Dear Readers, I’m going to try a different format for this piece. If you think it is a really bad way to present matters, let me know.
Question: Why do pensions exist?
Answer: They exist as a means of incenting employees to work for a given entity. It can be a very valuable benefit to employees, because it is difficult to earn money in old age.
Q: How did we end up with retirement savings being predominantly associated with employment?
A: That’s mostly an accident of history. First some innovative firms offered defined benefit [DB] plans [paying a fixed sum at retirement for life, often with benefits to surviving spouses, and pre-retirement death benefits] in order to attract employees. After World War II, many unions insisted and won such benefits, and many non-union firms imitated them.
Q: Why didn’t many defined benefit plans persist to the present day?
A: In general, they were too expensive.
Q: If they were too expensive, why did they get created?
A: They weren’t expensive at first. The post-WWII era was one of booming demand and excellent demographics — there was only a small cohort of oldsters to support, and a rapidly growing population of workers. Also, the funding mechanisms allowed by the government allowed for low levels of initial funding to get them started, and they assumed that corporations would easily catch up at some later date. Sadly, some of the funding was so low that there were some defaults in the 1960s, leaving pensioners bereft.
Q: Ouch. What happened as a result?
A: Eventually, Congress passed the Employee Retirement Income Security Act in 1974. That standardized pension funding methods and tightened them a little, but not enough for my taste. It also created the Pension Benefit Guarantee Corporation to insure defined benefit plans. It did many things to standardize and protect defined benefit pensions. Protection comes at a cost, though, and costs went higher for DB plans.
Some firms began terminating their plans. In the mid-1980s, some firms found that they could get a moderate profit out of terminating their plans. That didn’t sit well with Congress, which passed legislation to inhibit the practice. That indirectly inhibited starting plans — few people want to in the “in” door, when there is not “out” door.
Some firms began funding their plans very well, and the IRS didn’t like the loss of tax revenue, so regulations were created to stop overfunding of pension plans. These regulations put sponsors in a box. Given the extremely strong asset returns of the ’80s and ’90s, it would have made sense to salt a lot of assets away, but that was not to be. Thanks, IRS.
Q: Were there any other factors aside from tax policy affecting DB plans?
A: Four factors that I can think of:
- Falling interest rates raised the value of pension liabilities.
- Demographics stopped being so favorable as people married less and had fewer kids.
- Actuaries got pressured to be too aggressive on plan valuation assumptions, leading to lower contributions by corporations and municipalities to their plans.
- By accident, the 401(k) was introduced, leading to an alternative pension plan design that was a lot cheaper. Defined contribution plans were a lot cheaper, and easier for participants to understand. The benefits were valued more than the technically superior DB plan benefits because you could see the balance grow over time — especially in the ’80s and ’90s!
Q: Why do you say that DB plan benefits were technically superior?
A: Seven reasons:
- They were generally paid for entirely by the employer.
- A lot more money was contributed by the employer.
- It gave them a benefit that they could not outlive.
- Average people aren’t good at investing.
- Fees for investing were a lot lower for DB plans than for Defined Contribution [DC] plans. (Employer provides a sum of money to each employee’s account.)
- The institutional investors were better for DB plans than DC plans, because plan sponsors would go direct to money managers with talent, while plan participants demanded name-brand mutual funds that were famous. (Famous means a lot of assets recently added, which means poor future performance. Should you give your kids what they want, or what you know they need?)
- If the companies could continue to afford the benefits, the benefits would be much larger in present value terms than the lump sum accumulated in their DC plans.
The last point is important, because the benefits promised were too large for the companies to fund. Eventually, they will be too large for most states and municipalities to fund as well, but that’s another thing…
Q: So people preferred something that was easier to understand, rather than something superior, and companies used that to shed a more expensive pension system. That’s how we got where we are today?
A: Yes, and add in the relative impermanence of most corporations and some industries. You need a strong profit stream in order to fund DB plans.
Q: What are we supposed to do about this then?
A: Stay tuned for part two, which I will write next week. Believe me, there are a lot of controversial ideas about this, and there are no easy solutions — after all, we got into this problem because most corporations and people did not want to save enough money for the retirement of employees and themselves, respectively.
Q: Till next time, then!