Risk Transfer: Why Employers Love 401k Plans

I’ve spent a lot of time telling people they were stupid to not set up their 401k plans. And I will continue to do so. But if you haven’t yet set up your 401k plan, you probably feel pretty smart right now.

Regardless, the 401k plan is a big headache for Joe the Employee. It’s supposed to be.

Pension Plans
There are two basic types of retirement plans. The first type is called the defined benefit plan (e.g. pension plan). Basically, if you work at a company for a while, then after you retire, your employer will send you pension checks for the rest of your life.

Employers who offer pension plans have to manage a pension liability account. This is an investment account full of bonds and stocks. The employer’s goal is to make sure this account is big enough to help pay for those pension checks.

In other words, if the stock market collapses and that pension liability account shrinks, your employer has to put more of its own money in that account. Remember, your benefit is defined. This means your the size of your pension payments are promised by the company.

Big headache for the employer. No headache for you.

401k Plans
The second type of plan is called the defined contribution plan (e.g. 401k plan). Basically, you are allowed to put a portion of your paycheck (Pretax! Yea!) into a 401k plan, which is your retirement account. It is your responsibility to make this account big enough so that you can live off of it during retirement.

What’s your employer’s role. First, they take a big stack of confusing pamphlets from Fidelity, Blackrock, Vanguard, etc about growth, value, income, and different sized caps. Then they stick it in an envelope, hand it to you, and tell you good luck.

More importantly, most employers will offer to match your 401k contributions with their own contributions. Hence, it's a defined contribution plan. And they’re happy to give you some extra cash. Why?

If the stock market collapses and your entire retirement plan shrinks by 40%, it’s your problem.

Big headache for you. No headache for your employer.

Risk is Transferred
Thanks to the 401k plan, employers can pass to you the hot potato of retirement planning risk. But risk isn’t always a bad thing. Risk may be risky, but if you’re not retiring in the next 5 years, you can really clean up on stock investments. I can (almost) guarantee that.