Defined-Benefit Pensions Should be Outlawed
No institution, including city and state governments, should be permitted to grant a new defined-benefit pension. A defined benefit plan is a plan in which the benefit on retirement is determined by a set formula, rather than depending on investment returns. We do not have Nostradamus’s ability to prognosticate and we can’t know if today’s iconic companies will be mere shells when those pensions come due 30 years hence. Do we need to be reminded of those great icons of the Airline industry like TWA, Pan Am and Eastern to understand how empty those pension promises can become?
Yesterday it was the Airline industry today it is the Automotive industry. GM’s pension system had a $20 billion shortfall as of Nov. 30, 2008, based on numbers the company provided the Pension Benefit Guaranty Corporation (PBGC). By law, the agency would be able to make up only $4 billion in case of bankruptcy. Current and future retirees of Chrysler LLC, the other U.S. automaker facing bankruptcy, would forgo $7.1 billion. Chrysler’s plan is underfunded by $9.3 billion, and the agency would cover only $2.2 billion.
If we have learned anything it should be that today’s icons could well be tomorrow’s dogs. Even a pension promise from today’s great American companies like Apple, Google or Microsoft could be worthless in 25 or 30 years. The typical pension plan in the U.S. is only 60 to 70% funded.
What is the solution? All new pension plans should be defined-contribution. A defined-contribution retirement plan is one in which a certain amount or percentage of money is set aside each year by a company for the benefit of the employee. The following rules should be promulgated for all pension plans:
1. Companies must pay their pension obligations in full by the end of each quarter.
2. The funds must become the exclusive property of the individual employee, subject only to the existing restrictions, as to when and how one can withdraw these funds without penalties.
3. All pension plans should be portable, permitting the employee to take their individual pension fund to the next place of employment.
4. The employee should also have the right to choose the institution that will manage their money.
5. All institutions must be registered with the appropriate regulatory authorities.
City and states that promise defined pensions to its employees are in a similar state of disarray. Their ability to project future revenues is at best flawed. The tax systems in place to generate those essential revenues are poorly conceived and worse, subject to wide undulations.
For example, after reading that one percent of the households in New York City, roughly 40,000 people, pay 50% of the income taxes in this city of more than 8 million inhabitants, it made be begin to wonder where we were headed as a nation. This astonishing figure brings home the practical consequences of relying on taxes from a small group of high-earners to fund city, state and national budgets. In the case of New York City, the Mayor can only hope that this small group does not become disenchanted and weary of their burden and move to Connecticut or West Palm Beach. If even only a small percentage does, the financial impact on New York would be devastating.
If New York were to loose its “Wall Street” tax base - could it go bankrupt - and be forced to renege on its pension obligations to all those retired policemen, fireman, teachers, etc.? California is in an even more precarious situation, with tax revenue shortfalls that may cause it to curtail State services. Despite its 9.3% income tax on income above $47,056 and 1% surcharge, 10.3%, on income over $1.0 million, California with over 10% unemployment is about to make a financial slide into the Pacific Ocean.
It is time for real change and real reform in the American pension model! No more crystal balls, no more unfunded promises only cash on the barrelhead and prudent investment for America’s future.
It seems to me that defined-contribution plans are a failure. Americans have been conned into thinking they are great for us, but those lies were based on 8% expected yearly gains. However, there are many 20 or 40 year periods in history where gains are much much smaller.
Plus when we get laid off or have a major health situation we have no choice but raid our retirement funds. We are going to need to work forever. Defined-contribution’s are a failure.
April 10th, 2009 at 9:55 am
quoting …”If New York were to loose its “Wall Street” tax base - could it go bankrupt - and be forced to renege on its pension obligations to all those retired policemen, fireman, teachers, etc.? ”
Considering how EXCESSIVELY RICH and how burdensome they are to TAXPAYERS who DO NOT get anywhere near this level of benefits, I would consider our reneging A GOOD THING !
