Defined Contibution Plans Gaining Ground

As employers find it more and more difficult to keep up with costs of defined-benefit retirement plans, an increasing number are adopting the alternative strategy of defined contribution programs, in which a set amount is contributed each month without the promise of a fixed level of benefits in the future.

According to Aon Hewitt, the participation rate for defined contribution plans is now at its highest level ever, with 78% of employers participating in 2012. Over the ten years Aon Hewitt has been tracking the data, participation rates have steadily increased from 68% in 2002.

Balances in defined contribution plans have also reached their highest level in six years, with an average plan balance of $81,240 in 2012. These numbers are likely to continue to increase as defined benefit programs become less popular and automatic enrollment becomes more widely implemented.

California’s “Secure Choice” Proposal

With a rash of studies indicating major shortfalls in the nation’s retirement savings, there has been no shortage of proposals to reform pensions, both public and private, and to induce a greater savings rate for younger workers. As Baby Boomers move into retirement, the lopsided nature of the workforce to retiree ration means that now, more than ever, people need to be mindful of where the money for their twilight years is going to come from.

One such proposal is California’s Secure Choice Retirement Savings Program, a mandatory savings initiative that would require private sector employers to put aside three percent of their workers’ pay into a retirement account guaranteed by the government. The proposal is modeled, in part after mandatory savings programs that exist in other countries, and which have widely been touted as successful, with Australia being a particularly noteworthy case. Although secure choice has not yet passed the California legislature, it has the support of Governor Jerry Brown and other states are already beginning to show an interest in adopting similar ideas.

Naturally, the idea of a mandatory savings program is not without controversy. Critics of the idea point out that Social Security was also supposed to be a guaranteed retirement account, but that that promise was broken long ago, leaving the program struggling for solvency. They argue that another entitlement program isn’t the answer, and there are also concerned about an already paternalistic state telling private sector workers and employees what to do with their own money.

Supporters of Secure Choice, on the other hand, are quick to answer that there is an ability to opt out of the savings requirement, and that the program only affects private sector employers who do not already offer some type of retirement account. Three percent of one’s wages is not going to be a sufficient sum on which to retire, but is intended merely to supplement Social Security and any other private savings workers have accrued throughout their careers.

Secure Choice is not the only option on the table to increase American retirement savings; Michigan has been experimenting with a prize-based approach that shows some promise. But California’s bold initiative is one of the more dramatic and attention-getting ideas. If it proves successful, it could end up spreading rapidly, changing the savings landscape significantly in a relatively short period of time.

The Danger of Defined Benefit Plans

The danger of public sector defined benefit plans is highlighted by the revelation that 92 Detroit retirees are collecting more than $80,000 a year from the government, with 23 of those collecting more than $100,000 a year. The city is locked into these extravagant commitments in spite of their desperate financial situation.

The desire to avoid situations such as this why private and public institutions alike are rapidly making the switch to defined contribution plans, instead of promising a lump sum they may not be able to deliver in the future. Whereas a defined benefit plan uses a formula to determine a designated monthly payout based on things like age, tenure and salary. The problem with such plans is that the payout is unrelated to the financial health of the institution offering the plan, and when the balances come due there is no guarantee that they will be able to meet their obligations.

Defined contribution plans address this difficulty by having employees and employers alike set aside a specified amount of money that will then be available for them when they retire, although without the promise of a specific monthly dollar amount.
The repeated failures of defined benefit plans may explain why we are now seeing record high enrollment in defined contribution plans, a number which will likely continue to increase as automatic enrollment becomes more popular and more companies and governments adopt such programs.

Indiana Uses Surplus Revenues to Strengthen 5 State Pensions

As announced earlier in the year, Indiana will be using surplus tax revenues to make payments to five public pensions. Of all Indiana’s public pensions, all but the Pre-1996 pay-as-you-go teachers pension is considered fully funded. Today, Governor Mitch Daniels released the details of these payments. The five state pensions are the Judges’ Pension Fund; Conservation, Gaming, and Excise Officers’ Pension Fund; Prosecutors’ Pension Fund; State Police Pension Fund; and Pre-1996 Teachers’ Pension Fund. The Teachers’ Fund will receive the largest portion with a payment of $206.8 million of the $360 million total. Another $360 million will be distributed to taxpayers–$100 per filer ($200 per joint filer)–on next years tax returns.

