With a funded model, there's always an incentive to set aside less money than is needed to pay future benefits, often with the hope that some risky investment will succeed and make up the difference. Private companies and the government would rather put their money to other uses than reserving it to pay benefits 50 years down the road. That's why there's a long history of private companies underfunding pensions.
It's telling that once corporations were forced to fully account for the cost of pensions — after the Employee Retirement Income Security Act passed in 1974 — most companies stopped offering them. Now most pensions are found in public sector jobs, where shoddy accounting standards allow them to be underfunded and overexposed to risky investments. Unlike a 401(k), workers have no say over that risk. Hence, public pensions are chronically underfunded and suffering even more with the current market downturn.
If your pension fund runs out of money, your promised retirement payout could be severely cut. Or, as often happens, there is a government bailout, which means higher taxes or reduced funding for other services such as libraries or schools. The biggest problem with pensions is that it's very hard to create the incentives to fully fund and invest them responsibly. And when it comes to government pensions, where politicians tend to be short-sighted, it's especially difficult.
Alternatively, individual retirement accounts such as 401(k)s are by definition always fully funded because there is no promise of future payments. They do have their problems: Left to their own initiative, many people don’t save enough in their retirement accounts. People can make poorly informed investment decisions for their accounts and are exposed to the ensuing market risk.
Figuring out how much you need to save and how much you can spend in retirement is a very hard problem because you don’t know how long you’ll live.
The reason people think individual retirement accounts are a worse deal is that they reveal the truth we’d rather not face: Retirement is very expensive, no matter how you fund it. Chile had one of the more successful retirement account programs, but it will probably be scrapped because the saving rates — about 10% — weren't enough to fund an adequate retirement for most people.
Yet pensions have the same problem. American workers and their employers together pay a combined 12.4% of their annual earnings for Social Security retirement benefits, and the program is still facing financial strains. The same goes for most countries that provide pensions. The difference is that 401(k) accounts make the underfunding problem clear to everyone. So no wonder Chile’s system is facing an overhaul and there are calls to expand pensions in other countries. These calls will grow louder if there is a recession and the market retreats further. But increasing reliance on defined-benefit pensions would be a mistake; They're just another form of debt that goes unfunded.
Transparency is what makes 401(k)-type accounts so unpopular, but that's also what makes them better. With all the uncertainty we face today, that 401(k) is still a better bet in the long run, because they expose something we’d rather not face: It takes a lot of money to retire. At least with a 401(k) we know what to expect and can act on the information.
Allison Schrager is a Bloomberg Opinion columnist covering economics. A senior fellow at the Manhattan Institute, she is author of “An Economist Walks Into a Brothel: And Other Unexpected Places to Understand Risk.”