Risk is not just a board game

As David Eggert reports, it was a narrow vote, but the Michigan Senate decided to shift retirement plans from defined benefit to defined contribution (401 k type of programs).  Commented Sen. Mark Jansen
“Rather than kick the can down the road, my amendment ends this problem and provides stability for future school retirees as it ensures the money will be there for them to collect when they retire,” Jansen told senators. “In the future, legislators will look back on this group as the Legislature that fixed an unending nightmare.”
Is this a big deal? Is our long nightmare over? The differences may be smaller, according  commentator   rovingbandit
 there is, from the point of view of Wall Street, very little difference between a pension and a IRA/401k.

The principal difference is not in the investment but in the transfer of risk from the employer to the employee. Associated with that is the question of asymmetrical information, where the employee lags in information about the actual investment choices. This asymmetry favors the seller, and potentially resulting in lowered returns.

Secondly, the we have the problem of overall outcomes. While some employees will be brilliant at their investment, most will not; some will lose significantly. Employees naturally play it safe; the observed behavior is for low-risk low-return plans. So looked at the retirement outcomes for the employees as a whole, there is a distinct risk to the society for under-performance — i.e. more poor teachers, say.

Now with more risk on the teachers’ back, what are they to do? That risk is typically compensated one of three ways: higher up-front compensation where teaching is compared to other potential jobs, shorter tenure where teaching is not a career but a job — this behavior is noted with 401 k programs, btw, or with reduced spending — that can have significant impact on the community insofar as the employee defers spending now in order to spend later, but at a different location. It should be clear, that for the purpose of educational reform and improved performance, increasing financial risk for the participants decreases the very stability one needs for long-term success.

While 401 k and defined benefit plans function in similar financial fashion, they treat risk quite differently, and this in turn can have substantial impact on communities, and on the State’s overall desire for improved educational outcomes.

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