In the spring of 2003, huge demonstrations in France brought the nation to a virtual standstill. The proposal that drove 300,000 workers, teachers, and students to march in protest through Paris was reform of the public pension system. During the same period, widespread strikes called by the Austrian national union federation drew a million people into the streets to challenge a government plan for pension reform. Labor unrest also gripped Italy when its government suggested modest pension changes, and Germany is now facing fierce union opposition designed to prevent the government from accepting an advisory panel’s recommendation to gradually reduce pensions and raise the retirement age.
The government of every developed nation is struggling to figure out how it will fulfill the promises made to older people. Birth rates have declined in recent times, and workers have been retiring earlier and living longer, leaving more pensioners but fewer active workers to contribute to their support. How much of an additional burden is caused by this increase in the number of retirees depends on the size of the working population. If employment keeps pace with the growth of the retired population, there is no extra burden, but if employment declines, the burden may become overwhelming for current workers. Experience has varied. The proportion of the working-age population to be employed has declined steadily since the1960s in France and Italy, but until recently, at least, has grown in the United States.
These trends portend severe problems for the public pension funds of some European nations and Japan, where the demographic trends are most pronounced.1 William Frey of the Brookings Institution projects that in Europe the median age will jump from the current 37.7 to 52.3 in 2050 (compared to 35.4 for the US, only slightly above what it is now). The European Union’s total population,2 now 90 million more than that of the U.S., will be 50 million fewer by 2050, and the working age population will decline by 40 million. As a result, in 2050, there will be 75 people of pension age for every 100 of working age.
The implications of the aging of the population in Europe and Japan are not confined to pension costs, but affect a broad array of economic, social, and political issues, including the decline of those countries as world powers and slower growth in per capita income. An aging and/or declining population poses problems for American multinationals in a variety of ways: declines and shifts in demand for particular products, the financial burden the private sector will inevitably help shoulder, and the impact of demographic change on the workforce and society at large. To compensate for declining birth rates, countries have been accepting more immigrants, but this has bred fierce opposition and the rise of extremist political parties. Already in Germany there is evidence of intergenerational conflict fomented by the pension situation. Young Union, a new political group claiming 135,000 members, has arisen and one of its prime targets is the “lavish living” of pensioners. In this issue of IRConcepts, then, we examine the consequences of aging on the pension systems of advanced nations. This article will further analyze the current state and consider what might be done.
In order to understand the current situation, we must explore how history since the industrial revolution has brought us to where we are. An accompanying piece examines the US model for using privately funded pensions to supplement pubic support systems for the aged.
Rise of the Concept of Retirement
In early history, human societies were not much concerned with caring for the aged. Life for most people was short and brutish. Although there were many births, few survived. With the development of agriculture and fixed abodes, an informal system of dealing with the problem of economic security arose. The extended family cared for people in need, whether due to a poor crop, illness, loss of a job, or old age. Even though the system was voluntary, there was strong social pressure for its maintenance. It is still the mainstay in most developing countries and about 70 percent of the world’s elderly rely on it exclusively.
Retirement, in the sense of complete and permanent withdrawal from paid labor, is a modern concept stemming from monumental demographic and economic changes. The demographic change started in northwest Europe, where mortality began to decline around 1800. The dimensions of the old-age problem exploded, and with industrial labor forces massing in burgeoning cities, the informal arrangements could no longer cope. Fertility rates began to decline by 1890, but population continued to grow as improved public sanitation and diet and medical advances led to increased longevity.
An increasing population of the aged unable to work was becoming a problem, but under laissez-faire concepts people were expected to save for their “rainy days,” and private charity was supposed to care for the needy aged. However, people were unable to save enough to live on when no longer capable of working. Though this was clearly a case of market failure, no industrialized nation faced the issue.
