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