The Portability Myth

401(k)s no doubt have a place in the retirement landscape, so long as people understand the real intrinsic differences between defined-contribution plans and defined-benefit plans. Portability is not one of those differences. Plan sponsors are in a position to correct this misconception, and should not be swayed from pursuing an effective defined-benefit strategy in the name of portability
By Bart Pushaw
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t was during the late 1980s when we first heard the beating of the portability drum. Defined-benefit plans were firmly entrenched as the foundation for an employee’s retirement security planning, but 401(k) plans had just been awarded long-overdue IRS regulations and were gaining in popularity as a differentiator for companies in their quest for talent.

One of the selling mantras offered to employers reviewing 401(k) plans was portability. Employees, the story went, were much more likely to change jobs than ever before, and because of this they demanded benefit portability. And everyone knows that if they want portability, you need a 401(k) plan—pension plans just won’t cut it.

Since then, and for reasons other than those mentioned above, the number of 401(k) plans grew, often at the expense of pension plans, employees and shareholders. So what is portability, exactly, and is it a good thing? Portability of benefits is a fuzzy term, readily recognized by all but still misunderstood. Upon closer examination, portability has a twofold meaning.

First, it refers to the ability of employees to "take it with them." With a portable benefit, when a worker changes jobs, she can cash out the prior employer-plan benefit and take it with her or roll over the benefit.

Second, and of greater significance, portability refers to the ability of an employee to retain his ultimate retirement benefit level in a job-hopping career. In this case, benefit plans are portable if the employee’s ultimate retirement benefit is unaffected by his number of employers.

Some two decades later, do we really know what portability is? Did employees demand it? Do they still? Has portability lived up to the promise?

Plan type or benefit structure
The supposed lack of portability was considered a problem of plan type: 401(k) versus pension. This was and is incorrect. The issue is one of benefit structure, particularly pay averaging. A majority of pension plans based the retirement benefit accrual upon final average pay, while 401(k) plans base benefit accruals solely upon current pay.

Without doubt, an employee who job-hopped among final-pay pension plan employers would receive a reduced benefit compared with a similarly situated employee who remained at the same employer—even if each employer had identical pension plans.

However, this problem is erased if the pension plan determined benefits based upon each year’s pay, as does a 401(k) plan. Such benefit structures, referred to as career average plans, are not uncommon. If every employer maintained career average plans, then the "portable" employee would have portable benefits in the most meaningful sense. Identical benefits can be offered across multiple job environments if each individual employer maintains the same benefit level within all plans. This is achievable in either pension or 401(k) environments. Here is an example of benefit structure with and without job hopping:

		1% final average pay		1.76% career pay
	Ending pay	Hopping	Same job	Hopping	Same job
First 10 years	$40,477	$3,647	******	$5,676	******
Second 10 years	$69,143	$6,230	******	$9,682	******
Final 10 years	$118,107	$10,642	$31,925	$16,557	$31,925
Career pay	$1,810,922	$20,159	$31,925	$31,925	$31,925

Likewise, the "take it with you" portability concept is also something of a nonissue, because any plan can offer lump sums upon termination. Cash-balance plans are often lauded for this feature, and indeed, they are an attractive option. But there’s no intrinsic reason why pensions can’t also utilize a design that taps into the same notion of portability.

Was the portability shift the right reaction?
Since portability became fashionable, academics have looked at the question of employee mobility. One study, "Job Tenure and Pension Coverage," by Alicia H. Munnell, Kelly Haverstick and Geoffrey Sanzenbacher of the Center for Retirement Research at Boston College, stated the question very directly: Which came first—mobile employees or plans that encouraged employee mobility? Did the plans altruistically provide the solution to a changing demographic, or did the mobility solution actually open the door to the problematic mobile employee? The research showed unequivocally that employee mobility picked up only after 401(k) plans became widespread.

At the time portability was first being marketed, plan sponsors were also increasingly disenchanted with paternalism. The growing distaste for paternalism infused the portability debate with increased urgency, though it may have been a mistake to conflate the two. Consider a sponsor who is contemplating changing from a pension plan to a 401(k) plan, both of which attempt to provide similarly adequate benefits at retirement. This reaction to portability and paternalism leads to counterintuitive results that can’t do anything but harm the company.

Why does this harm the company? When a pension plan and a 401(k) plan are compared, more monies are accumulated by the young and recently hired employees in the latter than in the former. This is balanced out later in one’s career as the long-service employee eventually receives more from the pension plan annually compared with the 401(k).

So in an attempt to break the paternalism relationship and in the name of portability, the employer provides more money to those who leave the firm at a cost to those who stay with the firm. What results is an increasing paternalism toward those who leave as opposed to those who stay, because the employer now is providing for employees who are theoretically mobile, but in actuality are staying with the company by changing the plan type—when benefit structure is the actual issue.

The irony for the employer is that even if a career-average structure were adopted for portability’s sake, the benefit could have been delivered much less expensively in a defined-benefit plan than in a defined-contribution plan. Even if benefit levels established under the benefit policy are kept constant in order to maintain competitive and adequate income levels, a defined-benefit plan would cost the company less and increase shareholder returns.

As it happened, most—if not all—switches from pension plans to 401(k) plans did not maintain targeted benefit levels. Most changes have led to, and will continue to lead to, reduced retirement income.

There’s no doubt 401(k)s have a place in tomorrow’s retirement landscape, so long as people understand the real intrinsic differences of defined-contribution plans and defined-benefit plans. Portability is not one of those differences. Plan sponsors are in a position to correct this misconception, and should not be swayed from pursuing an effective defined-benefit strategy in the name of portability.

Workforce Management Online, July 2008 -- Register Now!

Bart Pushaw is a principal and consulting actuary in the Dallas office of Milliman. To comment, e-mail editors@workforce.com.

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