Saving Defined Benefits Requires Lower Pensions for Existing Workers and Retirees

Among pension reformers there is a spirited ongoing debate regarding what might constitute a financially sustainable yet equitable solution. On one side there is a call to do away with defined benefits entirely, replacing them with defined contribution plans. The argument is compelling; with defined contribution plans, when the participant retires, they survive on the assets they have invested, and the employer has no contingent liability whatsoever. This is an appealing scenario to anyone who fully appreciates just how close our public sector pension funds are to financial collapse. But some of the ways defined benefits are characterized by their detractors are inaccurate.

For example, defined benefit plans are often referred to as “Ponzi schemes,” based on the premise that pension funds depend on new participants making contributions in order to fund the distributions being made to retirees. But the scam used by Ponzi (and Madoff) was to let new investors fund interest payments to existing investors, while all the while making the promise that existing investors had a claim on their original principal investment and could have it back at any time. Defined benefits do not offer a return of principal. If incoming contributions, plus interest earned on assets under management, offer sufficient extra capital to fund distributions, a pension fund is sustainable. A Ponzi scheme by definition is not sustainable.

Slightly more apt, but still inaccurate, is to characterize defined benefit plans as “Pyramid schemes,” based on the same premise – that their solvency depends on new participants making contributions in order to fund the distributions being made to retirees. But Pyramid schemes only work when an expanding number of new entrants buy into the scam. As soon as the number of new entrants in a given year is not, for example, twice as plentiful as the number of existing participants, a Pyramid scheme collapses, and the last ones in lose everything. Properly managed pension funds do not require an increasing number of entrants.

It doesn’t take a lot of imagination to see the problem with putting everyone onto an individual matching 401K plan, i.e., convert everyone to a defined contribution plan. Every participant is on their own. No matter how generous the employer matching may have been, and no matter how much money they may have put away during their working years, if any retiree’s investments lose their value, they will be financially ruined. And even if their investments perform to expectations during their retirement, they will continuously have to worry about how much they can spend, because should they be fortunate enough to live longer than average, they may still find themselves penniless.

Hence there are two distinct virtues to defined benefit plans, both based on the fact that these plans allow large numbers of participants to pool their risk. This means that even though some participants may live longer than average, their income is secure their entire life, because by definition whoever collected more from the plan by living longer than average had their higher than average withdrawals offset by those whose lifespans were shorter than average. And because risk in a defined benefit fund is shared across generations of workers, during eras when investment returns are low, existing workers guarantee extra cash coming into the plan to keep it solvent, and during eras when investment returns are high, surpluses are fed into the pension fund that can also be used to make up the shortfall during lean years.

The only way defined benefits as they are currently structured for California’s public employees can remain solvent is if annual investment returns go into the double digits and stay there for the next 20 years. Even if that happens, contribution rates may have to go up. And if that doesn’t happen, the likelyhood that anyone is going to be willing to pay the required higher contributions is virtually nil – whether it is the participants themselves who are (at least according to Gov. Brown’s AB 340 pension reform that was signed into law on Sept. 12, 2012) going to eventually have to pay 50% of the required contributions through withholding from their paychecks, or taxpayers. So how can defined benefits be saved? A question that big defies concise answers, but it is unlikely that any financially viable, equitable solution can be found that will not affect existing workers and existing retirees. Here are some options:

• For all pensions to existing retirees over $50,000 per year, whenever necessary, reduce the pension payout by an amount proportional to the amount the existing pension assets are underfunded. Restore them – but not retroactively – whenever and to the extent the funds move back towards being 100% funded. This can be accomplished by declaring a fiscal emergency.

• For all participants still working who are unable or unwilling to afford to pay 50% of the required pension contribution – should it skyrocket in the face of persistent low returns to the fund – offer them an opportunity to accept a smaller defined benefit that they can afford. This can be done pursuant to AB 340.

• Impose a ceiling on pension benefits to retirees, based on the principle that pensions are supposed to ensure retirement security, not lavish affluence. Similarly, establish a floor for pension benefits to retirees, based on the principle that employees at the low end of the pay scale are nonetheless entitled to retire with an income sufficient to live with dignity. Assuming the pension ceiling is realistic, the savings from establishing a ceiling for benefits will greatly offset the costs of establishing a floor on benefits.

If the annual rate of return currently projected by most pension funds, 7.5%, is lowered, for example, to 5.5%, it will probably be necessary to consider all of these options in order to save defined benefits.

Preserving defined benefits will require hard choices. But defined contribution plans should supplement pensions or social security, not replace them. And comparing defined benefits – or social security, for that matter – to Ponzi schemes or Pyramid schemes are specious arguments that do not belong in serious debate.

References:

Local Pension Reforms and Proposed Reforms in California Since 2010

Statewide Pension Reforms and Proposed Reforms in California Since 2010