In the newly unified Germany, the growing working class was flocking to Marxism. In 1889, Chancellor Otto von Bismarck decided to steal the Social Democrats’ thunder and mollify industrial workers by establishing the first national pension system. Other nations began to follow the German lead, and by the mid-1930s, twenty-seven countries had well-developed national retirement systems. The United States continued to uphold the doctrines of laissez-faire and individual responsibility, but the Great Depression of the 1930s changed national thinking, as jobs became scarce, savings disappeared, and private charity funds were exhausted. The educational and research efforts of organizations such as Industrial Relations Counselors, Inc. (IRC) finally bore fruit with the adoption of the Social Security Act of 1935.
Application of the Insurance Principle
A pension system applies the insurance principle of sharing the cost of risk to the financial risk of old age. Under social insurance, a government agency collects the contributions and pays the benefits. In most advanced nations today, social insurance covers the financial risks associated with sickness, unemployment, and old age.
Public pension systems are compulsory and almost always supported by contributions from employers and employees, and sometimes also by government out of general revenues. They provide pensions to people reaching the required retirement age and benefits are a flat amount or related to previous earnings. In most countries, including the United States, benefits are paid as a right without a formal demonstration of need, and means-tested programs are generally considered public assistance (welfare) rather than social insurance.
Pensions can be fully funded, meaning the value of accumulated assets is sufficient to meet all the obligations accrued to date. A pay-as-you-go system, on the other hand, only needs enough money at any given moment to pay pensions to current retirees. In practice, under a pay-as-you-so system, aggregate benefits are financed by a tax on currently working generations, whereas in a fully-funded system benefits are financed by the return on previously accumulated pension funds. Pay-as-you-go amounts to an intergenerational pact whereby the currently active agree to maintain their parents and grandparents when they are too old to work.
Before World War II, most countries’ pension systems were partially funded; that is, in addition to being able to meet current obligations, they had some reserves for future needs. These systems were financially sound, since expenditures were limited by the fact that many workers did not live long enough to collect pensions, and those who did survived only a few years. Although life expectancy rose and the retirement age gradually declined to 65 in most countries, funding was not undermined. Pensions, being viewed as a safeguard against poverty in old age, were quite modest, equal to only about 15 to 20 percent of average wages.
Following World War II, a left-right consensus emerged on reconciling the working class to capitalism by providing full employment, improved welfare, and union consultation. A keystone of this strategy was creation of a mixed economy with a substantial safety net. New and/or expanded pension programs were created, and incomes for the elderly were boosted to as much as two-thirds of average earnings. Furthermore, people were encouraged to retire, as the number of years of employment and the age required to qualify for a pension were reduced.
The new economic order worked. With Marshall Plan aid from the United States, Europe and Japan recovered from wartime devastation and joined in achieving rapid growth. As labor forces and real wages climbed at high rates, pension systems were in good shape and were expected to remain so.
In the boom years following the second World War, full funding was not deemed necessary for public pensions. Unlike private plans, public programs are expected to operate indefinitely. Since they are compulsory, there always will be new entrants, and governments can utilize taxing power to raise receipts. Writing in 1967, Paul Samuelson, Nobel Laureate in Economics, described the thinking of the time: “The beauty of social insurance is that it is actuarially unsound. Everyone who reaches retirement age is given benefit privileges that far exceed anything he paid in… How is this possible? It stems from the fact that the national product is growing at compound interest and can be expected to do so for as far ahead as the eye can see. Always there are more youths than old folks in a growing population. More important, with real incomes growing at some three percent a year, the taxable base upon which benefits rest in any period are much greater than the taxes paid historically by the generation now retired… A growing nation is the greatest Ponzi game ever contrived.”
Economic and Demographic Changes Alter the Pension Picture
Over time, the postwar consensus encountered strains, particularly a tendency toward inflation. Some saw the combination of full employment and union power as inimical to price stability. Then, in 1973, rapid economic growth was halted when the new oil cartel, the Organization of Petroleum Exporting Countries (OPEC), quadrupled the price of oil. Income that had been enhancing domestic demand and economic growth in the industrial nations was now being transferred to oil producing countries. Inflation worsened, as workers tried to maintain their living standards and companies their profits.
