Save up before the storm rolls in.

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New York Plans the Next Pension Crisis

Megan McArdle is a Bloomberg View columnist. She wrote for the Daily Beast, Newsweek, the Atlantic and the Economist and founded the blog Asymmetrical Information. She is the author of "“The Up Side of Down: Why Failing Well Is the Key to Success.”
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New York City is contemplating setting up a pension plan for private workers. Details are sketchy -- what it's actually doing is proposing to appoint an advisory board to study the matter -- but there are basically two ways the city could go. Either it can set up a defined-benefit plan, like a traditional pension, in which you get so much money a month in retirement, or it can set up a defined-contribution plan, in which you contribute money to a tax-advantaged account and can access those savings, and any investment returns, when you retire.

A defined-contribution plan could, in theory, be a good idea -- 401(k) accounts are managed by employers, and small employers don’t always have the resources to do so. A big pool could make it easier for workers at small companies to save something for their retirement, potentially at a lower cost. There are also risks: If the city yields to the temptation to play politics with fund choices, or if it picks high-cost mutual-fund options from preferred providers, then it might not be a good deal for workers. But as public-policy ideas go, this is pretty unobjectionable.

Pension Pinch

I suspect, however, that what a lot of people are hoping for is a publicly provided defined-benefit pension. And there are a whole lot of ways for this to go wrong.

Start with the problem of getting people to contribute. A good defined-benefit plan -- where “good” is defined as “one with a high probability of paying the promised benefits” -- is really expensive. There’s a reason these plans got so popular in the 1940s through 1960s ...  wait, no, actually, there are four reasons. First, and least interesting for our discussion, is that during World War II, fringe benefits were both tax-deductible and exempt from wage controls. Second is that the government exercised minimal oversight over these plans, so you could promise big benefits without setting aside enough money to pay for them. Third is that the workforce was growing at a brisk clip, so the pension funds had more workers paying in than were collecting. And fourth is that wages and productivity were growing rapidly, so responsible employers could set aside money to pay for future pension obligations while still giving their workers decent raises.

Well, pension benefits are still tax-deductible. But the other three things are no longer true. (And in the case of the second, we should be deeply glad.) What does that mean? It means that to give workers a defined-benefit pension, you’re either going to have to inject a big taxpayer subsidy or get workers to give up a big fraction of their paychecks.

I’ve written this before, but it’s worth saying it again: The fundamental problem of an adequate retirement has nothing to do with whether you save via a traditional pension or a defined-contribution plan. Each type has its benefits and drawbacks, but ultimately the money comes from the same place: money taken out of worker paychecks and invested in financial assets. People are confused about this because when your employer provides a pension, they don’t quantify the amount that you’ve had to give up in salary in order to get this benefit. But you’re giving up the salary just the same.

If every American saved 15 percent of their wages in a conservatively managed defined-benefit pension system, the country would be well set for retirement. And if every American saved 15 percent of their wages in a 401(k) filled with index funds, the country would also be well set for retirement. The problem is that we do neither of these things. And we can’t just go back to the magic era when defined-benefit pensions were plentiful and seemed free, because both wages and the labor force are growing a lot more slowly than they used to.

If New York starts a defined-benefit pension plan that makes the cost of such plans transparent -- i.e., that tells workers they have to save a big chunk of their paychecks rather than offering them a smaller salary along with a “generous,” “free” benefit -- then the uptake rate will be low. If it plays with the accounting to make the pension seem more attractive, then the system will end up ... well, like state and local pension funds all over the country, without enough money in the coffers to pay the benefits they’ve promised.

And what happens if New York gets private workers into the same pickle as so many government workers all over the country? Obviously, there will be political pressure to top up the pension with taxpayer money rather than let down all those needy senior citizens who were counting on their benefits.

I will, of course, be heartily sympathetic to the pleas of people who were told that there would be a safe benefit upon which they could retire. Which is why this is a path that New York should not go down in the first place. Instead, it should deliver the hard truth: that having a comfortable retirement means consuming less now, and it matters less how you choose to save than that you do so immediately.

(Corrects jurisdiction in first paragraph.)

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.

To contact the author on this story:
Megan McArdle at mmcardle3@bloomberg.net

To contact the editor on this story:
Brooke Sample at bsample1@bloomberg.net