Take this 401(k) and shove it

Money Magazine senior writer Janice Revell

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NEW YORK (Money) -- Last week's West Virginia election should frighten you.

No, I'm not talking about Hillary Rodham Clinton's steamrolling of Barack Obama in that state's Democratic presidential primary contest.

I'm referring to a far more obscure contest, one that virtually no one outside that state noticed - but one that illustrates perfectly why so many Americans are headed for a retirement crisis.

Here's the lowdown: The election in question involves nearly 20,000 West Virginia school teachers who are currently attempting to gain coverage under the state-run traditional pension plan.

These so-called "defined-benefit" pension plans give workers a guaranteed annual payment upon retirement - $2,500 a month, say, for an employee with 30 years of service and an average salary of $50,000. The employer puts up all or most of the money and workers gain real retirement security.

But for employers, these plans are an expensive proposition. That's because by law, retirees must receive their predetermined pension benefit each and every month, even if the pension plan's investments perform poorly.

For that reason, corporate America has taken an ax to these pensions in recent years: The proportion of private sector workers who participate in a traditional pension plan has dwindled almost 40% at the beginning of 1980 to only about 17% now. Scores of big companies, including IBM (IBM, Fortune 500), Sears (SHLD, Fortune 500), and Verizon (VZ, Fortune 500), have closed off the plans to workers.

The story is very different in the public sector, though, where traditional pension plans have continued to flourish. About 90% of all state and local government workers are currently covered by a defined-benefit plan. The main reason is that a much larger proportion of teachers and other public sector workers are unionized, and elected officials are often loath to take on those powerful unions, whose members can both vote and strike. Moreover, funding for public-sector pensions is backed by the full faith and credit of the taxpayer.

And that brings us back to West Virginia. For many years, West Virginia did, in fact, have a defined-benefit plan for its teachers. But by the early 1990's, the plan had run into massive financial difficulties. A combination of underfunding by the state legislature and poor investment returns made the West Virginia teachers' pension plan the worst-funded of its kind in the nation. It had just 14% of the money needed to meet its projected pension obligations to teachers; large injections from the state budget were required so the plan could continue to pay out those guaranteed pensions.

So in 1991, West Virginia took a page out of corporate America's playbook. In order to stem the financial bleeding, the state closed the defined-benefit plan to new teachers and created a 401(k)-style plan for them. These types of plans are cheaper - an employer's financial commitment to a 401(k) plan is pretty much limited to offering a matching contribution to the employee's account (and even that's optional.) And in this case, it limited the future outlays required by West Virginia taxpayers.

Fast forward to today. It turns out that for a very large segment of West Virginia teachers, the 401(k)-type plan hasn't panned out too well. According to a study done by West Virginia's Consolidated Public Retirement Board, the average account balance is just $33,944 and only a handful of teachers age 60 or older have amassed more than $100,000 in their accounts - a fraction of what the pension plan would've paid.

What happened? Despite receiving an annual matching contribution equal to 7.5% of their pay, many teachers are claiming that they were improperly steered into low-yielding annuities, even though the plan offered more appropriate investment choices. Others say they received no guidance or education on such important topics as asset allocation and rebalancing.

So the West Virginia teachers now want a do-over. Essentially, they want to treat the past 17 years under the 401(k)-style system as though it never happened. They are asking to be put back - retroactively - into the traditional defined-benefit pension plan. Like a bad dream, their paltry 401(k) balances will disappear, to be replaced by the more generous pensions they would have racked up had they been in the traditional plan all along.

Of course, millions of private-sector workers would also like a second chance. According to an analysis of 20 million 401(k) participants conducted by the Employee Benefit Research Institute and the Investment Company Institute, the median account balance of a worker in his or her 60's, making between $40,000 and $60,000 a year (in the same ballpark as a retiring West Virginia teacher) was $97,588 at the end of 2006. To put that amount in perspective, it would generate only about $8,000 a year in retirement income if it were invested in an immediate annuity.

But back to West Virginia. Incredibly, the state legislature has already agreed to go along with this retroactive pension switchover - as long as 65 percent of teachers formally elect to make the voluntary changeover. Teachers who are happy with the performance of their 401(k)-style plans don't have to make the switchover. (The deadline for voting was last Monday, the same day as the Democratic primary.)

The teachers who choose to go back into the traditional pension plan will have to take a modest reduction in the benefits they would have otherwise earned over the past 17 years. But even factoring that reduction in, the switch will represent a quantum improvement in the retirement lifestyles of many teachers.

That's good news for them, to be sure. But it's nonetheless a stunning development. That's because the West Virginia teachers' pension plan today remains one of the worst-funded pension plans in America. The value of the assets on hand is only enough to cover 51% of the projected pension benefits payable to plan participants - a $3.6 billion shortfall still exists.

The state legislature has already been diverting hundreds of millions of taxpayer dollars into shoring up the pension plan. If future investment returns fall short, West Virginia taxpayers will be on the hook for even more. And that's before those who were put into the 401(k)-style plan move back into the system.

The teachers, for their part, contend the move won't cost the state any additional money. Maybe, maybe not. It all depends on the pension plan's future investment earnings and the life expectancies of the teachers, neither of which are knowable at this point. What is certain, however, is that the taxpayers of West Virginia will once again be called upon to pick up the slack if the plan's assets fall short.

So if you don't live in West Virginia, why should you care?

The case is a cautionary tale offered up by the investing experience of the West Virginia teachers over the past 17 years. This was a predominantly college-educated workforce, and yet for the majority, their returns fell well short of what was needed to secure a decent income in retirement.

You can look at what's happened in West Virginia as a scary microcosm of a 401(k) system that has now become the only retirement plan for millions of American (mostly private-sector) workers. And for most, it's not coming close to generating enough money to fund a decent retirement lifestyle.

Public sector employees like the West Virginia teachers are quickly becoming the only Americans left with decent pensions. But the problem is that private-sector taxpayers have to foot the bill, while at the same time, their own retirements are going to pot.

I am reminded of a comment that Dallas Salisbury, the president of the Employee Benefit Research Institute, made to me a few years back: "The public employee, no matter who you compare him to, has become the dominant sector of the labor force that is well pensioned and well benefited," he said. "And the real question is, At what point, vis-a-vis tax burden, does the nonpensioned public start to pay attention to that as voters?"

There's no better time than right now.

Questions or comments about retirement? Send e-mails to jrevell@moneymail.com.