The goal of full employment gave way to that of fighting inflation. To ease the burdens on the unemployed and to provide job opportunities to young workers, governments extended practices introduced in the boom years, making it easier for people to collect pensions. For example, in 1983 France lowered the normal retirement age to 60, although there is no evidence that earlier retirement actually had any effect on unemployment.
Although the economies of the developed nations did recover from the oil price shock, the heady days were gone. More importantly, the end of the baby boom undermined the other leg sustaining pay-as-you-go pension systems—more youth than old folks in a growing population. During the 1960s, the birth rate per woman in the European Union had been 2.7, well above the 2.1 needed to maintain the size of the population, but, starting in the 1970s, fertility rates declined everywhere. Declining birth rates in the 1970s meant that there were fewer new entrants into the labor force in the 1990s. By 1995, the birth rate was down to 1.5 in the European Union, meaning still fewer workers in the future. The demographic outlook is worst in Japan, which is aging faster than any other nation.
At the same time, life expectancy has continued to increase. Now, not only are there more aged, but they are living longer due to better living conditions, especially public sanitation, and to recent medical advances. Europe and Japan thus face a future in which they will have to provide pensions for a large class of retirees while the size of the labor force paying for the programs shrinks. Let us turn to how they might deal with this problem.
Are Things as Bad as They Look?
The large increase in the number of retirees is still a number of years ahead, so there is time to forge solutions. Beyond that, we must take notice of a number of factors that could mitigate the dire effects of the demographic trends already cited. First of all, fewer children means reduced spending on the young, which frees up funds to be used to care for the aged. Secondly, one must recognize that all pension schemes are largely bookkeeping arrangements. Pension benefits, like all forms of income, whether “earned” or representing transfers, must come from a nation’s output in any given period. The faster the rate of economic growth, the larger the gross domestic product will be a generation later and the easier it will be to distribute part of that largesse to retirees. European economic growth, which has been sluggish in recent years, could pick up, enhancing the ability of countries to pay for pensions. Indeed, there are signs of a turnaround, which could be accelerated by economic reforms being enacted to encourage investment.
If more rapid economic growth were combined with reform of labor regulations that discourage employers from hiring workers, unemployment might be reduced and the number working increased. Such reform has already begun, albeit haltingly, and the resulting flexibility in the labor market, combined with greater investment, could lead to faster productivity improvement, making it easier for future workers to support retirees.
Countries also could enlarge their labor forces by encouraging greater female participation. In 1998, women in France and Germany had an employment rate of 54 percent and in Italy, 37 percent—far below the rates in Britain (64 percent) and Sweden (67 percent). Working women are discouraged from having children because it is difficult to be both mothers and have careers. This is partially attributable to the virtual absence of any sort of childcare facilities in many countries. Steps are being taken to deal with this problem, and Germany, for one, is moving to reverse it by such devices as establishing all-day schools.
The demographic situation has improved a bit lately. Fertility rates in Germany, Italy, and Spain hit a low in 1995 and have been moving upward since then. It is doubtful, however, that they will reach the 2.1 necessary to maintain current population size very soon, if ever. Having children has become more expensive, their economic contributions are diminished by years spent in school, and educated parents have higher value of time, which raises the opportunity costs of child bearing. Even if births were to return to replacement levels, they would not compensate for those not born a generation ago. Low fertility for the past three decades means that there are smaller cohorts of potential future parents.
However, nations facing population decline might be willing to accept more newcomers. In fact, Europe, which had been a net exporter of people before 1970, has been a net receiver of 17 million since then. The numbers required to replace missing babies, however, may be too high to be acceptable to many nations in which ethnicity has been the basis of citizenship. Strong anti-immigrant political movements are active in many European countries, and the Japanese historically have not been accepting of outsiders.
So, we must conclude that, while faster economic growth, increases of women and immigrants in the labor force, and a turnaround in birth rates could help ease the pressure, the problem of finding the wherewithal to support a growing population of retirees will not go away.
Solving the Pension Problem
Most of the pension systems in question are pay-as-you-go systems under which there is enough funding at any given moment to pay pensions to current retirees but not enough to meet all the obligations accrued. It is difficult to reform pay-as-you-go systems, since the major beneficiaries of reform would be future generations who would enjoy lower taxes in the future but who do not vote.
