Tag Archives: Defined Benefit

Pension Tension

America has a pension problem.  Lately, lawmakers all over the country, in places like Rhode Island, Detroit, and Chicago are hammering out decreases in pension benefits for retirees despite opposition from unions and pensioners alike.  For a variety of reasons, like increasing life expectancy among retirees, eroding tax bases, and the most recent recession, these pension systems have become severely underfunded.  In this post, I will detail some of the problems with pensions, both in general and in these specific cases, then I will discuss the strategies that some states and businesses are using to cover these liabilities.

One of the major problems with public pensions is that they simply pay too much.  According to a recent WSJ article, state pay their retirees retirement incomes that are too generous.  Before recently filing for bankruptcy, Detroit piled up an astounded $18 billion in debt.   At least half of that $18 billion is owed to retirees in the form of a defined benefit pension or retiree health care costs.  Although early indications point to Detroit’s pensioners recovering more of their obligations than other creditors, pensioners will still have their benefits cut by as much as 34% and receive few, if any, cost-of-living adjustments.  One major factor that caused that underfunding of Detroit’s pensions was a sharp decrease in the cities tax base.  The threat that of decrease in revenues highlights too drawbacks to a defined-benefit plan: large uncertainty in the future, and the ease of underfunding.

Since someone starts accruing a pension with a company early in their career, there is naturally a long time between when their work begins and when they start to receive money from their pension.  Since these liabilities are so far into the future, the economic factors that govern how well the pension is funded are nearly impossible to predict.  Chances are in the 70’s when many of the current Detroit retirees started their work for the city, nobody expected the city to head for a dramatic economic decline and a sharply decreasing tax base.  Thus, the pensions offered at that time probably assumed that Detroit’s economy would be at least as strong as it was then, and that the city would grow and therefore generate more tax revenue than it did.  However, since both of these things fell far short of expectations, Detroit ended up with an underfunded pension system.  Furthermore, as Detroit’s revenue fell, other more essential city services have to be paid for before they can fund pension liabilities.  Since Detroit’s revenue has decreased so much, pensions naturally got pushed to the back of the line and thus were underfunded.

There are many different ways that governments and firms have used to solved their pension problems.  The first option is legislation; in Chicago, lawmakers are increasing the amount that current employees must pay into the pension system, and are reducing the cost-of-living increases.  Rhode Island performed something similar by changing their benefits and reducing cost-of-living expenses.  Verizon was able to shift the liability of covering their pension payments to Prudential Financial, stating that, “our business is not monitoring rates and managing pension funds.”  This seems like a smart idea, but chances are their pension systems are not nearly as toxic as the one’s faced by municipalities across the country.  Boeing shifted their pension dollars into 401(k) plans for their employees, making the transition from defined-benfit to defined-contribution.

Defined-benefit plans are inherently more risky that their counterparts.  Promising money that you don’t yet have (and in the many cases don’t end up having) is a dangerous financial practice.  Fortunately, many employers are shifting away from tradition pensions and into 401(k)s and IRAs.  From 1979 to 2011, the number of private sector workers on defined-benefit plans dropped form 39% to 14%, and the amount in defined contribution plans double to 42%.  I believe that this is a step in the right direction for fiscal security.  With life expectancy continuing to rise, firms would be wise to shift away from dangerous pensions and into IRAs, as many have done.  Hopefully we will never see a crisis like this in the future when we personally retire.

Revised: Should Social Security Switch to a Defined Contribution Plan?

Just recently, I had the opportunity to have dinner with my dad.  Given our mutual interests, our conversation naturally drifted towards finance.  My dad playfully joked how excited he is to start receiving pension checks in just a few years.  Even though these checks will be small, I responded jealously; when I start working this fall, there will be no pension program waiting.

This shift away from pension programs is not unique to my father and me.  Over the last 40 years, many employers have switched away from pension retirement plans (more generally called defined benefit (DB) plans), for defined contribution (DC) plans (like 401K’s).  Under DB plans, employers pay a predetermined amount of cash to former employees after those employees reach retirement age.  Under DC plans, employers set aside a certain amount of money each year to assist employees in developing a retirement savings account.  As the graph below shows, the shift away from DB plans to DC plans has been staggering.  Since 1979, for employees lucky enough to have corporate-sponsored retirement plans, enrollment in DB plans has dropped 57% while enrollment in DC plans has grown 55%.

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This transition to DC plans is largely due to an increase in life expectancy rendering DB plans unsustainable (ie: as people live longer they collect benefits longer, increasing the onus placed on firms and requiring progressively more cash to fund DB plans).  This year, the Society of Actuaries released new life expectancies for the first time since 2000.  In the last 14 years, men’s life expectancy has grown from 82.6 years to 86.6 and women’s has grown from 85.2 years to 88.8.  Driven by increases in technology and better health care, this upward trend is only expected to increase.  Prior to this revision of life expectancy, outstanding private sector liabilities related to DB plans hovered around $2 trillion.  After this revision, these liabilities are expected to grow at least another 7%, bringing outstanding liabilities to $2.14 trillion, which represents over 13% of US GDP!