State Pensions Recieve Much Needed Reforms

This week, both Ohio and California legislatures passed reform measures to improve the positions and sustainability of public worker retirement plans. The reforms in both states increase employee contributions and the working year requirements to receive full benefits. States have contemporaneously picked up the cause as the national discussion of federal entitlement reform has heated up in recent weeks with the addition of Rep. Paul Ryan to the VP slot on the Republican presidential ticket.

While public worker unions have taken a hit in the public eye recently as these reforms and the teacher strike in Chicago have pitted public worker benefits against a growing recognition from taxpayers that earlier benefits promises were too generous to continue without hurting other valued government programs in the near future. These debates highlight the significant difference between public and private pensions; there is a third party–taxpayers–that carry risk for state employers and employees if pension funding does not meet the pension obligations.

Another Worry for Retirees: Underfunded Pension Plans

RealClearMarkets this past week had a good article by Robert Pozen entitled The Underfunding of Corporate Pension Plans.  Pozen points out an under the radar piece of legislation passed this past summer that could have negative budget implications down the road.  Congress revised the rule used by companies when funding pension plans—specifically it changed the criterion used to determine the discount rate.  Pozen writes:

Although a one percentage point increase in the discount rate may seem like a technical matter, the change will lead to much lower required contributions by companies with substantially underfunded pension plans.  For example, the required 2013 pension contribution for UPS will drop from $1.62 billion to $47 million, according to David Zion at Credit Suisse.  Similarly, he calculates that the required 2013 pension contribution by Lockheed Martin will drop from $2.35 billion to $1.4 billion. Continue reading

An Analysis of the US Savings Rate

Gross Domestic Product (GDP) grew by 1.9 percent in the first quarter 2012, down from a 3 percent increase in the fourth quarter 2011.  Since the end of the recession—a span of eleven quarters—the growth rate of GDP has averaged 2.4 percent.  Over the same eleven quarter period after the end of the 1981-82 recession, GDP growth averaged 5.5 percent.  What accounts for the slow recovery of the most recent economic downturn?  One possibility is the country is entering into a period of less than robust growth due to the anemic savings rate over the past thirty years.

According to the Solow Growth-Model, long-term economic growth comes from a country’s willingness to forego current consumption (i.e. save) in order to enjoy higher future consumption.  The increased savings is used to invest in education, technology, and capital-deepening.  Over the past thirty years the United States—and much of the industrial world—has done the opposite.  Americans have increased their current consumption at the expense of future consumption.

The chart above shows the US savings rate as a percent of income.  Since 1970 the trend-line for the savings rate has fallen—though it has increased somewhat since the past recession.  Between 1970 and 1989 the annual savings rate averaged 9.1 percent; compared to an average of 4.5 percent between 1990 and 2011.

Why has the savings rate fallen over this time?  Two suggestions:  (1) defined benefit pension plans, which became standard after the Second World War; and (2) the two asset price bubbles of the past twenty years—tech stocks and housing—created by the loose monetary policy of the Federal Reserve.

In theory, defined benefit and defined contribution pension plans are equal.  The former plan provides high rewards, but at high costs; while the latter provides lower costs but with fewer guarantees.  One downside of defined pension plans is it reduces the incentive for workers to save for their own retirement—especially when someone else is responsible for making the contributions.

The problem in the United States is most workers want the rewards of the defined benefit plan but pay the costs of a defined contribution one.  The US economy in the 1950s and 1960s allowed workers and employers this option.  Back then a GM or Ford employed hundreds of thousands of workers and had to finance relatively few retirees.  In addition, these firms didn’t face global competition.  As a result, firms put up limited resistance to labor demands for generous retirement plans.  GM and Ford could charge a few extra dollars for a car to finance those workers who were retired.  As well, to guarantee a dollar in future pension didn’t mean they had to put a dollar in an account right then.  They could contribute, say only eighty cents, because pension plans could invest that contribution and earn interest, which would be available in the future.  Another factor was life-expectancy.  In the post-war period, it was around sixty-five years of age.  Thus workers who retired at sixty could be expected to receive on average benefits for only a few years.