April 10th, 2009 at 6:52 pm
This author is no different from any person that was involved in the Savings and Loan issues of the late 80’s, the mortgage lenders of the present and the banks of the present. They all want to take risks and if it doesn’t work, push costs onto someone else. Yes, instead of paying for future retirmement accumulations now (DB plans), let’s let everyone fend for themselves (DC plans). This way, those that make bad investment choices can have the government (a.k.a. taxpayers) bail them out later…sound familiar?
April 11th, 2009 at 8:48 am
Chad,
No bailout of any institution is needed under my plan. Individuals not institutions control their pension funds. If they want to keep it in Treasury bonds - it’s their choice. If they want some corporate bonds or other securities - it is the individual who make the choice.
April 11th, 2009 at 9:27 am
And what if the indiviudal chooses poorly?
April 11th, 2009 at 11:00 am
@ Chad
Since all funds must be registered the options are limited by regulation to rationale diversified investment strategies - no trips to Vegas permitted.
April 11th, 2009 at 11:44 am
Bill,
Ok, so you’re essentially talking about investing for beta. And I’m assuming you’re also advocating life-cycle funds. These are great ideas, but how do we hedge away the longevity risk? What if folks simply don’t or can’t put enough away? How do we “pool” those risks? I think there are simply too many unknown variables to make this a viable option.. How about a base defined benefit, say, 30% of salary that’s funded and administered by the federal government through employment tax? Then the rest of the so-called three legged stool can be from the employer and the employee (DC). I don’t think that defined benefits, per se, are the culprit, I think the mismanagement of the liabilities (asset/liability risk) and high benefit levels are the real problem. A blatant indictment on defined benefits is not the answer.
April 11th, 2009 at 12:55 pm
@Chad,
I agree, that risk could be shared by having individuals subscribe to a consortium of employees; the only loss would be in the value of the estate should an individual die early. But that is probably a small price to pay. The problem I have with the U.S. Government management idea is that it will be run like Social Security and all contributions will be treated like general revenue and not invested, save for non-negotiable government paper. I ran companies in Europe for 20 years. The other problem that arises with large government mandated pension plans is it dramatically reduces salaries. Our French employees for example, where paid substantially less than our equivalent American employees and it all wasn’t made up in additional benefits.
April 11th, 2009 at 1:53 pm
Bill,
Yes, I agree if the government ran this type of scheme, there could be no “pay-as-you-go” methodology. The only way that this would work is if the plan essentially remains fully funded at all times on a near risk-less or semi-immunized basis. It’s not such a bad idea if you think about it. Since the plan would have to be fully funded at all times, the government would have a ready and constant buyer for its debt. Ultimately, members would have full faith in the fact that they would receive at least 30% of their salary at retirement and the costs wouldn’t be passed on to future generations. Your comment on the pay disparity and its relationship to mandated government pensions is interesting. What sort of factors contribute to that phenomena?
April 12th, 2009 at 10:06 am
Chad,
The disparity in pay appears to be the result of several factors:
1. Some European governments make a concerted effort to insure that private compensation does not differ materially from civil service pay. The rationale is that all citizens enjoy “cradle to grave” security therefore; there is not a need to pay a premium to private employees. Employers can then use it as an excuse.
2. Tax paying workers in France for example, have become a minority thus; the benefits paid on top of their salary must pay for the majority that is not employed. The theory is that the more salary a firm pays the less the government can burden businesses with benefits taxes.
3. To enforce this “European Exception” incremental tax rates at salaries above as little as 60,000 Euros can be taxed at 50, 60 or even 70%. Often a trip to a meeting in an exotic location or more days off is a greater incentive than a raise because employees, as you can well imagine, are resentful of the share the government takes.
April 12th, 2009 at 12:07 pm
There is a fundamental unfairness to the current system. Government pensions are protected by the ability to tax taxpayers. Private pensions are guaranteed by the PBGC, a federal agency which has the informal guarantee of US taxpayers.
The bulk of the taxpayers, with defined contribution plans and IRAs, have no guaranty.