As anyone familiar with a balance sheet knows, liabilities must be paid, and doing so is no easy task.  Considering that life expectancy is expected to grow further, it’s not surprising that firms are switching to DC plans from DB, as doing so helps reduce total liabilities.  Specifically, the switch to DC from DB helps reduce liabilities by shifting investment risk away from firms and to retirees.  Under a DB plan, firms are responsible for paying a set amount of retirement income in the future.  To generate this future outflow, firms invest cash now, hoping it will grow enough to fund the promised pension payments.  Unfortunately, very few firms invest enough to meet the entire defined benefit payment, as most firms assume unrealistically high returns when making investments.  Doing so causes many firms to drastically underfund their DB plans, generating enormous liabilities (with potentially crippling consequences) in the process.  In contrast, a DC plan is much more sustainable because it does not promise any future cash payments, and therefore does not create any liabilities.  Rather, a DC plan only requires firms to presently invest cash on behalf of its employees, with the future retiree bearing the investment risk.

Does this mean that the switch from DB to DC is a bad thing for retirees?  After research, I believe it’s a wash.  That said, I did find some strong evidence suggesting that, under the right circumstances, DC plans can offer higher returns than DB.  A study by Dartmouth College found that the typical DC 401K-retirement plan, “provides an expected annuitized retirement income that is higher across nearly every point in the probability distribution than the typical defined benefit plan.”

If you check my sources, however, you’ll see that this study was performed before the Great Recession, when the market collapse took a huge toll on many nest eggs.  But even with such a dramatic downturn, DB and DC plans still perform similarly; over the last ten years, DB benefits have only outperformed DC plans by 0.86%.  Furthermore, most of this underperformance is due to a failure of individuals to make maximum contributions to their plan.

Based on this data, I should be indifferent between DB and DC plans because I know my retirement income will be similar under both options.  However, I am largely in favor of DC plans because they eliminate the liabilities associated with DB payments.  So how is this conclusion relevant to social security?  Personally, I believe a gradual shift from government-sponsored DB payments (ie: social security payments) to government-mandated DC contributions could help solve social security’s sustainability issue.

According to the Heritage Foundation, the expected insolvency date of social security is approaching faster and faster; in the last five years, this date has declined 8 years and is currently set at 2033.  However, given current conditions, the Heritage Foundation predicts that insolvency could come as early as 2024 (when originally started, social security was designed to remain solvent until 2058).  Given that social security represents 22% of the US federal budget, insolvency is no trivial issue, and reform is needed sooner rather than later.

I propose that this reform should include a switch from a DB plan to a DC plan.  While social security payments should remain intact for current and soon-to-be beneficiaries, I believe that social security tax should gradually be replaced with a social security “withholding.”  For example, if social security tax is currently 10% of income, I propose it should be reduced to 5% of income in, let’s say, ten years.  In those ten years, the social security withholding should grow to 5% of income.  Eventually, social security tax should fall to 0% of income and be replaced entirely by the withholding (Personally, because I think savings is so important, I think that this withholding should ultimately represent a higher percentage of income than social security tax ever has or will).

Like a 401K contribution, I propose that this withholding should be invested, tax-free, in a retirement account on an individual basis.  Essentially, this withholding is equivalent to automatic-enrollment in a government-mandated 401K plan.  As individuals continue to work, instead of paying taxes to fund social security, they will pay withholdings to help fund their own retirement.

With respect to investment decisions, the government should have a default option requiring individuals to purchase relatively safe, well-diversified indexes (like a global fund).  If individuals would like, they should be allowed to invest up to half of their withholdings on indexes of their choice (I limit investment to indexes because, as Malkiel makes obvious in A Random Walk Down Wall Street, indexes are the safest way to make money.  On average, even professional money mangers cannot outperform indexes that track the aggregate market).  Once individuals reach retirement age (ie: the age they would have qualified for social security) they can begin making withdrawals from this retirement account.

My proposed plan has some similarities to George W. Bush’s proposal of private savings accounts in early 2000.  Under the most successful of Bush’s privatization proposals, taxpayers could divert 4% of taxable wages or a maximum of $1000 from FICA payments to fund personally managed retirement accounts.  These contributions would not replace, but rather would offset, social security’s existing DB payments.  Workers would then have the option to invest their private accounts in 5 different funds.

The key difference between my proposal and Bush’s proposal is the long-term implications for social security.  Bush’s proposal aimed to prolong, not eliminate, the insolvency date of social security by offsetting social security’s DB payments with some DC payments.  In contrast, my plan proposes a gradual but complete transition of social security from a DB plan to a DC plan, thereby rendering insolvency irrelevant.

