Opinionated @ CFE

The Unsustainability of Pensions

Feb
27

There aren’t a lot of cases where I find myself in agreement with Ezra Klein on economic issues, but on pensions, I think he may have nailed it. For those unfamiliar, pensions are little more than a way to say “I’ll gladly pay you tomorrow for a hamburger today”. Employees often take a smaller paycheck now so that they can collect income after they retire or leave their position. Unfortunately, the arrangement allows for a lot of lying and number fudging along the way.

As Ezra Klein points out, the biggest lies are coming from managers and union bosses. Managers have an incentive to push their compensation costs long into the future (likely after their own retirement) to keep short-term costs down. On the flip side, union bosses can crow about a better pension plan without having to actually show a single dollar in gain for employees right now. All the while, these employees are living longer than ever pushing the amount of time to be making payments even further out. It’s a game of “kick the can” that forces someone else to deal with the inevitable problems of actually funding those obligations.

A small glimmer of hope is that most pension plans are funded and backed by actual money. Unfortunately, the quality of the backing can often be suspect. Pensions depend on the employer both adequately funding the pension fund and properly managing it to meet future financial obligations. In both public- and private-sector pensions, the temptation is to worry about funding it later to either keep operating capital or, in the case of the public sector, keep taxes artificially low. Given that pensions are often seen as a way to realize short-term cost controls, can we be too surprised when an employer takes a similarly short-sighted view of the eventual day of reckoning that must come?

The real losers in all of this are the employees who are being promised things that won’t happen and the taxpayers who are often asked to be on the hook for those unfunded liabilities, both public and private. Given the huge short-term benefits and demands of both stockholders and taxpayers for immediate results, it’s hard to fault the people in a position of power for kowtowing to those demands and make it someone else’s problem. When Senator Dan Liljenquist says that “reality is not negotiable”, this is the kind of stuff he’s talking about.

As much as it will sting to acknowledge that the era of cushy pensions is over, employees and employers need to own up to that fact. Utah has already taken in lead in moving new employees to using defined contribution plans. Instead of the state managing a fund and having to come up with the difference should the fund fail to cover liabilities, this responsibility is shifted directly to the employee. That’s the only change: there are no socialized losses under such a system. This means the state pays their contribution to the employee’s retirement and is no longer involved.

This sounds like a win just for the employer side, but it’s also a win for the employee. It entirely removes the unpredictable “IOU” nature of the pension and puts them fully in control of their own fund. That money is theirs and is fully portable as they see fit. It also doesn’t allow managers or unions to play a game of three card monte with their compensation, shuffling off the hard decisions decades down the road with no liability for the consequences.

I’m sure it’s no surprise that the other employer benefit created during World War II wage freezes, health insurance, has been similarly ailing. At least with pensions, we’re doing something about it.

3 Responses to The Unsustainability of Pensions

  1. Pensions and 401K’s both are a complete disaster. 401K’s being subject to every peep and pop in the markets and every bit of volatility, nor do 401k’s give the hold more options “invest” their retirement because they are tied to what ever plan their employer has not a plan they have chosen due to what ever criteria suites their fancy. Employers have no incentive to have a good 401k plan due to liability like in a pension, they only have the incentive to have one and even then only up to whatever the tax benefit is for them.

    The next major issue with 401K plans is the inability to plan a withdrawal schedule for retirement such that the 401k will last you though retirement. Nobody knows their expiration date, and given this reality the amount of savings required can vary greatly. This is one area where pension plans are far superior to 401k’s, like in an insurance risk pool you can look at the wider group of people and pretty accurately predict death rates and future liabilities. Because some people die sooner and fund will save money on those benefits and will redirect them to people who live longer.

    I also have problems with Utah’s recent changes, the State only matches up to 3% in the 401k where as on the pension plan they matched 5%. The standard plan also reduces the employee contribution amount from 8% to 4%. All other things being equal that is still much less money going to retirement.

    Really forcing everyone on to 401k’s and making their retirement depend on the ethical behaviors of over zealous fund managers who are not restrained by liabilities like in pensions seems like a bad idea.

    Not to say I support pension plans the liabilities to the States/Employers is no longer a sustainable model. But their are several aspects of the pension plan that should be saved. We need to decouple retirement insurance/savings from the employer, We need to make pension like retirement insurance available on the open market, We need to simplify and make rules to encourage understandable information about retirement insurance/savings as frankly this is a complex issue a lot of people have a hard time understanding(frankly this is the case with all growth problems).

    I would suggest creating rules for transportable retirement credits, expand the federal pension guarantee corporation to cover open market plans, expand retirement savings tax benefits to cover all retirement savings not just employer contributions to 401k’s(or better yet end them altogether and directly use the funds for the guarantee corp).

    If pensions where broken off into a third party that would solve the problems of gaming as well.

  2. An employee who actively manages their 401k should be able to mitigate their losses. I know some employees don’t have many fund options, but most plans offer several. (My employer offers about two dozen funds to pick from.) The smart thing to do has always been to gradually shift money into cash (bonds, annuities, etc.) as you grow older. Those investment vehicles are very stable and protect principle. Sure, the returns often aren’t as great as with a roaring stock market, but you also don’t experience the drastic dips. Maybe a 401k should include some kind of scheduled shift of assets based on employee preferences?

    Another hedge against volatility could be some kind of old age insurance program. For a small premium each month, an employee could purchase coverage in case of financial hardship post-retirement. In theory, Social Security was supposed to work that way (and I think it should, but that’s another story), but it’s ended up being treated as some kind of savings account. That would help socialize losses, but in a more fair way that how pensions are currently handling it.

  3. Ronald D. Hunt

    “An employee who actively manages their 401k should be able to mitigate their losses.”

    Their are a group of people that can do this, maybe 10%-20% of the population. But that leaves far to many people out in the cold. And I don’t buy that the loses in 401K’s can be mitigated completely, in the 2007 crash 401K’s lost $18,000,000,000,000 dollars. My dad lost $40 thousand dollars in his 401K it is almost surreal in that most people don’t understand how big that is after you account for lost interest ongoing into the future. After that happened I hooked my dad up with the guy I save through and due to him switching jobs was able to roll over his 401K into an indexed annuity. Ohh his new job has exactly 4 different 401K options his old work had 3, who do you work for to have so many options?

    And the insurance pool isn’t about socialising loses, its about evening out the savings input required for retirement given the payouts required for an unknown quantity of time that a pensioner will live after retirement. Given knowledge related to the life expectancy’s of a sufficiently large group of people you can predict the needed input for payouts to those people through their retirement.

    If each person had their expire date stamped on their head their would be no need for such a thing, we could simply tell them they need to save X for their retirement. But the fact is we don’t know each persons expire date.

    “For a small premium each month, an employee could purchase coverage in case of financial hardship post-retirement.”

    Their is no way that would be a small premium, and we are taking about amounts of money that vastly exceeds the scope of simple insurance. As I said above 401K’s lost $18 trillion dollars in 2007, just imagining the size of the investment funds necessary to provide such insurance is mind boggling. Not that I believe that any private corporation would take up such a business, with payouts most likely to happen on mass during an economic downturn where savings deposits and investments are retracted as well would be more then enough to push even the most conservative firms into bankruptcy. well Either bankruptcy or junk insurance that prevents most people from actually using it.

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