Live Long and Prosper? Not If You Are Counting on a Healthy Pension PlanPublished: August 29, 2012 in Knowledge@Wharton
Everyone knows that pension plans, both public and private, are in trouble. But on closer examination, this isn't the apocalypse many people think it is. Most pensions will pay most beneficiaries most of what they are owed, and government pension-protection agencies have various techniques for keeping pensions as healthy as possible.
Still, there is plenty of reason to be concerned about retirees' futures.
To shed light on the situation, Wharton's Pension Research Council recently asked two top pension-protection officials to discuss conditions in the United States and the United Kingdom. The forum, "Saving Pensions: What Can the U.S. and U.K. Learn from Each Other?" was moderated by council executive director Olivia S. Mitchell, a professor of insurance and risk management at Wharton. Participating were Lady Barbara Judge, chairman of the U.K.'s Pension Protection Fund (PPF), and Joshua Gotbaum, director of the Pension Benefit Guaranty Corp. (PBGC) in the U.S.
The consensus: The U.K. fund, set up in 2005 with insight from lessons learned by the older U.S. system, established in 1974, is a more flexible, adaptable approach to the changing pension landscape. The U.K. fund is 100% funded, while the PBGC has a $26 billion shortfall that will be difficult to make up.
In the U.S., public pension plans -- generally, those for state and local government employees -- have on hand only about 76 cents for every dollar owed retirees, according to one study. But critics say the accounting has been too generous, and that new rules phasing in over the next few years will put the figure at 57 cents. Private pensions -- those provided by corporations -- have shortfalls estimated at around $500 billion. Together, public and private pensions may be trillions of dollars short of what they need to meet obligations to participants.
Pensions face similar problems in the U.K., according to Judge. In June, the PPF reported that U.K. pensions have only about 77% of the assets they need to meet obligations to participants, with a shortfall of £312 billion ($392 billion).
As in the U.S., pensions in the U.K. were developed to attract and retain good workers, and they were considered among the best plans in the world through the 1970s and 1980s. "It started to go wrong in the 1990s," Judge noted, with many firms taking "pension holidays" -- cutting or eliminating contributions to plans thought to be adequately funded due to the boom in the financial markets. Troubles followed, leading to the collapse of some funds and public demonstrations outside Parliament.
In response, the government set up the PPF in 2005. Like the PBGC, it takes over private plans that have collapsed and makes the payments to beneficiaries, though both systems cap payouts at levels that can fall short of what some beneficiaries were due under their failed plans. In addition to taking over assets of failed plans, both systems are funded by an annual levy, like an insurance premium, on all private plans in the country.
The size of any pension's shortfall cannot be measured precisely because, although pension plans know the current value of their assets, the amount they will have to pay out over coming decades depends on uncertain factors like how long each beneficiary will live. Also, no one knows for sure how any one fund's stock and bond investments will perform over time.
Current shortfalls are due, in part, to poor performance of stocks over the past decade, coupled with extremely low yields on bonds. In addition, rosy projections of investment returns led many funds to skimp on employer contributions, while economic shocks have produced corporate bankruptcies that left pensions under the control of the PBGC in the U.S. and the PPF in the U.K.
Another key factor in the pension problem, said Gotbaum, is the growing life expectancies in developed countries. Since most pensions pay benefits for life, longer lives increase payouts. While a rebound in the stock and bond markets could improve the situation, few expect that to be enough to cure the underfunding problem. "The fundamental fact, which affects retirement security in a way that most people don't pay much attention to, except for actuaries ... is that people are living longer."
In the U.S., the average retirement age has not changed much over the decades, with the typical worker now retiring at age 63 compared to 62 half a century ago, he said. But 50 years ago, the average American lived for 17 years in retirement; now it's 22 years, a 29% increase.
The PBGC and PPF were both set up to provide a safety net for participants whose plans fail, typically when a company goes out of business. For most of its history, the PBGC has functioned well, Gotbaum stated. But in recent years, it has taken over some major underfunded pension plans, including several from airlines and car manufacturers. With assets more than 20% short of obligations, the PBGC could, at some point, need a taxpayer bailout. The PPF is healthier -- fully funded.