The present system must be changed. Maybe we just print money to give pensions to all. Or, we cut back the future accruals in defined benefit plans until they are full funded. This is high politics, and the decision makers are the ones with the guaranteed pensions. Hmmm, is there anyone who expects a fair result?
April 13th, 2009 at 11:22 am
I thought the title of your post was as provocative as the content is uninformed. The issues you raise regarding defined benefit plans are missing the point. The issue is not the type of plan but rather the level of benefits promised.
Reasonable people can come to different conclusions regarding acceptable levels of retirement benefits. However, one thing is certain, defined benefit plans are almost always a more efficient vehicle for accumulating assets for retirement than defined contribution plans.
An August 2008 study by the National Institute on Retirement Security found that the cost of providing retirement benefits is 46% less for a defined benefit pension compared to a 401(k). The reasons for the efficiency are threefold. First, as you might imagine, professional investors outperform amateurs, in almost every case. Secondly, the costs of the investment vehicles are substantially more expensive in a 401(k). Lastly, a defined benefit plan is designed to operate in perpetuity allowing it to invest with a long-term perspective where defined contribution participants are advised to invest conservatively as retirement approaches.
Richard N Carpenter, CPC, CEBS
PO Box 25974
Christiansted, St Croix, US Virgin Islands 00824
404-277-7678
340-514-4714
RNC@USVIpensions.com
http://www.linkedin.com/in/usvipensions
http://usvipensions.com/
April 13th, 2009 at 12:21 pm
@Richard,
Sounds good, but there is one overriding problem, Bankruptcy! Unless we change the regulations and all defined benefit plans are required to be fully fund at the end of each quarter - they are not worth the paper there written on. Every economic downturn will create a new wave of bankruptcy and loss to those who were counting on their hard earned pensions.
You may find it difficult to sell the wonders of defined benefit plans to the former employees of TWA, Pam AM, Eastern etc. and the GM retirees who are abut to loose $16 billion because the PGGC can only legally assume 20% of the $20 billion unfunded pension obligation.
Cash on the barrelhead is the only real protection for American workers.
April 13th, 2009 at 8:01 pm
Bill,
You are obviously a very bright guy, but your proposal as stated is simply wrong if the objective is to provide for retirement. The bankruptcy issue is a bit of a red herring; GM is an anomaly because of the large numbers of huge benefits that were promised. That being said, there does need to be bankruptcy reform; I think pension benefits should get priority in reorganization (you may want to read the book “Pension Dumping”).
Retirement planning has three primary components; the size of the benefits, the timing/amount of the contributions and the investment of the assets.
By definition, one half of the population has an IQ of less than 100. These people will NEVER be able to successfully compete in the investment arena regardless of how many glossy educational materials are provided. The vast majority of participants in 401(k) plans dramatically underperform compared to any objective measure; this is not opinion, it is documented fact.
I’ll postulate that many if not most participants do not want drills; they want holes. They don’t want to be investors; they want to have a secure retirement. Forcing these people to become investors’ borders on pernicious.
I also need to re-emphasize the impact of increasingly conservative investing as one approaches retirement age. This prudent strategy in a defined contribution plan is unnecessary in a defined benefit plan.
Regarding the contributions it is an “everyone wants to go to heaven, nobody wants to die” scenario; we all want benefits but we have been unwilling to pay. I agree with you that consistent funding at significant levels are necessary for a secure retirement. Our point of departure is who should invest the money and should there be individual accounts or pooled funds. I submit that pooled accounts managed by professionals are a better alternative than expensive individual accounts managed by amateurs. I do concede that large pools of money have been and always will be a target of the corrupt.
The majority of problem retirement plans have a common thread; they involve unions. My problem is not with the unions but with the management that agreed to benefits that they could not afford or were unwilling to fund. As a side note, I was involved with some of the Eastern Airlines plans and I can recount events that would curl your hair.