Times are different today.  Now a GM and Ford have four or five times as many retirees as workers.  A fully finance pension plans adds thousands of dollars to the cost of every car.  With global competition, it is difficult for the carmakers to pass these costs on to the buyer.  Secondly, life-expectancy has risen to near eighty years of age.  This means the average retiree will receive benefits for twenty or more years, putting additional pressure on pension funds.  What has happened is the money put into pension funds today are not being invested, they are being used to cover the pensions of current retirees.

The second possibility lies with the Federal Reserve’s monetary policy over the past couple of decades, one which created two asset bubbles.  Americans saved less during this period because they assumed (wrongly as it turned out) that prices would continue to rise and would make up for any deficiency in their savings accounts.  The chart which plots the savings rates also does the same the federal funds rate.  As it is with the savings rate, there is a downward slope in the fed funds trend-line.

This in a way contradicts basic economic theory, which suggests a negative correlation between the savings rate and interest rates.  When savings is low—i.e. the supply of loanable funds is limited—the price of money (interest rate) should rise.  If savings is high, the price should fall.  It should be pointed out that the federal funds rates used are in in nominal and not real rates.  Nominal rates equal the real interest rate plus expected inflation.  The growth rate of the price level since the late 1980s has diminished greatly from the high rates of the 1970s.

Ben Bernanke and Alan Greenspan argue that the reason for the low rates—despite the equally low US savings rate—was the world-wide savings glut.  In a global economy, the Fed rightly needs to take into account more than just domestic economic conditions.  One such condition should be how the global savings is being invested.  A large portion of the money saved by the Chinese is going into US Treasuries.  This would be okay if the federal government was running deficits to finance projects designed to promote long-term economic growth.  Rather it is a situation where a growing part of the budget is going into transfer payments.  The graph below charts the size of the federal debt since 1990—which has increased by 360 percent over the past twenty-one years.

A large portion of the increase in federal spending was for outlays to Social Security and Medicare, which increased 250 percent since 1990.  Like with the private sector, the federal government has promised retirees a defined benefit retirement program in the form of Social Security and Medicare.  The problem is politicians have tried to finance it as if it was a defined contribution plan.  In addition to guaranteed lifetime monthly checks, the federal government provides generous cost-of-living raises.  At the same time they are unwilling to require current workers to pay the full cost of such future promises.  The federal government made things even worse when it reduced employee contributions to Social Security a couple of years ago as a short-term solution to stimulate consumption.  When interest on the debt and other income security payments are included, a large portion of the federal budget goes to transfer payment designed to help consumption—not savings.  In 2011 these outlays represented 62.9 percent of total federal government outlays.

This is not to say that the lack of savings is the only reason for the lackluster economic growth over past few years, just that it is a factor.  The US has enjoyed a two decade reprieve from reality, one which permitted them to consume like drunken sailors.  The thinking was they didn’t need to worry about the future because the rising stock market and housing prices would provide for their retirement.  There is an old saying that one reaps what he sows.  The US may now be realizing the consequences of their unwillingness to adequately save for the future.

Number Games

Monday, the Government Accounting Standards Board approved new accounting rules for state and local pensions. The new rules narrow accounting technique options that previously allowed states and localities to choose the rosiest presentation of the unfunded obligations. Now underfunded pensions will have to lower the estimated rates of return that often assume 8 percent year-over-year, often more optimistic than prudence and reality would suggest is accurate. In an effort to provide greater transparency, state and local pensions reports will also have to publish the total pension liabilities upfront, not just total contributions.

These two reforms in particular provide substantially greater transparency into the fiscal security of these pension funds. Total liabilities provides an absolute figure of the unfunded obligations — now and into the future — and more accurate representation of the expected rate of return should better project the shortfalls in revenues to meet those obligations; making it more than likely that taxpayers will have a clearer picture of the taxpayer burden for these promised benefits.

These reforms will certainly show state and local pensions in a less secure position than previous techniques, which seems appropriate when dealing with retirement savings that tend to present the most risk averse characteristics of human nature.