What is the principal difference between a traditional pension plan and a contemporary IRA, 401(k), or 403(b) retirement account? For a senior citizen in the United States, the difference is a matter of the placement of risk.
In both situations, someone contributes a target amount of funds each year into his investment account. He then hopes to manage those investments in a manner that will produce sufficient returns to pay himself (or his retirees) a target amount of benefits in the future.
But what if the actual returns are insufficient to pay the target benefits? In that case, for traditional pension plans, the contributor is on the hook to make up the difference. That’s why we say that such plans are required to pay their “defined benefits.”
However, for contemporary retirement accounts, the retiree must either make up the difference or settle for less than his target amount of benefits. That’s why we say that such accounts are only expected to invest their “defined contributions.”
This distinction can help us understand what U.S. Speaker of the House Paul Ryan has in mind when he promises to convert the Medicare program into a “premium support” model. At the moment, Medicare is primarily a defined benefit plan, with the government required to spend whatever is required (beyond a relatively small retiree contribution) to pay for a target level of medical benefits.
If Speaker Ryan has his way, though, Medicare will become a defined contribution plan. The government will contribute a target amount of funds to care for each senior citizen, but if the cost of medical benefits exceeds a senior’s contribution, the citizen will need to make up the difference or go without care.
Ryan calls this approach a “premium support” model because each senior citizen is responsible for financing the cost of his own medical care. Although Ryan’s proposed government program will offer a target amount of financial support to make the premium (i.e. the cost) more affordable, there will be no guarantee that this support will cover the full costs of care.
Thus, both traditional pension plans and the current Medicare program assign the risk of investment shortfalls to plan sponsors or the federal government. Under most circumstances, as long as these entities remain solvent, a retiree will bear no risk of possessing insufficient funds to meet his needs.
However, both contemporary retirement accounts and Ryan’s proposed new Medicare program assign the risk of investment shortfalls to senior citizens. Whether or not employers and the federal government remain solvent, a retiree will bear the full risk of possessing insufficient funds.
Is that fair to the retirees? For many of us, the question is a moot one in the investment industry. After all, many have already gravitated into contemporary retirement plans.
But for almost all American retirees, the question is a critical one in the health care industry. Speaker Ryan has not yet attempted to implement his plans, and a concerted effort to lobby (for or against) his proposal may result in the preservation or extinction of the existing Medicare program.