Pensions

Pension plans, particularly the one in the state of Wisconsin, are in the news these days.  I don't know the details of the Wisconsin pension plan and neither do most of the people arguing about it.  But I do know that it is what's called a "defined benefit" plan.  There has been a lot of talk over the years as to whether defined benefit plans are better or worse than the other general class of pension plans called "defined contribution" plans.  As with a lot of things there are pluses and minuses associated with each type of plan.  And that's what this piece is about.  Not the pluses and minuses of the Wisconsin plan in particular but the pluses and minuses of the two classes of plans in general.

So what is a defined benefit plan?  That's a plan where an employer contracts to provide a specific level of benefit at a specific time.  I have been a participant in a defined benefit plan in the past.  It was typical of the breed.  The way it worked was that if I continued working for the company for 40 years they would provide a pension that would cover 60% of what I was getting paid when I retired.  The way it worked was that my "guarantee" would go up on average 1 1/2% per year.  So if I stayed with the company for a year my pension would be 1 1/2%.  If I stayed 10 years I would get 15%, and so on.  There were "vesting" rules so I didn't get a thing unless I was with the company for at least 5 years.  And the percentage wasn't a flat 1 1/2% per year.  Sometimes it was 1% for a year, sometimes, 2%, but on average it went up 1 1/2%.  Why the variation?  The company was interested in retaining employees so the percentage was designed to encourage employees to stick around (high percentage per year) until they were stuck then the percentage was lower.

This sounds like a pretty good deal and I thought so at the time.  And most people like defined benefit plans like this one.  So what's not to like?  Defined benefit plans are a bad deal if they don't deliver on the promise.  For instance, in my case the company was bought by another company after I had more than 15 years in.  The new company honored the old plan but they folded it into their similar plan.  The problem was that they had a different pattern of percentages.  The old plan had higher percentages in the later years and lower percentages in the earlier years.  The new plan had the reverse.  So if you added up all the percentages in my case (lower percentages in the earlier years and now lower percentages in the later years) it no longer added up to the full 60%.  And I got laid off after just under 20 years.  In my case I did end up with something.  But it was a low percentage of my salary as it was when I was laid off many years before retirement.  But I at least got something.

The cost to the employer of a defined benefit plan depends on a lot of things.  How many people will go the full 40 years.  How much will they be earning when they retire.  Many other things.  And there is something called "present value".  My old company made contributions to the plan each year and those contributions were invested.  So when I worked my 15th year for the company they put in some amount of money that was supposed to cover what my pension would eventually cost.  That money would have many years to earn interest.  How much money did they need to put in that year?  Well, you make a bunch of assumptions and then you perform what is called a "present value" calculation and that's how much money the company put in.  Actuaries, usually employed by insurance companies, specialize in doing this kind of thing.  And once all the assumptions are made there is a precise mathematical way to perform the present value computation.  But it all depends on the assumptions in the end.  And that's where the trouble comes from.

There is no way to get the assumptions right.  If you make one set of assumptions the present value calculation says put a smaller amount of money in.  If you make a different set of assumptions the present value calculation says put a larger amount of money in.  Which set of assumptions are right?  No one knows so honest and ethical people can disagree.  And then there's the real world.  As time goes by things can turn out more like the "small money" assumptions.  Then it is likely that the pension plan is over funded.  And, of course, the real world can turn out more like the "big money" assumptions.  Then the pension plan is underfunded.  For many years the stock market has grown faster than the historical trend.  This has resulted in a lot of over funded pension plans.  Then when the stock market crashed a couple of years ago the value of many pension fund investments dropped a lot and many pension funds instantly became underfunded.  Neither of these outcomes are the result of anyone doing anything wrong.

For many years most large companies had a pension plan and it was almost always a defined benefit plan.  Defined contribution plans are a recent invention.  The first thing to notice about defined benefit plans is that how much money a company needs to put into the pension fund is a matter of opinion.  To a company pension contributions are just another kind of expense.  If you lower expenses you increase profits.  So companies always want to put in as little as they can.  So the first way a company can game the system is to use the "less cost" assumptions when calculating the pension contribution even if they are not justified.  That's not good.  But it can get worse, way worse.  Back when there were many companies around with defined benefit pension plans a common tactic for an unscrupulous "take over artist" would be to borrow a lot of money, take the company over, then raid the pension fund to pay back all the money that had been borrowed, and finally to pay themselves a large "fee".  After that, they didn't even care if the company stayed in business.  And many companies were literally driven out of business by these tactics.

And what happens to the pension fund if the company goes out of business?  Well, lots of times the fund is raided before the company goes completely under.  And even if this doesn't happen there will be no more contributions from the company.  So the fund is likely underfunded.  It used to be that the retirees just got completely screwed in these kinds of situations.  Now there is a federal agency called the Pension Benefits Guarantee Corporation and a law to go with it.  It can contain the damage to some extent but it does not pay the full contracted benefit.  And it is perennially short of money.  It is currently dealing with the GM and Chrysler pensioners, for instance.

So, if everything works out well a defined benefit pension is a good deal for employees.  But things frequently don't work out.   And many of the things that can go wrong with a private corporation do not apply to governments like the Wisconsin state government.  But some of them do.  A good way to reduce current spending is to underfund the state pension.  And state legislatures do this all the time.  It is one of the standard "budget gimmicks" you hear about.  The theory is that the state will make up the shortfall later when the economy is better.  But later there is always something more fun to spend the money on that a pension contribution.  As far as I can tell (the press coverage on this sort of thing is always poor) Wisconsin was fine before the market crashed and will be fine again if the market goes up enough.  But in the same way financial considerations affect business leaders, political considerations affect politicians.  This can result in bad behavior that jeopardizes retirees ability to get what they were promised.

