Buyer Beware: Pension Wealth Inequality Rises as 401(k) Plans Become More Popular

Don’t like your look, clothes, or house? Get a makeover. Whenever you turn on your TV, you see people and things being redone: Queer Eye for the Straight Guy, Extreme Makeover, or This Old House. Then, there is the administration’s own makeover of tax cuts for the rich. In the latest incarnation they are dubbed retirement savings accounts (RSAs) and lifetime savings accounts (LSAs), meant to foster retirement income security in an "ownership society."

Retirement income security remains an elusive goal for many workers. More than half of all private sector workers do not have a pension. As a result, many workers are inadequately prepared for retirement. That is, many future retirees will not be able to afford adequate food, housing, or health care. The Bush administration is expected to soon reintroduce its proposal for RSAs and LSAs. These programs are likely to increase wealth for those who already have a lot of wealth, but they will not improve retirement income security for those who are currently insufficiently prepared.

Traditionally, retirement plans were defined benefit plans. Under these plans, the benefit workers receive upon retirement depend on their earnings history and years of service and is guaranteed by the employer. Typically, the employer contributes money into a pension fund to pay for promised benefits, with the employer absorbing all the risks.

Spurred by changes in the tax code, employers increasingly replaced defined benefit plans with defined contribution plans. Employee and employers both contribute money into a retirement account, such as a 401(k) plan. The employee’s contributions are pre-tax, i.e. the individual does not have to pay income taxes on the contributions. When the employee retires, the benefit level is determined by the amount of money contributed into the plan and the rate of return on the assets. If the stock market does well, the employee will have a high benefit level; if the stock market is lousy, the benefit can be low at retirement.

The transition from defined benefit to defined contribution plans has been stunning. Among the age group 47-64 (the age group most affected by the transition), the share of households with a defined benefit plan plummeted from 69 to 42 percent between 1983 and 2001 and the share with a defined contribution plan skyrocketed from 12 to 62 percent.

Higher income earners have benefited more from defined contribution plans than lower income earners. Data for 2001 show that for the 80 percent of households with the smallest account balances, defined benefit wealth was greater than defined contribution wealth. Inversely, for the one-fifth of households with the largest account balances, defined contribution wealth was greater than defined benefit wealth. For example, among the top 5 percent of households, defined contribution wealth was 39 percent greater than defined benefit plan wealth. Thus, defined contribution wealth was more concentrated than defined benefit wealth among people with the largest wealth holdings.

The situation in 2001 was the culmination of a trend towards greater retirement wealth inequality. Households in the middle of the pension wealth distribution saw gains of about 5 percent in their inflation-adjusted pension wealth from 1983 to 2001. In contrast, the pension wealth held by the one-fifth of households with the largest pension wealth grew by 25 percent, and the pension wealth held by the top 1 percent increased by 123 percent. Put differently, households that already had large savings were most likely to take advantage of the growth in defined contribution plans.

Households with more wealth typically benefit more from defined contribution plans than people with less wealth. For one, people with more wealth also tend to have higher incomes, thus providing them with bigger tax breaks for their contributions. Second, wealthier households have more experience managing their money, and thus are more apt at avoiding many pitfalls. Also, an important aspect in accumulating wealth is to reduce risks. This can be accomplished by holding a wide range of assets, or to diversify. People with more wealth have more options to diversify, and they can often do it more cost effective than people with less wealth.

The government’s multibillion support for 401(k)s and IRAs has done little to increase retirement income security for most households. It has undoubtedly contributed, though, to a faster rise in retirement wealth amongst the wealthiest household than for others. Further tax incentives for individual accounts, such as raises to 401(k) contribution limits or the administration’s RSAs and LSAs, are likely to continue this trend. There are alternatives that could help to improve retirement savings for lower and moderate income households. These include updated regulations for defined benefit plans and better designed incentives that would favor lower income households, e.g. low income tax credits. Instead of promoting policies that can make a real difference in improving retirement income adequacy, the administration is foregoing options that would help achieve this goal in favor of promoting its "IRAs on steroids" as another tax cut for the rich.

  • Defined Benefit and Defined Contribution Pension Wealth among Account Holders by Pension Wealth Percentile, Ages 47-64, 2001
    In 2001, defined contribution pension wealth, held in individual accounts, such as 401(k)s, was more concentrated among wealthy account holders than pension wealth in traditional defined benefit pension plans. Among the 80% of households with the smallest account balances, the typical account balances in defined pension plans were greater than for defined contribution plans. The opposite was true for the 20% of households with the largest account balances.
    Source: Authors' calculations. Board of Governors, Federal Reserve System, Survey of Consumer Finances.

  • Pension Wealth in 2001 Dollars by Pension Wealth Percentile, Ages 47-64, 1983 and 2001
    Total pension wealth – the sum of pension wealth in defined contribution and defined benefit pension plans – has become more unequally distributed from 1983 to 2001. Households in the middle of the pension wealth distribution saw gains of about 5% in their inflation-adjusted pension wealth from 1983 to 2001. In contrast, the pension wealth held by the one-fifth of households with the largest pension wealth accounts grew by 25%, and the pension wealth held by the top 1% increased by 123%.
    Source: Authors' calculations. Board of Governors, Federal Reserve System, Survey of Consumer Finances.

Edward N. Wolff is a professor of economics at New York University. Dr. Christian Weller is a senior economist at the Center for American Progress.