Category: pensions

One of my earliest research projects focused on the shift from defined benefit (DB) to defined contribution plans and its implications for retirement income. I started it in 1993, along with my colleague (then at the NBER, now at Dartmouth) Jonathan Skinner, and after a lot of updates and modifications in response to comments, it was eventually published in The American Economic Review in 2004.

The reason we wrote it, and the reason why I mention it today, is that many commentators on pensions, and the public policy toward pensions (the name of the conference at which we originally presented it), simply have no idea about the generosity of defined benefit pension plans as they existed before the shift to 401k plans began. What was noteworthy about our article is that it used data on defined benefit pension plans, collected through the Pension Provider Surveys of the Federal Reserve's Survey of Consumer Finances, (SCF) to simulate the distribution of future retirement benefits that would obtain under the vintage of defined benefit pension plans that existed as this trend emerged.

We had data on DB pension plans in 1983 and 1989, and we were able to compare the distribution of benefits under those plans to the analogous distributions of defined contribution or 401k plans as they emerged in 1989 through 2001, the latest year of data prior to our publication. So we had the true heterogeneity in the DB plan universe, and our simulation framework incorporated uncertainty in both future wages and asset market returns. Our universe of 401k plans, and the contribution and investment behavior of participants, was drawn from those SCF respondents who relied on the 401k as their sole pension plan, not those who had it as a supplemental plan.

The key point of the paper was that even for workers who remained with the same pension plan for an entire working career, the vintage of 401k plans that existed by 1995 was providing a comparable distribution of retirement income. Put simply, participants who relied on the 401k as their sole source of pension income were, along with their employers, contributing enough and holding enough in stocks (as opposed to bonds) to match what they would have received under the DB plans that were supplanted. In a nutshell, the DB plan formulas were not necessarily that generous in terms of their replacement rates, and their reliance in many cases on "final average pay" exposed participants to a lot of uncertainty.

The comparison is even worse when we consider workers who switch pension plans one or more times during their career. When the job changes happen before the worker reaches the DB plan's early retirement age, the worker is typically entitled only to "vested deferred" benefits, the value of which is eroded by inflation (if taken at the plan's normal retirement age) or full actuarial reductions. The balances in defined contribution plans like 401k plans are fully portable and do not suffer from this "backloading" of benefits under DB plans.

This study is what informs my view, which I expressed to Bloomberg View reporter Ramesh Ponnuru in his article that appeared today. I am quoted as saying:

Criticism of 401(k)s frequently idealizes the defined-benefit plans they have largely replaced. It’s true that 401(k) participants have more responsibility for their retirements than defined-benefit plans involved, and they are also exposed to market risk. Andrew Samwick, a professor of economics at Dartmouth College, pointed out in an interview that defined-benefit plans had their own risks. The company sponsoring those plans could skimp on pension contributions, or allocate its investments poorly, or go bankrupt and leave plan participants short.

And the shift to 401(k)s has coincided with a large increase in the number of people with retirement plans: Most workers didn’t have those defined-benefit pensions. “People have a very distorted notion of how good things were under defined-benefit plans or how good they would be today if that system of defined-benefit plans had continued,” Samwick said.

Our comparisons also did not consider the problem of DB plans that the security of the participants' retirement income depends on the solvency of, and funding decisions made by, the plan sponsor. It was not over 401k plans that Daniel Gross declared "the decade of cramdown."

Mary Williams Walsh brings us all up to date on the problem in today's New York Times:

Across the country, government workers’ pensions are protected by guarantees even stouter than those on pensions in the private sector. The legal promises, often backed up by union contracts, cover more than 15 million people.

Years of supporting court interpretations have enshrined the view that once a public employee has earned a pension, no one can take it away. Even during New York City’s fiscal crisis 30 years ago, no existing pension promises were reduced.

But now a number of state and local governments are quietly challenging those guarantees. Financially troubled San Diego is the highest-profile example, but a handful of states, cities and smaller government bodies have also found ways to scale back existing promises and even shrink some current payments.

While still only scattered cases, these examples may be an early warning sign of what could be coming elsewhere. As local officials take stock of unexpectedly large obligations to retired public workers, some are starting to question whether service cuts, sales of government property and politically acceptable tax increases can ever go far enough to bring things into balance.

And it's not just retirement income benefits:

Governments are also studying the guarantees on retiree health benefits because of a new accounting rule that is now requiring them to calculate, for the first time, the total value of the health benefits they have promised to retirees.

