SchoolsRetooled TM

Trouble with Defined-Benefit Pension Funds

March 30, 2011 at 9:01 AM 1 comment

Pension funds scarce and getting scarcer

“The N.J.E.A. – the teachers’ union – decided to launch its first strike in the coming battle when it obtained what it said was a list of the recommendations that will be in the final report of a pension study commission…Edithe A. Fulton, president of the association, said that some of the proposals ‘represent the most outrageous assault ever attempted on the state pension system’…According to the teachers’ association, the proposals would raise retirement ages, lower benefits, increase premium co-payment requirements for health care and penalize those who retire early… At present, a person retiring at age 60, with 20 years of service and a final average salary of $28,000, would receive an annual pension of $9,333, or about $777 a month. The new formula would reduce that to $3,242, or about $270 a month. 

The February 19, 1984 edition of the New York Times foretold of an upcoming debate over management of under-funded teacher pensions in the State of New Jersey. The numbers are quite different today, but the story is sadly similar. Unfunded pension benefits, once thought to be an artifact of 1980s stagflation, have reared their ugly heads again. While the nature of the problem seems similar on the surface, a number of differences will make the solution much more difficult this time around.

The problem in 1984…pension funds had gotten into trouble after years of inflation and a relative absence of economic growth in the US. By the early 80s, inflation topped 18%, and this high cost of capital meant greatly discounted pension fund valuation. As retirees lost private benefits, Congress reconsidered the Social Security Opt-Out provision of ERISA and added benefit protection for private beneficiaries. However, the greatest amount of relief came in the form of lower inflation. By 1986, the slow, painful stagflation scenario had played itself out and discount rates began a rapid decline. Fund balances were adjusted upward and the stock market grew. A problem of supply of funds was resolved with market-based renewal of that supply.

Fast forward to the current situation…During periods of unprecedented growth on the stock market, flush fund managers had allowed pension trustees to pay out generous benefits to retirees. Defined-benefit plans created schedules of accruals that presumed these conditions would continue indefinitely. As we now know, the market conditions were buoyed at least partially by fraudulent financial vehicles and imprudent behavior. The world economy has stalled and volatile market behavior has made fund valuations more difficult. Interest rates are already low, and inflation fears only make the situation more ominous. Essentially, there is no chance of a magic pill in the form of a market-based improvement in the supply of pension funds. Our greatest hope lies with long-term growth in the economy that must happen over time.

To complicate matters, Baby Boomers are becoming eligible for benefits in record numbers. Even as pension funds become scarcer, this new level of demand for pension funds is accelerating. The solution to the problem necessarily relies on artificially increasing the supply of funds or moderating demand. The former would mean adding money to the pot from public or private sources, i.e., government bail-outs or increased employee contributions. Demand reduction would mean postponing eligibility for benefits or reducing benefit payouts. However, defined-benefit plans limit flexibility for benefits that have already accrued for existing employees.

Several states and municipalities have moved to stop offering defined-benefit pensions to new employees, choosing instead to offer defined-contribution plans such as 401K or 457 plans. The relief offered by such changes will not be adequate to prevent the looming financial crunch for retirees. Nevertheless, it will allow future retirees to have more control over their money and timing in a proactive way.

 Now, back to the 80s…when the Social Security safety net was restored. In 1983, Congress put an end to government workers opting out of Social Security. Because of a grandfather clause, about 5 million Americans still do not participate in Social Security. As the mantle of control over solvency in old age gets shifted to the individuals in private plans, perhaps it is time for the hold-outs to opt back IN to Social Security.

Entry filed under: The Pension Trap. Tags: defined-benefit pension plan, pension reform, social security, teacher pensions.