Yet reform must come. If the current rules remain in effect, the average pension contribution rate in the European Union would need to rise from 16 percent today to 27 percent by 2050. The imbalance between workers supporting the pension system and pensioners drawing on it has been exacerbated by private and public early retirement policies, which have reduced the size of the labor forces, and devices such as “disability retirement” which have pushed more older workers out of the workforce. Labor force participation by older workers has fallen steeply in Germany and France, more modestly in Canada and the United States, and slightly in Sweden and Japan.
In response, European nations have begun to pursue three types of reform:
1. Reducing the ratio of retirees to economically active individuals
Postponing the age at which people retire by three years would cut pension costs by as much as one third. The retirement age could be raised without causing great pain to older workers. While people are retiring younger, years of healthy life are increasing roughly as fast as life expectancy. Indeed, retirement today means only withdrawal from paid work. Most retirees, especially the younger ones, pursue all sorts of other activities. Some nations, including Germany, Italy, the Netherlands, Denmark, and Austria, have cut back on the inducements to earlier retirement. However, keeping workers in the labor force longer necessitates creating more jobs, changing attitudes toward older workers, and using higher benefits as an inducement to work longer. Instituting programs of partial employment/partial retirement might be a good way of starting to handle the matter.
2. Cutting benefits for retirees, which could be compensated for by encouraging people to save more for their old age
Unsurprisingly, the countries that provide the most munificent pension benefits have the severest funding problems. Generosity of pensions varies sharply, with the British offering the least and the Germans the most. Germany has taken some corrective action, reducing pensions a decade ago from an average of about 70 percent of after-taxes pay to 64 percent, but given the lack of support from trade unions, the ability of most governments to push through significant cuts in pension benefits remains problematic. With the rise of living standards, most workers should be able to save enough to contribute a portion of their environment income.
3. Raising contributions from current workers
The economically active also will have to share the pension burden through higher taxes. Growing economies should enable them to bear their share and still enjoy higher living standards. The World Bank has proposed a model for balancing generational interests that features three complementary vehicles for funding retirement: mandatory publicly managed, tax-financed, pensions; mandatory, privately managed, regulated, and fully funded pensions;3 and voluntary savings.
But there are no magic formulas. Even the World Bank’s model is problematic. As we have seen, public pensions have suffered from the fall in the birth rate. It is reasonable to assume, however, that nations will not allow themselves to disappear and that, at some point, population size will stabilize, making defined benefit public plans viable once again. Meanwhile, all generations will have to share the burden through a combination of higher taxes for younger citizens and longer periods of work and lower benefits for older ones.
The World Bank’s proposal also calls for privately managed fully funded pensions to complement the public program. But these, too, will depend for funding on contributions from current workers, and if nations cannot control the size of their workforces, private corporations certainly cannot. Since employment in a given company can nosedive because of technological change, the rise of alternative products, shifts in consumer demand, and competition, it is impossible for an employer to assure its workers pensions of a given size. For that reason, traditional defined benefit programs are being replaced by defined contribution plans. Private pensions, however, may not be able to contribute as much to support of the aged as some believe. In the US, where the type of system advocated by the World Bank is well entrenched, 1.2 million elderly must rely on public welfare to get by.
With respect to voluntary savings, most workers today have the wherewithal to save for part of their retirement income. In fact, a reduction in public pensions is likely to lead people to save more in order to compensate for at least part of that loss. Low-income workers, however, cannot possibly save enough to protect them against old age economic insecurity. The public portion of the pension system, then, will have to remain a mainstay and contain redistributive features.
As yet, there has been no mad rush to follow the World Bank model. Given the demographics, they will need to do so, but we can expect that there will be significant variations in how each combines the elements and determines the burden each generation will bear.
The Economist, July 19, 2003
The New York Times, December 27, 2003.