While my plan is not perfect, I believe it effectively addresses the sustainability of social security by gradually eliminating government-paid DB benefits.  Furthermore, it forces individuals to save for retirement by replacing a significant portion of their taxable income with government-mandated savings.  I believe this system, by eliminating the liabilities related to DB retirement plans, is much more sustainable than social security, and it has the double-benefit of encouraging savings and investment literacy.  As always, I welcome any and all suggestions as we collectively try to address the issue of social security sustainability.

Should Social Security Switch to a Defined Contribution Plan?

After discussing defined benefit (DB) and defined contribution (DC) retirement plans in class yesterday, I was  intrigued to explore the issue further.  Professor Kimball mentioned that DC plans are starting to replace DB plans, but what is motivating this switch?  And are there any implications for social security?  After a little research, I’ve concluded that, given the growth in life expectancies, DB plans are unsustainable.  As such, firms are necessarily switching to DC plans to avoid insolvency.

This year, the Society of Actuaries released new life expectancies for the first time since 2000.  Since 2000, men’s life expectancy has grown from 82.6 years to 86.6 and women’s has grown from 85.2 years to 88.8.  Driven by increases in technology and better health care, this upward trend is only expected to increase (Professor Kimball joked that we may be one of the last generations to die).  Prior to this revision of life expectancy, outstanding private sector liabilities related to DB plans hovered around $2 trillion.  After this revision, these outstanding liabilities are expected to grow at least another 7%, bringing outstanding liabilities to $2.14 trillion, which represents over 13% of US GDP!

As anyone familiar with a balance sheet knows, liabilities must be paid, and paying down the above mentioned DB liabilities is no easy task.  Considering that life expectancy, and in turn outstanding DB liabilities, is expected to grow further, it’s not surprising that firms are switching to DC plans from DB.  Indeed, while some 60 million Americans are still covered by DB plans, since 1979, DB enrollment has fallen from 38% of Americans to 14%.  In the past decade alone, enrollment in DC plans has more than doubled to include over 40% of Americans.  Given the magnitude of outstanding DB-related liabilities, firms have had little choice but to initiate this switch.

But is the switch from DB to DC a bad thing?  After research, I believe it’s a wash.  That said, did find some strong evidence suggesting that, under the right circumstances, DC plans can offer higher returns than DB.  A study by Dartmouth College found that the typical DC 401K-retirement plan, “provide an expected annuitized retirement income that is higher across nearly every point in the probability distribution than the typical defined benefit plan.”  

That said, if you check my sources, you’ll see that this study was performed before the Great Recession, when the market collapse took a huge toll on many nest eggs.  But even with such a dramatic downturn, DB and DC plans still perform similarly; over the last 10 years, DB benefits have only outperformed DC plans by 0.86%, with most of this underperformance caused by a failure of individuals to make maximum contributions to their plan.

Based on this data, I should be indifferent between DB and DC plans because I know my retirement income will likely be similar under both options.  That said, I am in largely in favor of DC plans because they eliminate the liabilities associated with DB plans.  So how is this relevant to social security?  Personally, I believe a gradual shift from government-sponsored DB payments (ie: social security payments) to government-mandated DC contributions will solve social security’s sustainability issue.

According to the Heritage Foundation, the expected insolvency date of social security is approaching faster and faster; in the last five years, this date has declined 8 years and is currently set at 2033.  However, given current conditions, the Heritage Foundation predicts that insolvency could come as early as 2024 (when originally started, social security was designed to remain solvent until 2058).  Given that social security represents 22% of the US federal budget, insolvency is no trivial issue, and reform is needed sooner rather than later.

I propose that this reform should include a switch from a DB plan to a DCB plan.  While social security payments should remain intact for current and soon-to-be beneficiaries, I believe that social security tax should gradually be replaced with a social security “withholding.”  Like a 401K contribution, I propose that this withholding should be invested, tax-free, in a retirement account on an individual basis.  Essentially, this withholding is equivalent to automatic-enrollment in a government-mandated 401K plan.  As individuals continue to work,  instead of paying taxes to fund social security, they will pay witholdings to help fund their own retirement plan.

With respect to investment decisions, the government should have a default option requiring individuals to purchase relatively safe indexes (like the Russell 2000 or the S&P 500).  If individuals would like, they should be allowed to invest up to half of their withholdings on indexes of their choice (I limit investment to indexes because, as Malkiel makes obvious in A Random Walk Down Wall Street, indexes are the safest way to make money.  On average, even profession money mangers cannot outperform indexes tracking the market).  Once individuals reach retirement age (ie: the age they would have qualified for social security) they can begin making withdrawals from this retirement account.

I believe this plan effectively addresses the sustainability of social security.  It eliminates the need for the government to pay DB payments in the form of social security.  Furthermore, it forces individuals to save for retirement by replacing a significant portion of their taxed income with government-mandated savings.  While this is not a perfect system, I believe it is much more sustainable than social security, and it has the double-benefit of encouraging savings and investment literacy.  As always, I welcome any of your suggestions as we collectively try to address the issue of social security sustainability.