So now we know the bad news about defined benefit plans.  So what's the bad news about "defined contribution" plans?  Before getting into that let me explain how a defined contribution plan works.  The best place to start is with a 401k plan.  In a 401k plan (applicable to a for profit corporation, there are similar plans with different designations for non-profits and governments) the employee makes a contribution to the plan, say 5% of salary.  This money is taken off the top before taxes are calculated and put into a fund.  Frequently there is an employer match.  The most common match is that the employer will match at a rate of 50 cents on the dollar anything the employee puts in up to 6%.  So in our case the employee would put in 5% and the employer would contribute an additional 2 1/2% so the total amount going into the fund would be 7 1/2%.  None of this so far is a pension.  But the employer can contribute in a similar manner to a fund on behalf of the employee that is not dependent on how much the employee kicks in.  This is a pension plan.  It is called "defined contribution" because there is a formula that determines how much the employer is going to put in (typically a fixed percentage of the employee's salary) but the employer does not guarantee how much income this will translate into when the employee retires.

Before going into the problems let me go into the benefits of this type of plan.  The first benefit is that the employer can't game the system by coming up with some optimistic assumptions and underfunding the plan.  There is a rule and the employer is bound by law to put in the exact amount the rule specifies.  There is no wiggle room.  Secondly, the employer looses control of the money.  The money goes to the plan administrator, typically someone like Fidelity or Vanguard.  The money is no longer under the employer's control.  The employer can't raid the fund.  Third, and this is not obvious, all of the "defined contribution" pension cost for a particular year is paid in the year the cost is incurred.  With a "defined benefit" plan extra money may need to be put in (or possibly can be taken out) because previous years now look underfunded (or over funded).  This means that a company can accurately predict the cost of doing business in the current year.  In summary, with a defined contribution plan the money is reliably there and corporations get a more predictable cost structure.  So what's the down side?

The down side is that the employee does not know how much income he will get at retirement.  If enough money is put into the defined contribution plan and the money is invested well an employee can do as well or better than with a defined contribution plan.  But if the money is invested badly there may be little or nothing left at all at retirement time.  This is not as far fetched as it sounds.  Let's say you were an Enron employee and Enron had a defined contribution pension plan.  (I don't know what kind of plan Enron actually had).  With many companies the 50% match on the 401k is in company stock.  And many employees believe in the company they work for so they invest their portion of the 401k money in company stock too.  And some companies will contribute company stock in lieu of cash as their pension contribution.  So in this case it would be possible for all of an employee's pension money to be tied up in Enron stock.  Enron stock is now worthless so people who were 100% in Enron were completely wiped out.  Enron was a high flier.  But for most if its life Washington Mutual was a well run and staid bank, technically a mutual savings bank.  For most of the life of the company, employees would be justified in believing that WaMu stock was a conservative investment.  Many WaMu employees had a large part of their retirement tied up in WaMu stock.  That investment is now worth a few cents on the dollar and may eventually be worthless.  So the down side of defined contribution plans is the investment risk.

In summary, defined benefit and defined contribution pension plans both have risks.  With the defined benefit plan you are betting on the company being reasonably ethical and surviving for a long time.  It should be noted that the only stock listed in the 1900 Dow Jones Industrial average that was still there 100 years later was GE.  You are also betting you can stay with the same company for your entire adult carrier.  I worked for three companies as an adult.  I worked for the same company for 19, 4, and 15 years.  And I worked hard to stay with a company after I got there.  In no case did I quit, although I did retire from the last one.  Most people are much less successful at longevity than I have been.  My 4 year stint would be a dead waste to a defined benefit plan.  I do get a nice to have but very modest pension from my 19 year stint.  By the time I retired from my 15 year stint the company had converted to a defined contribution plan.  So it is a lot harder than it looks to cash in on a defined benefit plan.

I also was able to avoid the "put all your eggs in one stock" problem I have described above.  It was part of a pretty conservative investment strategy that has stood me in good stead.  But there's no doubt about it.  It would have been easy to screw up some time over the years and lose all or a lot of my retirement money.  So it is also harder than it looks to cash in on a defined contribution plan.  Most people are more aware of the risks inherent in a defined contribution plan so they characterize it as the more risky of the two.  I hope I have convinced you that it is not necessarily more risky and is frequently less risky.  And the fact that both options are risky is why I strongly advocate leaving Social Security pretty much as it is.  Assuming it can survive the current political attack on it, it represents the only truly low risk retirement option available to people.  Everyone needs a low risk component in their retirement plan.

Finally, what should be done about government pension plans like the one in Wisconsin?  Probably the biggest reason private defined benefit pension plans are risky is bad behavior by company management.  They either abuse the pension plan or they run the company badly.   There is no reason to believe that state legislatures are likely to do a better job.  The current activities of the legislatures in Wisconsin and several other states strongly supports this contention.  The money pot invariably associated with a defined benefit plan just represents too tempting a target.  So I think that governments should follow the lead of private industry.  Private industry has almost entirely shifted over to defined contribution pension systems.  I think it is both inevitable and likely that in the coming years governments will switch over to defined contribution systems too.  The switchover needs to be watched carefully.  It can be done properly so that the employee at least starts out with an equivalent benefit.  But it can also turn into a license to steal if done badly.

But once done opportunities for mischief are greatly reduced.  It now becomes a discussion between the employer and employee about total compensation.  The employer is now indifferent as to how much of the compensation is in salary and how much is in the form of a pension contribution.  He only cares about the total amount.  And there is no longer an opportunity to raid the pension fund or to underfund the plan in the current year.  Pensions would be off the table completely in Wisconsin if the state had a defined contribution plan.  And that would be better for state employees and for the rest of us.