World Bank, Averting the Old Age Crisis, Oxford, 1994
Dora L.Costa, The Evolution of Retirement, Univ. of Chicago, 1998
Assar Lindbeck and Mats Persson “The Gains from Pension Reform,” Journal of Economic Literature, March 2003
Alan Walker. “Thatcherism and the New Politics of Old Age,” in John Myles & Jill Quadagno, States, Labor Markets, and the Future of Old-Age Policy, Temple University, 1991
George E. Rejda, Social Insurance & Economic Security, Prentice Hall, 1991
Ronald Lee, “The Demographic Transition: Three Centuries of Fundamental Change,” The Journal of Economic Perspectives, Fall 2003
Lucio Baccaro, “Negotiating the Italian Pension Reform with the Unions: Lessons for Corporatist Theory,” Industrial and Labor Relations Review, April 2002
Case Study: Private Pensions in the United States
The retirement income systems in many developed countries depend almo\st entirely on public pensions financed by taxes. As a result, when the retiree population grows faster than the current workforce, pension funds are squeezed. This is the current situation in a number of European countries and Japan and, as we note in the lead article of this issue of irConcepts, one strategy for dealing with it is to supplement public retirement benefits with workers’ individual savings and with privately funded pensions.
The system in the US is built on such a strategy. It does not entirely mirror the three-component model recommended by the World Bank (see pages 5, 6)—despite programs such as IRAs, only a small percentage of Americans has any retirement savings to speak of and the privately-funded pension system, being voluntary on the part of employers, covers only about half of the American workforce. Nonetheless, the United States’ long experience with private pensions offers some important lessons for reformers in the US and abroad.
Chief among these lessons is not to rely too heavily on privately funded pensions to support older residents. The private sector certainly can have a role, especially if it is mandated to provide pensions to workers as the World Bank’s model suggests, but because of the risks involved, a strong public program must continue to be the backbone of a healthy pension system. It is useful to take a step back and study the US case in depth to see what we can learn from its successes and difficulties.
Genesis of Employer-Provided Pensions
Private pension plans in North America predate the establishment of public systems. The Grand Trunk Railway of Canada started the first private plan in 1874. The following year the American Express Company in the United States followed suit. By 1929, employer pension plans covered 3.7 million American workers in railroads, public utilities, oil refining, banking and insurance. Some unions also operated pension plans covering about 800, 000 workers.
Many pension plans were dropped or scaled back in the Great Depression, but new ones sprang up as the economy started to grow again. In 1949 the Supreme Court ruled that pensions and benefits provided through group insurance were mandatory subjects of collective bargaining. Following the negotiation of pension plans in the automobile and steel industries in 1949 and 1950, private pension programs spread widely through US industry. Favorable tax treatment of employer contributions to retirement and welfare funds encouraged their spread beyond unionized firms. Today, half the private workforce participates in them.
Understanding Pension Financing and Benefits
Single-company plans in the US are almost always administered exclusively by the employer, but, in collective bargaining situations, the employer and the union determine rules and regulations jointly. In small-scale industries, it is more common for the union to participate in administration of the plan as well. Until recently, most pension plans have been defined benefit plans under which the company agrees to provide the worker with a benefit amount based on a specified formula. As a result of tax code provisions allowing employer contributions, but not employee contributions, to be deducted as a business expense, defined benefit plans have usually been financed entirely by employers.
As jobs have become less stable and the labor force has grown more mobile, the original goals for pension plans have changed. Employers no longer look to them to reduce turnover, promote loyalty, and stabilize employment as they once did. Some companies have adapted their defined-benefit plans to fit the new environment, converting them to cash balance plans. The company continues to pay the total cost, but uses a career average formula and communicates the benefit as present value of an individual account.
Cash balance plans are advantageous for younger workers who change jobs, but conversion to a cash balance plan can cause losses to older, long-term employees. In 2003, Federal Judge G. Patrick Murphy of the Southern District of Illinois ruled that IBM’s cash balance plan discriminates against older workers. In February 2004, he ordered IBM to make retroactive payments to 140,000 present and past employees. All cash-balance plans, except those that allow employees the option of sticking with traditional plans, are in jeopardy. The Bush administration has proposed legislation that would provide a new legal formula to permit cash-balance conversions while providing some safeguards for older employees.
