Broken Promises: Can the World's Stressed-out Pension Plans Be Rescued?Published: December 06, 2010 in Knowledge@Wharton
From Chicago to the Champs-Elysees and beyond, distressed retirement plans these days face a set of bleak options. Countries around the world are trimming benefits and raising their retirement ages to make up for pension shortfalls. In the United States, a blue-ribbon panel has been studying ways to keep Social Security solvent, even as many state and local pension plans are seriously underfunded. Companies, too, are feeling the pain; the bloated liabilities of pension plans are increasingly squeezing corporate profits.
These challenges come amid a global economic crisis that has battered savings and investments counted on by many people to finance their retirement. Now governments must struggle to rescue their pension plans while economies still are reeling from the sharpest downturn since the Great Depression. "Decisions that were made 30 years ago are now coming home to roost," says Keith Ambachtsheer, president and founder of KPA Advisory Services in Toronto, which advises public and private pension plans. "Under rosy optimistic assumptions that were the reality of the 1980s and the 1990s," he says, promises were made, risks were ignored and demographic shifts were downplayed or swept under the rug.
Here is a look at some of the most daunting challenges that today's pension plans face and the actions that are being taken to address them.
Global View -- The Challenge: For national retirement systems, the problem frequently boils down to falling birth rates and longer life spans. "It's the two blades of the scissors coming together: Not enough workers paying in and people living a very long life," says Olivia S. Mitchell, professor of insurance and risk management and executive director of the Pension Research Council at Wharton.
The relentless aging of the world's population creates this scissors-like phenomenon. By 2050, developed countries will average just two people between the ages of 15 and 64 for each person 65 and older, according to the United Nations, down sharply from five younger persons for each older one in 1999. With fewer people to finance their retirement, older individuals will have to settle for less generous benefits or spend more years on the job, or perhaps do both.
The Action: The growing imbalance is forcing governments to revamp their retirement promises in sometimes politically explosive ways.
- In October, French lawmakers voted to raise the retirement age from 60 to 62 despite rancorous street protests, with the increase to take full effect in 2018.
- Germany is gradually raising its retirement age from 65 to 67 beginning in 2012 and taking full effect in 2029; Spain plans to phase in a similar increase between 2013 and 2025.
- In Britain, the retirement age will rise from 60 to 65 for women and from 65 to 66 for men by 2020 and is to reach 68 for both sexes by 2046.
- China and India, the world's two most populous countries, are reconsidering their retirement ages. Rapidly aging China is studying raising the age from 50 for female workers and 60 for males, without saying what the increases might be. India is mulling a move to boost the age from 60 to 62 for central government employees.
- While Sweden has kept its retirement age at 65, the country indexes its pensions to longevity projections so that monthly benefits fall when the national longevity rate rises.
- Australia, which requires employers to contribute to workers' privately managed retirement accounts, plans to increase the mandatory contributions from 9% to 12% of pay by 2019 to bolster the funds.
The Outlook: While some countries may have pulled pension plans back from the brink, other plans are still on borrowed time. The economic crisis has proved that governments cannot borrow endlessly to fund unrealistic pension obligations, says Ambachtsheer. Whether by forcing citizens to save, or by increasing the minimum retirement age or reducing pension benefits, governments around the world will have to make tough choices to keep their retirement plans solvent. "When assumptions change," says Ambachtsheer, "you had better turn the dial so that you get sustainability."
Social Security -- The Challenge: Although the United States is aging less rapidly than Europe or Japan, the strain on Social Security is growing. Some 155 million U.S. workers paid Social Security taxes to cover about 38 million recipients in 2000, for a ratio of 3.4 workers per beneficiary, according to Social Security trustees. Today, roughly the same number of workers supports 43.5 million beneficiaries for a ratio of 2.9 to 1. That number is certain to keep falling as 77 million baby boomers move into retirement.
The Social Security trust funds are projected to run dry by 2037, at which time payroll taxes will cover just 78% of the benefits that retirees will require. But the date 2037 belies the true nature of the crisis that is already unfolding, says Kent Smetters, professor of insurance and risk management at Wharton. "The system is taking in less money than it's paying out," he says.
Nor is the system's $2.6 trillion trust fund really something to fall back on, according to Smetters, since Washington counts the fund as both an asset for Social Security purposes and a source of financing for the federal debt. This amounts to "counting the same dollar twice," Smetters says. "The real question is, 'What is our nation's ability to pay future retirement benefits?' The trust fund itself does not really contribute to that ability."
The Action: The United States has quietly reduced Social Security benefits "through the back door," says Wharton's Mitchell. In the past, only half of Social Security income was taxed," she says. "Now it's up to 85% and it may go up to 100% if the system gets into worse trouble."
But such fixes may be stopgaps at best. The chairmen of President Obama's have floated the idea of raising the full Social Security retirement age to 69, up from the current ceiling of 67 for those born since 1960. Raising the age to 70 would solve about 20% of the Social Security shortfall, says Smetters. Attacking such increases are critics who say that raising the age would leave people who hold physically demanding jobs unable to work long enough to collect full benefits.
Permanently eliminating the annual cost-of-living-increases for Social Security benefits could be another step toward fixing the program. These increases began in 1975 and will be suspended in 2011 for the second straight year because of low inflation. But like the notion of raising the retirement age, the idea of permanently ending the increases is highly controversial.
