How Pension Plans Beguiled Us

And how they will tear apart communities.

Having a pension plan has been part of the American Dream for millions of workers. Put in thirty or thirty-five years with a company, retire, and then the company will send you a check every month for the rest of your life—an attractive prospect. The amount of the check is pre-determined. It is a “defined benefit” promised to the worker.

Unfortunately, this simple vision has proved difficult to implement. The basic problem has been that pensions are a promise for the future, but nobody can guarantee the future. In our dynamic economy, the Schumpeterian process of “creative destruction” relentlessly weeds out the companies that no longer meet consumers’ most valued desires. As a result, one can work for a company for several decades, then see the company go broke, shut down, and—poof!—there goes the pension.

Theoretically, companies have been expected to set aside enough money to make good on their pension problems. This is easier said than done in competitive markets. In a year when revenues have fallen, does the company pay its suppliers or fund its pension when it can’t do both? Would employees rather take a cut in current pay so that the company could fund its retirement plan, or would they rather maintain current income and hope the company can find funds for the pension plan later? If the company raises its prices in an attempt to increase its revenue, the company may actually lose sales and revenues due to the elasticity of demand and the decision by marginal buyers to take their dollars elsewhere rather than pay higher prices.

When the Studebaker Corporation (if you’re a young reader, Studebaker made cars) closed in 1963 and many of its employees lost all or part of their promised pensions, it got the ball rolling for future federal involvement. A decade later, President Ford signed ERISA, the Employee Retirement Income Security Act. Among other provisions, ERISA initiated federal regulation of private pension plans, which included stipulating the extent to which defined-benefit pension plans had to be funded each year.

The crucial question is this: How much money should be set aside today in order to fully fund pension payments decades into the future? The feds understood that it would be impractical, if not impossible to set aside the full amount in the present, so they established guidelines based on discounting future obligations by an anticipated rate of return on current investments. While I can’t explain in detail how they compute the discount rate, the calculations include assumptions (i.e., guesses) about future interest rates, GDP growth, inflation and other unknowables. In other words, they totally winged it, and ended up assuming that pension fund assets would appreciate at a rate of 8% per year (now reduced to 7.5%). Oops. After the market collapse of 2008, many defined-benefit plans found themselves underfunded, and many employers have been forced to curtail other expenditures and deposit additional funds into their defined-benefit plans. Subsequently, the zero-interest-rate environment of recent years has rendered 7.5% an unrealistic rate of return.

As a result of these intractable difficulties, private-sector defined-benefit plans have become rare, replaced by defined-contribution plans whereby a company deposits what it has promised to deposit in employees’ pension plans today, and then has no further financial liability.

There is, however, one sector of the economy in which defined-benefit plans live on—in government. While private companies have found defined-benefit plans to be unfeasible due to their uncertain ability to increase revenues when needed, governments have retained defined-benefit pension plans, partly because they can (theoretically) raise taxes at will to obtain additional revenues, partly because it’s easier for them to promise generous pensions since it isn’t their own money that’s in play, and partly because politicians have a central bank to bail them out with newly created Federal Reserve notes to cover whatever red ink they spill.

Now this doesn’t necessarily guarantee that public sector employees’ defined-benefit plans are secure. The recent bankruptcy of Detroit is evidence of that. In fact, governments at all levels have jeopardized the defined benefit plans of government workers due to the profligate proclivities of politicians. According to Matthew Brouillette of the Commonwealth Foundation, here in Pennsylvania, the unfunded liability in the pension funds of public school teachers and state workers is a staggering $47 billion—assuming a 7.5% annual rate of return, which means that the total could be considerably larger. Other states are in even worse financial straits. New York State’s pension debts total $133 billion, Illinois’ $167 billion, and California’s $370 billion. The total for all fifty states lies in the $2.5-3.0 trillion range. Add the unfunded liabilities of the country’s cities, and the total swells to over $4.5 trillion. While chickenfeed compared to the tens of trillions of Uncle Sam’s unfunded liabilities, it’s still a huge deficit to make up. Brouillette calculates that the increases in Pennsylvania’s pension costs over the next four years comes out to approximately an extra $1,000 tax liability for every Pennsylvania family for the next four years.

The dichotomy of the private sector having predominantly defined-contribution pension plans while the public sector has predominantly defined benefit pensions raises serious questions about fairness. Why should government employees have the promised (though, as we have seen, not guaranteed) security of defined-benefit pensions while the defined-benefit plans of taxpayers are exposed to market risk? Further, when a local school district finds that its employees’ defined-benefit plan is underfunded, it is the local taxpayer who has who has to make up the entire difference. In effect, public teacher defined-benefit plans impose a blank check on future taxpayers, making teachers’ retirement plans a ticking time bomb for taxpayers.

The problem of unfunded public employee pension plans is enormous. PA Gov. Tom Corbett's 2012-13 budget proposed increasing payments into state pension plans to $1.6 billion, a breathtaking 60% increase from the previous year’s $1 billion. By 2016, projected state and school district pension payments will balloon to $5.6 billion, an increase of more than 400% in just five years. And that’s just at the state level.

State and local governments’ need for significantly more tax revenues creates a politically explosive situation. Local taxpayers, most of whom have a defined-contribution pension plan—if, indeed, they have any pension plan at all—have seen their plans struggle in recent years, and many self-employed people have seen their incomes decline. There is going to be a lot of pushback when local school boards try to raise taxes on people who have been experiencing economic hardship in order to meet the looming shortfalls in the teachers’ defined-benefit plans.

In sum, defined-benefit plans beguiled us. Attractive on the surface, they were inherently flawed due to the impossibility of knowing the future. Now it appears that they will cause a huge amount of strife and divisiveness in communities and states across the country in the coming years. There will be a lot of pain, and the political struggle will be over how that pain is distributed. It may take decades to sort out the mess, but ultimately, the only fair and viable (though still imperfect) system would be for everyone to have defined-contribution pension plans. Getting from here to there isn’t going to be easy.

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