Many companies have moved away from defined benefit plans to defined contribution ones, which now cover about 70 percent of all participants. Under a defined contribution plan, the employer makes regular contributions, either a specified dollar amount or percentage of earnings, to individual accounts established for each employee. Employees usually contribute as well, and a person’s benefit at retirement reflects the total of employer and employee contributions and investment gains and losses. In this case, employees cannot know what their pensions will be when they retire, but they trade off uncertainty for the potential of higher benefits that may result from investment gains. Moreover, unless the employee takes his or her pension in the form of a fixed annuity, risk continues during retirement, since pension payments can fall when the assets in which the funds were invested decline in value. During the recent stock market fall, participants whose defined contribution plans were heavily invested in equities faced the prospect of much lower benefits and/or a need to postpone retirement, and many retirees from companies with such plans found their income reduced.
Defined contribution plans may be of many different forms. Most permit employee contributions; some, such as thrift plans, require an employee contribution, which the company then matches. 401(k) plans, to which employees and their employers may contribute on a pretax basis, have become the most popular form of defined contribution plan, and may become even more so, since starting this year, individuals are permitted to make larger tax-exempt contributions to their 401(k) plans and employers may match part or all of it. Like most defined contribution plans, under 401(k)s employees bear a significant responsibility for providing for their retirement.
However, there are serious problems with respect to 401(k) plans, especially the fact that many people fail to take advantage of them; beyond that, many who do participate fail to diversity their investments and do not choose sensible portfolios for long-term investments. The Enron experience indicates that it is extremely dangerous to invest too heavily in the employer’s equities, and legislation may be needed to prevent this, to protect employees from fraudulent promises by equity sellers, and to compel employees to participate in 401(k)s. The Internal Revenue Service recently took a step in that direction by issuing an advisory that permits employers to enroll employees in their 401(k) plans automatically. Although workers can opt out at any time, fewer are likely to do so than the number who fail to opt in under a system requiring the employee’s prior consent for enrollment. Certainly, better information and education for participants are essential.
In many countries, public policy has encouraged early retirement, but in the United States it has been corporations that have offered inducements to older workers to retire. The fact that, beginning in 1961, the federal social security system permitted men to collect old-age insurance benefits, albeit actuarially reduced, at age 62, gave added impetus to include early retirement provisions in private pension plans. Many companies have lowered the normal retirement age to less than 65 and permitted retirement at ages as low as 55, and a few have eliminated any age requirement. In the automobile industry, for example, the United Auto Workers (UAW) won company agreement to “thirty and out,” which permits a worker with thirty years of service to retire with a pension regardless of age. The results have been dramatic. In 1960, more than four out of five 60-64 year old American men were in the labor force; now only a little over one out of two are.
Companies introducing new technology in the 1960s encouraged early retirement to accelerate attrition and avoid layoffs. In recent years, companies downsizing have combined generous severance pay with monetary inducements, such as actuarially unreduced pensions, monthly supplements or bridging payments until people are eligible for social security, and cash buyouts to foster retirement. Workers, too, consider retiring older workers on a pension to be more equitable than laying off younger ones.
Although early retirement drives up the costs of retirement programs by reducing fund income and increasing expenditures, many companies believe that early retirement can be cheaper in the long run, because it contributes to greater efficiency. They see younger workers as more productive, more amenable to retraining, and better able to adapt to new technology. Early retirement may not be desirable from a societal point of view, because it wastes valuable human resources, but it does provide a mechanism for companies to ration jobs when there are too few available.
Government Regulation of Pensions
US law does not require employers to establish pension plans, but voluntary plans are regulated under the Employment Retirement Income Security Act (ERISA), adopted in 1974. ERISA protects employees by requiring vesting and setting funding standards for employer pensions. ERISA’s vesting provisions establish rules that allow employees who have worked a sufficient length of time for an employer to receive pension benefits from that company even if he is no longer working there when he retires. Funding standards require companies to amortize past-service liabilities over 30 years, rather than the 40-year period most were figuring on before ERISA was passed, and to use reasonable actuarial assumptions and methods of valuing assets. Defined benefit pension plans must buy reinsurance from the Pension Benefit Guarantee Corporation (PBGC) in the Labor Department to guarantee the payment of vested benefit rights up to a specified monthly amount.
