Government Should Bring Some Truth to Pension Plans
Recently the New York Times ran a story on how some of what were supposed to be the safest pensions in the country were actually failing, potentially leaving retirees with little or none of their promised retirement income. This report extends a long line of evidence that defined benefit pensions are simply too risky for workers to rely upon. Government action to ban defined benefit pensions-those promising a set income upon retirement, usually a percentage of past earnings based on years worked-is a rather extreme intrusion of the government into what should be a free market for firms to offer a variety of compensation plans, but certainly the government needs to devise a far better and more stringent regulatory apparatus for such plans and, in the meantime, workers should demand their employers switch them to defined contribution plans.
The particular pension plans in the report are multiemployer plans, ones where many employers pool money together for workers with some unifying feature. Usually, these are union plans designed to provide uniform pensions to members of a union that work for lots of different employers. The thinking was that because lots of employers paid in, safety would be gained through diversification, similar to a stock portfolio. If one employer did not pay, the shortfall would be small (and often the other employers in such plans are required to make up that shortfall).
Unfortunately, such financial planning has proven as accurate as the models behind the infamous mortgage backed securities. Many of these multiemployer plans have failed and many more are in serious trouble. In general, government should allow free markets and if workers want to accept pensions, they should be allowed to do so. However, the government is essentially allowing employers to lie to workers and then break employment contracts later by not funding the promised pensions. Worse, the government collects insufficient premiums in order to guarantee the pensions, so taxpayers are potentially on the hook for the broken promises.
With defined benefit plans, whether single or multiemployer, employers are allowed to put in less than the actuarially full amount of contributions each year or to assume a future investment return that is high enough to make paltry current contributions look sufficient. Then when the investments have a bad year (or ten), life spans increase, or tough economic times mean companies cannot make up earlier shortfalls in either contributions or returns, all the employees suddenly find their secure retirement to be an illusion.
In contrast, with a defined contribution retirement plan employers are required to place a specified contribution in each worker's individual retirement account every pay period. All defined contribution plans are fully funded at all times and the accounts are protected by federal law, even through bankruptcy. Workers generally control how the money is invested by choosing among employer approved options designed to aid workers in making reasonable choices with their money.
While defined contribution plans do not come with a promise of a formula-based retirement income, workers can always convert their defined contribution plan balances into an annuity (yielding a fixed monthly payment) upon retirement, buying the income security they want without the chance of being left with nothing.
While workers, particularly union workers, continue to believe in large numbers that defined benefit plans are safer than defined contribution plans, more and more evidence accumulates that they are wrong. It is actually defined contribution plans that are safer because, while the promise of retirement income may be less specific, the odds of receiving an adequate retirement income are much higher. Defined contribution plans avoid the risk of plan failure which can leave retirees with little to none of their promised pensions.
A perfect example of the risks in defined benefit plans is Detroit. Current and future retirees have faced pension cuts as part of the city's bankruptcy. This week a deal was reached with at least some of the city employee unions for much smaller pension cuts than the city had proposed initially. If the fact that Detroit is going to cut pensions is not scary enough for workers counting on defined benefit plans, then they should be scared that one key part of the deal is that Detroit agreed to assume higher future returns in order to make it look like the city can afford smaller pension cuts. No extra money appeared, no investment rules changed. The city and its workers simply agreed to be more optimistic and act like that solved the problem.
If the government does not want to ban defined benefit plans, the least it could do is effectively regulate them so that employers cannot game the system with assumptions about high future investment returns or promises to catch up on funding the plans in later years. While the government is policing truth in advertising for our prescription drugs and on our food packaging, no federal agency does anything to ensure that pension promises made to workers are worth the paper on which they are written. For an administration that claims to be on the side of workers, they can do better.
