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:
Maslow’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.