Role of the PBGC
The Pension Benefit Guarantee Corporation pays benefits to retirees covered by private pension plans unable to meet their obligations. PBGC is currently footing the bill for benefits to 460,000 retirees in failed plans and is responsible for the pensions of another 475,000 current workers in those plans. These retirees may not receive their full pensions, since there is a PBGC maximum benefit, which can be considerably lower than that of the failed plan. That maximum, moreover, is related to when the plan was terminated, not the year in which the employee retires.
The PBGC is in financial trouble. In January, the reinsurer’s debts exceeded its assets by a record-breaking $11.2 billion. In 2003, it took over 152 plans covering 206,000 workers, up from 144 plans with 187,000 participants in 2002, and it paid a record of $2.5 billion in benefits, an increase of about $1 billion. The PBGC applies any assets left in the pension funds that have defaulted toward paying benefits to participants. This money makes up roughly half of PBGC assets, and, as in the case of the private pension plans themselves, a large share of it was invested in equities. When the stock marked fell, the value of PBGC’s portfolio declined precipitously. To prevent repetition, PBGC is planning to change its investment policy, and put a larger share of these monies in fixed assets. This move, however, does little to remedy the current shortfall.
The other half of the agency’s financing comes from premiums paid by companies with defined benefit pension plans. That money goes solely into fixed-income securities. One obvious way to put the PBGC on sounder financial footing would be to raise premiums, as has been done in the past, but even then the shortfall is so great that the contributing plans, many of which also are underfunded, would not be able to bear the cost of making the PBGC financially sound. Talk has begun about using general revenues to bail out the PBGC, but with a ballooning federal deficit there will be opposition to that approach. Indeed, the announced federal deficit ignores such items as the PBGC shortfall, and while the government is not technically required to back up the PBGC, it would be under tremendous public pressure to do so if the agency could not meet its commitments.
Problems Facing the Private Pension System
Employer-provided pension programs—the defined benefit variety, that is—are in trouble in the US. In airlines and some manufacturing industries in which employment has fallen, they face severe difficulties in fulfilling their obligations. Even some defined contribution plans have failed because of poor investment policies or corporate malfeasance. America’s defined benefit private pension plans are $350 billion underfunded. Much of the problem stems from the drop in stock prices, low interest rates, and economic slowdown, but for some companies, the problem is systemic—too many retirees per active worker.
Pension plans invest funds in various types of assets, about 60 percent in equities. As stock prices climbed in the 1990s, the value of their assets shot up and companies had to contribute less to stay within legal funding requirements. Those that might have wanted to contribute a lot more were deterred by fear of being penalized, through loss of the tax deductions on their contributions, if their plans are “overfunded.” When stock prices collapsed, plans did not have enough money on hand to meet future obligations. Aided by stock prices rising again, some companies have been able to recover. In 2003, for instance, General Motors wiped out $18 billion in underfunding of its plan. Many companies, however, continue to have underfunded pension plans, leaving them in a bind. While they may be able to reduce future benefit accruals, the law bars them from reducing already accrued benefits.
Health benefits for retirees, $20.6 billion in 2003, may pose even greater potential fund shortfalls. Where those benefits are embedded in collective bargaining contracts or stated company policy, they cannot easily be curtailed (although even when retiree health benefits are specified in collective bargaining contracts, bankruptcy courts have generally upheld cutting them in financially troubled companies). In other cases, companies can cut or even eliminate health benefits for retirees, and many are doing so. In February 2004, the Supreme Court upheld the right of a division of General Dynamics to eliminate future retiree health benefits for all employees under 50, ruling that age discrimination law does not apply to younger workers. A survey of 408 companies by the Kaiser Family Foundation and Hewitt Associates, found that 71 percent had made retirees pay a larger share of insurance premiums in the last year, 10 percent had eliminated subsidized health benefits for future retirees, and another 20 percent planned to do so.