The numbers now being disclosed are daunting. Mercer Human Resource Consulting estimates that when all the calculations are done, the nation’s states and cities will find they have promised a total of about $1.4 trillion, said Derek Guyton, a senior consultant.

Little, if any, money has been set aside to fulfill these obligations.

We'll be hearing more about this issue in the coming years, as the bills come due in more places and other localities join San Diego in its financial woes. (For example, see Walsh's earlier article from August.)

If there were anything with which to take issue in the article, it would be the title, "Once Safe, Public Pensions Are Now Facing Cuts." Safety comes from direct ownership or a binding guarantee. Public sector employees are in a situation where they thought they had more of a guarantee than they do. If you were open to attack but weren't attacked, were you really "safe?"

As a matter of policy, when focused on replacing income in retirement beyond Social Security, I'd much prefer the transparency and ownership of a defined contribution or 401(k) plan to the vague promises of a defined benefit plan, acknowledging that running such a plan effectively requires thoughtfulness applied to plan design and participant education.

Continuing her fine reporting on pension issues, Mary Williams Walsh turns her attention to state and local government pensions in "Public Pension Plans Face Billions in Shortages" in today's New York Times. In a nutshell, the accounting standards are even more lax with public plans than with corporate plans, and there actually seem to be laws that bar oversight entities from blowing the whistle on bad practices. The size of the problem is staggering:

It is hard to know the extent of the problems, because there is no central regulator to gather data on public plans. Nor is the accounting for government pension plans uniform, so comparing one with another can be unreliable.

But by one estimate, state and local governments owe their current and future retirees roughly $375 billion more than they have committed to their pension funds.

And that may well understate the gap: Barclays Global Investments has calculated that if America’s state pension plans were required to use the same methods as corporations, the total value of the benefits they have promised would grow 22 percent, to $2.5 trillion. Only $1.7 trillion has been set aside to pay those benefits.

So this may be an $800 billion problem, compared to the $450 billion problem in the corporate sector. Lovely. And how did we get this way? Here's one method, favored by those in the Garden State:

Still, officials in Trenton have been shortchanging New Jersey’s pension fund for years, much as San Diego did. From 1998 to 2005, the state overrode its actuary’s instructions to put a total of $652 million into the fund for state employees. Instead, it provided a little less than $1 million. Funds for judges, teachers, police officers and other workers got less, too.

To make up the missing money, New Jersey officials tried an approach similar to one used in San Diego. They said they would capture the “excess” gains they expected the pension funds’ investments to make and use them as contributions.

Clever. Too bad Enron isn't around to hire these officials. Another culprit has been (absurdly) long funding schedules, which serve to reduce the required contribution in each year:

Illinois officials say the state’s 50-year schedule is actually an improvement; before adopting it in 1995, the state had no funding schedule at all. In Colorado’s most recent legislative session, lawmakers enacted pension changes that they hope will make the plan solvent in 45 years.

And the National Association of State Retirement Administrators says it is unrealistic to expect all public plans to be fully funded, because they do not have to pay all the benefits they owe at once.

I'm guessing there's no financial literacy requirement to be a spokesperson for NASRA.

Wishing won't make this problem go away. At some point, state and local taxes go up or benefits to public employees or retirees get cut. There is no ERISA coverage for these plans, so I presume that attempts to cut benefits will wind up in court.

When last we discussed pension reform, the prospects for any meaningful increase in pension funding requirements seemed bleak. But sometimes five months can make a difference, and the intrepid Mary Williams Walsh is back on the case:

Earlier this year, as Congress inched toward a broad overhaul of the nation’s troubled corporate pension system, experts said the bill was so fraught with escape clauses that it could become easier for companies to shortchange their pension funds than under the current, flawed law.

But under the version just approved by lawmakers, companies appear to get a break in putting money into their pension funds for only a couple of years before the rules start to tighten. Within a decade from now, according to a new analysis by the Congressional Budget Office, companies will be putting substantially more money behind their pension promises.

The CBO's cost estimates can be found here. The higher contributions take about five years to kick in. I don't see the rationale for waiting so long (and even making the contributions lower in the next couple of years), but I suppose I'll take what I can get. Ditto for the special extensions granted to the airlines (a lot to Northwest and Delta, somewhat less to American and Continental) and to GM and the UAW.

A big win in the legislation is that the variable rate premiums to the Pension Benefit Guaranty Corporation--the extra amounts proportional to plan underfunding--go up to the tune of roughly $5 billion over ten years.

Read more coverage of the legislation's provisions here.