The Outlook: Social Security's problems will continue to worsen until the gap between the cash coming into and going out of the system is finally corrected, says Smetters, who worked on Social Security reform as a deputy assistant U.S. Treasury secretary for economic policy from 2001 to 2002. Countries like Australia and Mexico have developed fixes for their retirement programs that include a combination of public pensions and mandatory private savings accounts, adds Smetters. "In general, that's a good idea, but I don't think we have the political ability to do it here. These other countries got to where they are because something went really wrong."
Corporate Pensions -- The Challenge: If Social Security isn't fixed, Americans will have to rely more on personal savings or company pensions to fund retirement. But these, too, are on shaky ground. When the stock market crashed in 2008, assets in retirement accounts and pension funds lost trillions of dollars. The loss devastated millions of American workers in defined-contribution programs such as 401(k) accounts, especially those workers near retirement who held most of their assets in stock. Nearly one in four workers between the ages of 56 and 65 had more than 90% of their accounts in equities on the eve of the market crash, according to the Employee Benefit Research Institute in Washington, D.C.
Corporations have been slammed as well. requires companies to keep their defined benefit plans -- those that promise lifelong payouts -- at least 60% funded. This forced companies to shift more money into their plans as the stock market fell, whacking corporate profits. In a double whammy, record low interest rates have slowed the growth of pension assets in relation to promised payouts, causing companies to divert still more money into plans to maintain the funding requirements. The Federal Reserve's November decision to buy $600 billion of U.S. bonds to stimulate the economy is expected to worsen the problem by further lowering interest rates.
These woes mark a dramatic turnaround from the 1990s when pension plans actually padded company profits since surplus funds can be counted as income. At the end of the last century, corporate defined benefit plans were 130% funded, according to Milliman, a Seattle, Washington-based actuarial consultant. Back in the 1990s, General Electric "made more money from their pension plan than from light bulbs," quips John Ehrhardt, a coauthor of Milliman's annual pension studies.
The Action: Corporations have been shedding their defined benefit pensions since 1978, when Congress amended the tax code to cover defined contribution programs like the 401(k) plans for which employees bear the risk. A Towers Watson study in 2010 found that just 59% of Fortune 1000 companies still sponsored defined benefit plans, and roughly one third of those have frozen out new employees. Wharton's Mitchell sums it up this way: "Defined benefit is dead and we're never going back."
The Outlook: Companies must continue to pay pension benefits to retirees who now collect them and to employees who are vested in the programs. The federal Pension Benefit Guaranty Corporation insures these plans. But new employees who are not eligible for pensions, and workers in plans that have stopped accruing funds, must learn to invest on their own behalf through defined contribution programs and individual retirement accounts. "For the majority of Americans who don't understand financial investing, this makes it a lot harder for them," says Wharton management professor Keith Weigelt. "If the 401(k) is how we're going, we need financial education earlier."
State and Local Plans -- The Challenge: State and local governments, the final holdouts for traditional defined benefit plans, may be in the deepest distress of all. State governments say they are about $1 trillion in the hole when it comes to unfunded pension liabilities, while municipalities count themselves $190 billion in arrears. Even these numbers may severely underestimate the problem, according to studies by Robert Novy-Marx of the University of Rochester and Joshua Rauh of the Kellogg School of Management at Northwestern University. The authors place the true figures as high as $3 trillion for the states and $574 billion for local governments. By Novy-Marx's and Rauh's calculations:
- Illinois will run out of pension assets in 2018 even if it earns an 8% annual return on investments.
- Chicago has a $44.8 billion unfunded liability and only enough assets to last until 2019.
- New York City, the largest municipal plan in the country, is $122.2 billion in the hole and its funds are on track to run out in 2021.
How could all this happen? For years, state and local governments have calculated their future pension obligations based on aggressively high rates of return, says actuary Jeremy Gold of New York City-based Jeremy Gold Pensions. This allowed the governments to reduce the amounts they socked away and drew the plans into riskier investments. "Since the mid-90s, [state and local pension plans] have been substantially underestimating the value of their promises," says Gold. "If you put a dollar on a dollar's worth of benefits, then we as the taxpayers are indifferent. But if you're putting 70 cents on a dollar's worth of benefits, then you're giving away too many benefits."
The Action: States and municipalities will soon be forced to choose from an unappetizing menu of options that include raising taxes, slashing benefits and even scuttling plans. "In some places, particularly towns and counties, we're going to see situations where they will have to renege in one fashion or another," says Gold. In a worst-case state like Illinois, there has been talk of a federal bailout.
The Outlook: While the ultimate solution will be to raise taxes or cut benefits, states and municipalities know that neither policy is feasible in today's economic doldrums. So instead of scaling back, some local governments are investing in riskier assets, such as international funds or private equity or venture capital funds, says Smetters. "They're all playing the double-down game. They lost the first round and now they are risking everything to get it back."
There are few easy fixes to the world's pension problems. Whether the plans are public or private, defined benefit or defined contribution, individual or group, the deepening dilemmas reflect an aging world, wishful thinking, misguided investment strategies and plain bad luck. Digging out will take years of hard work. "It's some combination of put in more money, work longer, reduce your benefits," says pension consultant Keith Ambachtsheer. "These economic principles can't be violated."