Why the difference? In many respects, Gotbaum noted, the PPF, which is more flexible and less politicized than the PBGC, is the system one would choose if starting from scratch under today's conditions. The PPF, Judge added, was designed after extensive study of the strengths and weaknesses of the PBGC.
A key problem for the PBGC, Gotbaum pointed out, is that employers' premiums are set by Congress, which is reluctant to antagonize businesses by raising charges. The PBGC, unlike a private insurance company, therefore cannot easily match premiums to changing risks. In addition, oversight of the PBGC is divided among various congressional committees and federal departments, he noted, making policy changes difficult. Over the years, for example, the Treasury Department has successfully pressured the PBGC to keep a large portion of its assets in Treasury securities, which today produce very low yields.
Shifting the Risk to Employees
According to Gotbaum, pension problems are just one part of a larger problem of funding retirement.
Under current projections, most U.S. pensions will pay out most of what they owe, but fewer workers have traditional pensions than in the past. About 50% of U.S. workers have a retirement plan through their employers, a figure that has held constant for three decades. But 30 years ago, the large majority of these plans were traditional pensions, or "defined-benefit" plans, that guaranteed a set benefit based on the employee's income and years with the company. Today, the vast majority of workplace plans are "defined-contribution" plans such as 401(k)s. The shift moves the investment risk from the employer to the employee, making the retirement income dependent on the employee's success in choosing among investment options offered by the employer. "Companies are trying to reduce their employment costs," Gotbaum said.
That does not mean traditional pensions are dead, or aren't worth saving, he added. Today, about 75 million Americans participate in defined-benefit plans, including retirees and about 36 million active workers. About half of the active workers are in public plans, half in private ones.
Another myth, Gotbaum noted, is that most active workers are in plans that have been frozen, meaning participants no longer accrue additional benefits, although they are entitled to the benefits earned before the freeze. In fact, about 80% of active employees are in plans that are not frozen. "The idea that defined-benefit plans are already gone -- they are not," he said, adding, "Are they threatened? Are they losing market share? Absolutely. But are they gone? No."
For most workers, a defined-benefit plan is preferable to a defined-contribution plan, since the defined-benefit plan has a guaranteed payout for life, he pointed out. "We have a form that offers a better service. We should do what we can to preserve it."
The problem, Gotbaum said, is that the average employee skimps on contributions to a defined-contribution plan, putting in less than the maximum allowed. In addition, many make poor investment decisions and unwisely take lump-sum distributions upon retiring.
Judge agreed that it is tough for ordinary people to make the best retirement-funding decisions. She recalled that when she was in her late 30s, her employer offered her the option of joining the defined-contribution pension plan or receiving a larger salary. She chose the latter. "Why would I want a pension?" she remembered thinking. "I'm going to work forever.... I took the money. And where is that money? It's gone.... These people who are in defined benefit plans I look at as really lucky."
For many people the retirement-funding picture is gloomy, Gotbaum said. "My fear is that as we live longer, and as we shift the majority to defined contribution investments, we will get a lot of people who discover in their late 70s that they have run out of money." Added Judge: "When I grew up, people always counted on the fact that the next generation was going to make more than their parents.... and life was going to be better. And now we know that's not true."
The solution to this problem? The U.K. is weighing various options, including a proposal to replace the current raft of old-age benefits with a single state-sponsored pension that will provide an equal benefit for everyone, Judge said.
In the U.S., employers are experimenting with plans that combine features of defined-benefit and defined-contribution plans. Some are adding features to defined contribution plans such as insurance-company annuities that, like traditional pensions, make cash payments for life. However, the cumbersome insurance system, which relies on state-by-state regulation, can make experimentation difficult, Gotbaum noted.
Unfortunately, nothing that is done to shore up the traditional pension system will completely resolve the problems caused by people living more years in retirement. As they approach retirement age, people will have to come to grips with their limited options, Judge concluded: "Work longer. Save more. And expect less."