Reforms in bankruptcy and pensions are needed. Currently there are tens of millions of our fellow citizens approaching traditional retirement age that are without the means to retire. The cold hard truth is that these people will have to stay in the workforce after they reach age 65. Trivializations aside, as a society we are in a precarious situation regarding retirement. Much of this is of our own making; we spent the money instead of saving it. In essence, we have made a giant fecal sandwich and everyone is going to have to take a bite.
Richard
April 14th, 2009 at 5:45 am
The writer is poorly informed, and obviously does not really understand the mechanics of defined benefit and defined contribution systems, particularly as they apply to the public sector.
As Richard pointed out above, Defined benefit systems are actually cheaper per level of benefit provided than defined contribution systems. A public entity, unlike a private one, cannot shift the risk of the employee’s poor investment choices. If an IBM employee invests poorly, it’s not IBM’s problem. If a NYC police officer does, it’s still NYC’s problem since that officer will then seek out public benefits such as welfare, food stamps etc in retirment. When West Virginia shifted back to a DB system from an experiment with a DC system for its teachers, one reason given was that teachers were retiring then going on welfare. A defined benefit can be pre-funded and investment returns can lesson overall expenses. Welfare benefits can not be prefunded.
Additionally, defined contribution accounts are extremely expensive and have high administrative fees compared to defined benefit plans. A lot of the money contributed to DC accounts winds up in the hands of account managers, record keepers, etc.. It’s one reason why DB plans enjoy overall investment returns which are significanly higher than what can be obtained by DC account plan holders.
Furthermore, becuase of the size of the asset holdings, there is a wide array of complex, investment options DB plans can partake in which receive higher than average returns than is available for DC plans.
I can go on and on, but I don’t have the time. One thing, it is time for ideologues, such as the writer here, to stop commenting on the problems with DB plans until they learn what the real facts are.
As for bankruptcy, a public entity never goes out of business.
April 14th, 2009 at 6:10 am
@Richard,
I clearly agree that reform is long overdue and our pension system is among the worst is the industrialized world. The first reform that is needed: All pensions defined benefit or defined contribution including state and city must be funded in the quarter in which the obligation is incurred. There is certainly no guarantee that Microsoft or Apple or any other iconic American company will be here to meet its obligations 30 years from now. This deals with the ubiquitous problem of over promising and under funding.
As far as public pensions are concerned there is a demographic time bomb that cannot be ignored. Just like Social Security which started with 16 workers for each retiree and has degenerated to 2 workers per retiree; all unfunded pensions will ultimately face the same problem. Many municipal Pension plans have more in common with Ponzi schemes than with retirement programs. There will never be enough children and grandchildren to pay.
I am not suggesting that individuals mange their accounts, only that they have a choice of regulated and registered investment firms with a limited choice of professional investment options.
April 14th, 2009 at 7:53 am
To summarize, it appears that your problem is not with DB plans, per se, but with unfunded or underfunded plans. That is a totally different issue. The solution, as you have hinted, lies in fixing the funding requirements. A properly funded trust is not impacted by the bankruptcy of the employer.
April 14th, 2009 at 9:13 am
Obviously the person who wrote this article does not know much about pension plans. I work for a TPA firm, which is a third party administrator of qualified retirement plans. I work on defined benefit plans and defined contribution plans for a living. Basically all of the problems you highlight above are no longer existant concerns after PPA 2006 was passed. Ever hear of an AFTAP, segment rates, new funding capabilities like 150% funding, have you studied the new regulation put forth to restict actuarial assumptions. If you studied everything under PPA 2006 you would know all the concerns like use of high interest rate assumption for asset growth are no longer allowed. In fact the assumptions now have to be set under the traditional industry rule of thumb that properly managed assets will earn about 6% in the market. You would also know if you studied defined benefit plan in general that there are several types of defined benefit plan such as the 412e plan. The IRS requires the 412e plan funds are invested in garunteed contract that are comparable to a basic CD at a bank. Should we get rid of CD’s as well? They promise a certain amount of money at the end of a term, but your bank has to stay afloat for you to get paid. To all of you “tax payers” out there who claim you’ll have to bail out these plans…obviously your just as uneducated as this author. You don’t pay into the PBGC and that’s who has to take over these plans. Ever here of PBGC premiums, probably not cause you don’t pay them and companies do. If you don’t pay premiums you are not eligable for the PBGC to take over your plan if your company fails. Do you know the requirements to be eligable to have your plan covered by the PBGC, probably not. Have you ever heard of a destress termination…probably not. Do you know what happens to the benefits of the owners, highly compensated individuals, when a plan fails…no you don’t. I suggest to all of you if you do not work on these plans for a living as I have for the last 8 years don’t offer your oinion as an uneducated individual.
