The Changing Face of Retirement
by Eric Krell
The gold watch often symbolizes the retirement that employees enjoyed in the past. The symbol now carries a disconcerting implication: today’s employees can no longer expect the same security that characterized their predecessors’ golden years.
There is little doubt that the gold watch no longer suffices as a retirement symbol, but those who understand the forces bearing down on U.S. retirement would argue that the representation never really worked as a symbol. It is far too simple to capture the multifaceted, interlocking, political and ever-shifting dynamics of retirement funding, which typically relies on a mix of pensions, personal savings and Social Security.
That complexity is causing problems: a reduction in pension payments promised to retirees of a growing number of companies, soaring healthcare costs, and serious concerns about the solvency of the federal pension insurance fund and the future of the Social Security system. Those problems have sparked some alarming headlines (“The Looming Retirement Disaster,” “Pension Tension,” “How Retirees Blow Their Nest Eggs”).
But the forecast for U.S. retirement funding is not all gloom and doom. “There are many things that are going well with retirement plans,” points out Baylor University Professor of Finance and Insurance Allen Seward. “As a nation we’re wealthier than we’ve ever been. More people are retiring at a comfortable standard of living than has ever been the case. And more people are using retirement plans to build up wealth for future generations.” Like most other retirement and pension experts, Seward also notes that broad problems require attention.
“Given the way we’ve structured things over in the past 40 years, to continue to do what we’ve been doing will cost a lot more than it has in the past,” says Sylvester Schieber, director of U.S. benefits consulting for Watson Wyatt Worldwide and the co-author of “The Economic Implications of Aging Societies: The Cost of Living Happily Every After” (Cambridge University Press, 2005). “That represents the best circumstances of continuing to do what we’ve been doing.”
A more troubling scenario is already playing out for retirees of U.S. Air and other bankrupt companies who are receiving lower pension payments than they expected to based on their former companies’ agreements. These sorts of problems have sparked contentious debates about the severity of current retirement challenges and potential remedies.
Despite these differences of opinion, there is agreement that major changes are necessary to solve some formidable challenges.
Traditional Plans on Ice?
Traditional pensions are referred to as defined benefit plans. They use a mathematical formula, one based on length of tenure, annual salary levels and related factors, to determine how much a company will pay retirees each month in retirement until death.
Defined benefit plans have been giving way to defined contribution plans, under which a company gives employees a set amount of money each paycheck. The employees typically allocate that money among mutual funds and other investment options selected by the organization. Highly popular 401(k) plans are frequently lumped in with defined contribution plans. Through 401(k)s, employees can select to contribute portions of their own paychecks, often pre-tax dollars, to investment vehicles selected by the company, which typically (but not always) matches a portion of the employees contribution.
In the past five years a growing number of companies have terminated or frozen their defined benefit pension plans. When companies do so, they typically replace the traditional pensions with defined contribution plans – and they are obligated to fulfill their existing defined benefit commitments to current employees, but are given some latitude in exactly how they do so.
The shift in pension plan preference has several causes. First, many employees expressed a preference for defined contribution plans, and their companies listened. The robust bull market of the 1990s fattened up many 401(k) balances, which spurred demand. Second, macroeconomic factors have in many ways de-valued career longevity and employee loyalty, qualities that defined contribution pension plans were designed to encourage and reward.
“Traditional manufacturing firms were dependent on workers who cultivated over time a deep knowledge of a production facility’s processes,” Schieber explains. “The companies needed to hire workers for a long time and structure benefits in a way that rewarded longevity and that did not reward, or even penalized, employees who do not come and stay.” As the U.S. has evolved toward a more services-based economy, much of the need for long-tenured employees has subsided. Defined contribution plans generally are much better suited to employees who work for different companies throughout their careers.
Regulatory factors represent a third factor that has nudged many companies away from defined benefit to defined contribution plans. In fact, a law passed 31 years ago has caused a stir on Capitol Hill and in corporate executive offices this year.
The Rising Price of Pension Insurance
In 1974, the Employee Retirement Income Security Act was signed into law. The sweeping legislation was designed, imperfectly it is now evident, to provide insurance for defined benefit pension plans in the private sector. To fulfill that role and to enforce other aspects of the new law, the legislation established the Pension Benefits Guaranty Corporation (PBGC).
