participants saved the maximum dollar amount in the plans.

Over the past year, about one in five workers age 45 or older has stopped contributing to a 401(k), IRA or other retirement account, according to a recent survey commissioned by the AARP, an advocacy group for older people.

Peg Kelley, a 58-year-old small-business consultant in Watertown, Mass., didn’t contribute anything to her 401(k) last year. Instead, she’s focused on paying down credit-card debt and building an emergency fund in case the bad economic times turn worse. She’s also still paying off an $8,000 loan she took from her 401(k) plan four years ago to buy a new car.

Afraid of reliving the dot-com market meltdown, which knocked $100,000 off her retirement savings, she moved her entire 401(k) from diversified stock and bond holdings into cashlike investments early last year.

“I’m not going to get rich on my 401(k),” she says, “but also don’t want to get poor because of it.” She had hoped to retire early, but now she figures she won’t quit work before age 65.

As I see this downturn lasting a very long time, even this kind of thinking will not go far enough in dealing with the economic insecurity to which we have all been exposed. Going forward, I see the whole idea of defined contribution coming under attack as people realize that huge financial burdens have been transferred from corporations to individuals. This conversation will take on a populist tone because I think many will notice that the owners of capital have become much richer over the preceding generation, while ordinary workers have not. With the illusion of wealth now gone as paper wealth declines, many will come to realize that we have just seen a massive transfer of risk.

Will this result in increased forced savings? Perhaps. After all, It is now evident to all that defined contribution pension plans work in good times but are woefully inadequate in bad times. I see this as the basis for some fundamental change. With that in mind, I say that if we are to follow the New Deal in any regard, it should be to increase the economic security of average citizens in a time of crisis. When politicians talk about change, this is where change must begin.

Maslow’s hierarchy of needs – Wikipedia
Do 401(k) plans still make sense? – MSN Money

  1. Nick von Mises says

    Interesting discussion but I think you skirt the fundamental issue: we are not as rich as our paper statements made us believe. Whether pensions are DC or DB it still relies on somebody picking up the tab. In a bull market you simply get the illusion that no-one needs to due to unrealistic paper valuations of what are essentially unrealised (and non-existent at a macro level) gains. You correctly predict much upcoming populism on the subject but essentially it will be about baby boomers desperately trying to force the tab onto the younger generation.

    Also, I found the statement on risk/costs being transferred from corporations to individuals misleading. All costs everywhere are bourne by individuals, whether as employees, customers, or shareholders. Putting a pension cost onto a corporation is putting the cost on it's shareholders, who may be people with 401ks invested in that firm. There are definately winners and losers among those individuals, but still individuals.

    1. Edward Harrison says

      Hi Nick, I understand from your comments, you see the corporation as a collection of individuals (trough the shareholders). Fair enough.

      However, I am making a different point. To be clear, what I am saying is that corporations have gotten rid of DB plans because they viewed this as a burden which decrease earnings, thus decreasing executive compensation.

      In order to increase earnings, companies decided to slough off the retirement responsibility onto individuals. This disproportionately benefits the executives of those companies, making the switch to DC another issue directly-related to executive compensation. So, I do not see this as merely an issue of transferring risk between individuals (employees, customers shareholders) but a transfer of risk from corporations, which have over the preceding period been used to enrich insiders, to their employees.

      The point your making is that society as a whole, i.e. individuals bear the burden of saving for retirement, so under-savings is a burden we all share. In the future, increased savings and decreased consumption will be a collective burden. I agree with this. However, I am also suggesting that there was a permanent transfer of wealth from employees to corporate insiders due to the change from DB to DC. Had the switch occurred during a bear market, insiders may not have profited and individuals would have saved more money.

  2. Nick von Mises says

    I'll agree with the bolded comment, sure. I think it was a more a case of fleecing the shareholders and taxpayers (the "going broke for profit" model) by a pump'n'dump for execs than it was the fleecing of employees. The latter were lied to but it's likely the shareholders or taxpayer will have to make up the shortfall to employees more than the employees simply doing without (for DCs).

    The age thing is important too. This is about the older generation fleecing the younger. Most changes have involved new workers being denied benefits in order to protect benefits of older workers. When the younger generation finally figure this out en-mass it'll be the end of the unions.

    1. Edward Harrison says

      Nick, that last part was an interesting bit I hadn't really considered: the transfer of security from younger to older workers leading to unions' demise. At the Big Three automakers that is exactly what is happening, older workers have good benefits that will end up killing the proverbial goose and screwing the younger employees. So, how does a younger person react? By leaving the union, you suggest. It does make sense.

      And you're right, shareholders and taxpayers were fleeced even more here.

  3. Nick von Mises says

    I've been looking at demographics as a huge time bomb, mainly because of the promises the retirees expect to collect upon rather than the gross numbers of people themselves. I think the high living standards of the entire post-war consensus was a combination of (i) running down the capital stock of the West and (ii) converting payments now into promises to pay later. The former is the reason it now takes two wages to live like one wage used to. It has been masked under women entering the labour force, household debt, global outsourcing, and inflation to jig the numbers so they seemed to go up in nominal terms. The latter was thru social security, pensions and stock market prices that could never survive the boomer liquidation.

    1. Edward Harrison says

      I take a fairly conservative view on the Coming Generational Storm and social security. I think it is indeed a ticking time bomb. Moreover, Japan's malaise may have much to do with the same generational issues that they got to fist and we are now getting to. In my view, this requires two things: 1. a promotion of mental and physical health amongst younger workers so that they are healthy when they get older. 2. a lengthening of the working years. This view is very much in contrast to Dean Baker, someone I respect, but who sees the generational and social security issues very differently.

  4. Nick von Mises says

    As a parable, I think it's like a dissolute playboy inheriting a fortune then squandering it on immediate desires, then writing a bunch of worthless IOUs until people figure out he's broke. The boomers are the playboy.

    Three years ago all the talk was of "inter-generational theft", especially as housing was out of reach. Now I think the boomers are realising that they can't collect and institutions like the AARP, old-school unions, and public sector groups are going to be the new enemies of the working taxpayer.

    I think an unpoliticised young person should react by keeping assets offshore. Activists, I'm not sure. I don't really follow issue politics

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