April 16th, 2009 at 8:57 am
@ Sue,
Reality check - GM has over $20 billion and Chrysler has $9.3 billion underfunded liabilities to their pension plans - the PBGC can only legally pick up $4.0 billion of the GM and $2.2 billion of the Chrysler shortfall. In bankruptcy GM employees will lose $16 billion and Chrysler employees $7.1 billion. Ask all those airline employees how well they did in bankruptcy court!
Maybe your firm is better than most but the average defined benefit plan in the U.S. is only 60% funded.
At a minimum all plans should be 100% funded.
April 16th, 2009 at 11:45 am
A plan’s funding status is actuarially determined. It depends on the investments balance, projected earnings from the investments; projected contributions from employers and employes and projected benefits to be paid. A year ago my state’s PERS (public pension system) was fully funded but is now $15 billion in the hole as a result of 2008’s terrible results in the stock market. Your requirement that my state immediately provide $15 billion to its PERS is totally unrealistic. It has many years to adjust, hopefully the market will recover making increasing the employer/employee contribution rates unnecessary.
April 16th, 2009 at 4:13 pm
@ Gary
Your point is well taken, well managed and funded State plans will not be adversely effected in the long run by cyclical downturns and clearly do not need to be 100% funded in a downturn. But, how many States and municipalities are 100% funded in boom times? if a plan is not 100% funded in good times, municipal plans can actually become insolvent in bad times. For example, remember, it was not long ago that New York City nearly went bankrupt. Given the potential loss in revenue from its primary base “Wall Street” it could find itself in a similar position within the next year or two and not be able to meet its pension obligations.
Clearly, corporate underfunding is a more serious problem - bankruptcy judges have not been kind to retirees - they are just another class of creditors.
April 16th, 2009 at 4:42 pm
In the UK 90% of defined benefit pension schemes are in deficit. The total deficit is over £250bn and we have a tiny pension protection fund to cover that of just a few £bn. If some big schemes go bust then either the government will have to bail them out, which it can ill afford to do, or people will lose their pensions.
There certainly need to be tighter rules in place over what sort of investment strategy is appropriate for pension funds - we tend to invest in riskier assets to make up for the fact that we don’t invest enough. We need to focus on investment that matches the liabilities instead. But we also need to recognise that defined benefit pensions are like blank cheques. We have no idea how long people will be living in 10 years time. Actuarial predictions are just guesses. Even being out by a few years adds huge costs to your scheme and there is simply no way to calculate this in advance. So how much do you invest?
One thing is certain, we need to contribute much more and work for longer. In 2012 the UK is introducing a new system where every employee is automatically enrolled in a new type of pension called a Personal Account. The employer must contribute a minimum amount into this pension for them although this is currently only 3%. In Australia they already put in much more.
We all need to take personal responsibility and invest as much as we can but in the knowledge that there will be a safety net for those who cannot afford to do this.
April 18th, 2009 at 4:20 am
Hi, gr8 post thanks for posting. Information is useful!
June 14th, 2009 at 6:02 pm
What Can we common Poeple do about the Bailout? Nothing.. we just have to wait and see if the company comes up and develops new cars and prototypes to please the americal consumer
June 15th, 2009 at 8:35 am
tks for the effort you put in here I appreciate it!
July 21st, 2009 at 2:33 am