The new Medicare prescription drug plan may ease company problems a bit. With Medicare picking up part of the tab, some employers may drop or curtail their benefits, especially since the Equal Employment Opportunity Commission has opined that doing so would not constitute age discrimination. In order to discourage such behavior, the new law provides subsidies to companies that maintain benefits when Medicare starts offering drug coverage in 2006. Some people are incensed, however, by the fact that companies can qualify for subsidies even if those benefits are largely or entirely financed by retirees’ private contributions.
In April 2004, the House and Senate reached agreement, and just days before companies had to make their quarterly pension contributions, President Bush signed a bill giving companies $80 billion in pension savings over two years, plus an additional $1.6 billion relief to steel producers and airlines. The measure had passed overwhelmingly (70-19 in the Senate and 336-69 in the House), as labor and Democrats were split. Unions representing workers in single employer (generally large company) plans backed the bill, but those in small-scale industries opposed it, not because of the contents of the legislation, but because it omitted multi-employer funds in which unions play a prominent role. The relief was provided through an accounting change. The formula for calculating pension contributions had been tied to the yield on the 30-year Treasury bond, but now will be based on a blend of corporate bond rates. The relief is temporary, however, and does nothing to solve long-term problems. In fact, the effect of this legislation may be to further weaken pension funding.
The United States’ public pension system is in good shape. But social security alone is not enough to maintain a retiree above poverty level. Many older people rely on additional public assistance to get by. Half of the country’s workforce is counting on their employers’ pension plans to help provide them with a comfortable retirement, but it is increasingly difficult for these plans to remain solvent. The other half of the workforce—employees in nonunion, generally smaller firms—have no private pension plans at all. Because they have lower salaries and shorter working tenures, women who are covered by private plans can look forward, on average, to half the pension benefits men will receive (but since they live longer, women will collect benefits for more years than men).
The first conclusion we can draw, then, is that a continuing strong public retirement income system is imperative. However, a supplementary private system can help even out the tax burden on the younger generations. To effectively spread the burden, however, without penalizing those firms that provide private pensions, participation should be mandatory for all employers and employees.
Since defined benefit plans are encountering greater and greater funding difficulties, it is likely that private pension plans will shift to the defined contribution model in the future. Those defined benefit plans remaining will need tighter funding controls to ensure their ability to meet their obligations. As a result of these changes, individuals would bear more responsibility for providing for their retirement. With more people having private supplementary pensions and personal savings, few will find themselves too heavily depending on Social Security benefits. Such a system would, in fact, conform very closely to the model recommended by the World Bank.
Dallas L. Salisbury, “The State of Private Pensions,” in Friedman and Jacobs, op. cit.
Alicia H. Munnell, Annika Sunden, and Elizabeth Lidstone, How Important Are Private Pensions, Boston College, 2002
Peter Diamond, “Social Security,” The American Economic Review, March 2004
Edward Lazear, “Why is There Mandatory Retirement?” Journal of Political Economy, December 1979
Richard A. Beaumont and Roy B. Helfgott, Management, Automation, and People, Industrial Relations Counselors, Inc., 1964
Roy B. Helfgott, Computerized Manufacturing and Human Resources, Lexington Books, 1988
Los Angeles Times, January 20, 2004.
The New York Times, February 25, 2004
Los Angeles Times, January 15, 2004
Los Angeles Times, February 19, 2004
The severity of the circumstances varies among countries. Sweden’s pension system is in good shape, while Japan’s is almost on the verge of collapse. The situation in the United States is manageable. The demographics are different, and the US reformed its pension system in 1983, reducing scheduled benefits, increasing the tax rate, and raising the retirement age. (See “Social Security: Maintaining a Perspective on its Problems and Their Possible Solutions,” IRConcepts, spring 1996)
All references to the European Union deal with its constituency prior to the admittance of new members in 2004.
The US system relies heavily on such private pensions.