There is a key paradox in pension obligations… that is, contributions should increase when interest rates are low.
That’s because retirement nest eggs can only grow in two ways:
1. From earnings, and
2. From contributions
That means you need higher-than-normal contributions to balance out a year of poor earnings.
What’s alarming is this same paradox holds true for defined contribution retirement plans like 401(k)s and IRAs. Most financial planning models assume retirement accounts grow at a constant rate. But most investments within these accounts don’t grow at a constant rate.
In theory, these models only work if workers sock away extra money (increase contributions) during the years of below average stock returns, and contribute less when the stock market is performing above average.
This is where theory and reality don’t mesh.
The stock market falters when the economy is struggling. When the economy is struggling, savers are struggling. Just ask workers to double or triple what they contribute to their 401(k) because the stock market was flat last year… good luck getting that to happen.
Today, the traditional “defined benefit” plans, where the employer is on the hook to provide a specific pension payment each month to the retiree, is a dying breed. Just look at the chart below. It shows how employers have shifted the retirement income burden off their shoulders (green bars) and onto the backs of their workers (yellow bars).
Unfortunately, many retirees will face the same endgame, whether they were promised a pension or persuaded to fund a 401(k).
If you haven’t done so already read the Survive & Prosper issue on “Entitled to Something from an Entitlement Program?”