Companies with defined benefit plans were required to pay insurance premiums to the PBGC of $1 per employee per year. The growing fund is used to fulfill pension payments to retirees of companies that filed for bankruptcy or cannot otherwise meet their responsibilities. The PBGC insures pension benefits worth roughly $2 trillion for some 44 million pension plan participants. As of January of this year, the premium has risen to $19 per employee per year.
However, the PBGC does not necessarily cover 100 percent of the promised payments. Most United Airlines retirees, for example, can expect to receive, on average, about 80 percent of their accrued benefits through the PBGC; some employees, as PBGC Executive Director Bradley Belt recently told a Senate committee in June, may see their promised pension benefits reduced by more than 50 percent.
But premium increases have not kept pace with the demand. The PBCG reported a $23.3 billion deficit in its insurance program for the past fiscal year. The organization has about $40 billion in assets, but more than $60 billion in liabilities. As a result, it “will be unable to meet its long-term commitments without additional revenues beyond those currently mandated by law,” according to Belt.
This represents a major concern for many retirees, current employees, federal legislators and corporate executives. A June survey by Financial Executives International (FEI) found that CFOs were more pessimistic about the U.S. economy than they had been in more than 12 months. The finance executive who responded to the survey cited concerns about the PBGC’s future solvency as one of their major concerns. Further, if PBGC premiums rose high enough, a third of those CFOs whose companies provide defined benefit plans indicated that they would consider a reduction in benefits or an outright termination of the program. The majority of CFOs also indicated that they believe a taxpayer bailout, which would require a new law, is the most likely outcome of the PBGC’s problems.
A key component of the draft legislation to reform pension rules working its way through U.S. Congress this summer was a sizeable hike in pension premiums for all companies with defined benefit plans – and not just those whose plans are dangerously under-funded (many companies have managed their defined benefit pension funds perfectly well).
That sort of fix does address the fundamental flaw of defined benefit pension funding rules under ERISA, which is that companies are allowed to manage their funds on a significantly under-funded basis. “Companies with high-risk funds have had no incentive to become fully funded or to avoid risks,” notes Seward.
In 2004, all of the defined benefit pension funds in the U.S. were under-funded by a combined $450 billion. About one-quarter of that shortfall exists at financially weak companies, according to the PBGC. Not all pension funds need to be 100 percent funded every year (the cyclical nature of equity markets and other investments make that impossible), but most should be close. That has not been the case.
“This has nothing to do with financial market shifts,” Schieber asserts. “The recent shifts simply made it worse and brought it to our attention. Many [defined benefit plans] have been chronically under-funded for years.”
Social Security: Pay Now or Pay Later
As Congress has wrestled with the ways to address the PBGC’s shortcomings, the national debate over two other retirement-related issues, the soaring cost of health care and Social Security management, seemed to subside.
In truth, both issues continue to simmer and will reach a boiling point within the next decade. Schieber ticks off a short list when asked why these issue will not go away: the shift away from traditional pension, the need for Social Security reform and the demise of retiree health insurance for people who are not eligible for Medicare. He also points out that American retirement has changed in the past 40 years. In the 1960s, the typical worker retired at about 65. Today, the same worker retires at 62. Americans have added three to four years to their average life expectancy in that same time. We’re also entering the workforce later than we did 40 years ago, thanks to that extra semester in college.
As a result, Americans are trying to finance a retirement period that is about six years longer from a career whose length has shrunk. “The arithmetic,” Schieber adds, “just doesn’t balance out after a while.”
Nowhere is that imbalance more noticeable than in the Social Security fund. But there are solutions.
“One of the things you can do to make Social Security completely solvent instantly is to cut benefits back to 95 percent for current and projected levels,” Seward explains. “A 5 percent reduction in benefits puts the Social Security system is back in balance.”
He admits that is more drastic than the small figure might sound, particularly for retirees who live entirely off of their Social Security checks, without the benefit of pensions or personal savings. Yet, that solution is still much less severe than the recent adjustments to similar programs in Germany and Japan, which are each about 10 years to 25 years ahead of the U.S. in dealing with the effects of a baby boom generation. In both countries, benefits were reduced, across the board, by about 15 percent.
“Social Security is not going to go away,” notes Seward. “It is going to exist … The question is at what level of generosity will the benefits exist in the future?”
The longer the country takes to respond to that question, the more disconcerting the answer is likely to be – and the clock is ticking…
Baylor Business Review, Fall 2005