Monday, April 20, 2015

Why Did We Abandon Defined Benfit Pensions?

Retirement is a relatively new concept - dated to just after World War II.  In the next 20 years, retirement is about to change dramatically.

One thing I have harped on this in blog is the essential need to save.   We live in a 401(k) world now, and the idea of getting a "pension" is now obsolete, except for a few remaining government employees - and even that number is starting to shrink, as more and more governments switch to a 401(k) type plan.

The question remains, why did we switch to this new paradigm?   After all, isn't a guaranteed payment amount - for the rest of your life - far better than trying to save up heroic amounts of cash, which can be lost in a market crash or dissolved over time due to inflation?

And the answer to the second question is, yes, of course a guaranteed pension can be a better deal - provided the people guaranteeing it are solvent.  And that last part there is one of the reasons why we went to the 401(k) and IRA in place of defined benefit pensions.

So, why did we make this switch?  The reasons are numerous:

1.  It was a pyramid or Ponzi scheme to begin with:   Prior to World War II, not a lot of people "retired" or if they did, they did not  retire for long.  Old Gus at the finger-cutting factory would reach age 65, and the President of the company would give him a gold watch, and he would shuffle off to live with his children for a few years, until he kicked the bucket.   Age 65 was about life expectancy, and most companies did not have elaborate pension plans.  As in most third world countries today, having lots of children was your best pension plan.

Back then, we didn't have "retirement communities" in Florida, and the idea that you would sell your home and move away from your family and play golf for a decade or two, was alien.   But with the advent of Social Security and Medicare, along with company pensions, this became a new reality - it was made possible by the money being provided, both by the government and the private sector.

The problem was - and is - that early on, not many people were retired, so there were a few people taking money out, and a lot of people paying money in.   So in the 1950's, 1960's, and 1970's, the system worked pretty well.  Until that is....

2.  Most Pensions were underfunded:   Since these were future obligations, most companies paid only the minimum amount necessary into the pension plans needed to fund them.  Even at these rates, the amount of money set aside grew rapidly and companies became takeover targets often because of all this excess cash laying around.   Unions (such as the Teamsters) wanted to get their paws on the company pension plan, to use the money to fund Las Vegas, and perhaps for some money-laundering.

It was just too temping, all that money around.   In the 1970's, after the first energy crises, companies had to cut back on spending - and pension plans were the first things to be cut.  Companies like General Motors lost more and more market share and shed employees as a result.   But the number of retirees continued to grow and grow and grow.   As the company was in financial difficulty, they paid as little into the pension plan as possible.  It took another 30 years, but eventually something had to give - GM went bankrupt.

Underfunding of pensions is still a problem today, with many State and local governments failing to set aside a proper amount for pension plans - sometimes even after being ordered to do so by the courts.   But if the choice is to shut down Police and Fire protection or underfund the pension plan, you can guess what every Mayor will do.

It is a way of kicking the can down the road - eventually, though, some poor sap has to deal with the problem later on.

3. Vesting:  For the working Joe on the assembly line, a pension could be a good thing.  And companies valued them as they promoted worker loyalty.  You weren't going to quit a company if you were going to get a pension.

On the other hand, for Engineers and others, pensions were just cruelty.  Most companies had a "five year" vesting rule in their pensions - you had to work at a company for five years to collect even a minimum amount upon retirement.   As Engineers are often hired or fired depending on what projects a company is working on, and many Engineers would work a few years here and there during their career.  (GE was famous for this, hiring Engineers in anticipation of getting a government contract, and then letting them go if the contract wasn't awarded).

As a result, a lot of people never got pensions, even if they worked for a company that provided pensions, because of vesting.   And yes, it was a popular sport back in the day, to fire someone just a few days shy of their vesting in their pension.

4. Pensions are not as secure as you might think:  When companies go bankrupt, the pension often goes bankrupt as well.   And there were sneaky ways that some folks would raid a company and take all the money out, often by underfunding the pension or even trying to steal from the pension plan.  Mitt Romney was quite fond of this, and that is how he "created jobs" at Bain Capital - but crushing companies, tossing retirees out on the street, and foisting off pension liabilities onto the US Government.

Yes, long ago, the Government stepped in to protect pension plans.  If the plan is insured, the Pension Benefit Guarantee Corporation, a quasi-government entity will step in and take the tattered assets of the plan, and use that (and the premiums it receives from insuring members) and pay out at least a portion of the amounts due to pensioners (capped at $54,000 a year as of 2011).

If you don't get a huge pension, you may be covered.  For others, such as airline pilots, who often granted pay concessions in return for generous pension plans, you may feel a little cheated when your $100,000 a year retirement plan turns into a $50,000 one.

Bear in mind the PBGC insures only private-sector plans, not government plans.   While the idea of a Federal Pension defaulting seems remote, some States, Counties, Cities, and Towns have been known to default on pension liabilities.  For example, one small town in Alabama stopped paying pension payments entirely.   Detroit, in contrast, appears to be keeping its promises to pensioners.

California, some say, is headed toward a pension crises, but like a slow-moving freight train, no one seems to think it is imminent enough to do anything about it.

5.  People are living longer:  One of the problems that has exasperated all of the above is that in post-war America, people are living longer.   Average life expectancy is now around 78 and keeps going up every year.  And more troubling, if you reach retirement age of 65, the odds are very strong you will live to at least 85 if not 90.

Average life expectancy can be a deceiving number, as it includes all those infant deaths, kids killed in motorcycle accidents, and middle-aged men who keel over of a heart attack - before ever collecting on a pension.

If you live long enough to collect one, these days, you can expect to collect for 20 years or more.

As a result, the retirement age is going up - and keeps going up.  "Full" benefits for Social Security are now at age 67, not 65, and I suspect the "early" collection age will go up over time.

While many people say they will "work until they are 70" they often do so at a second career as their first employer is quite likely to lay them off at age 55.  And often this second career pays far less than the first one.  If you have a defined benefit pension, however, the idea of working until you are 70 is something only workaholics have to embrace.

So, for all of these reasons, we switched to this new 401(k) and IRA system.   People like to say our government is poorly run and that Congress doesn't know what it is doing.   And likely that is because they listen to the news and hear about all the political grandstanding and meaningless measures that are passed to garner votes for "the folks back home".

But in 1974, Congress created the PBGC and in 1978, they created the 401(k) and IRA programs.  They were looking ahead - quite far ahead.  The idea was, to allow people to self-fund their retirements, using tax-deferred money.   At first, I think this was viewed as a way for people who did not have pensions to save for retirement.  I am not sure whether the drafters of these laws envisioned that Defined-Benefit Pension Plans would evaporate over time.

But that is exactly what happened.   Many companies - and even the Federal Government - realized that Defined Benefit Pensions were impossible to fund properly and were a nightmare waiting to happen.   So one by one, companies switched to 401(k) type plans, at first for salary employees, and eventually, when the unions collapsed, for hourly employees.

1978 was the year I graduated from High school.  The year I entered the workforce, so to speak.  Today, I am 55.  In 10 years, I will reach "retirement age" along with the rest of the "401(k) generation".   Some are already retired and living off the proceeds of their 401(k) and/or IRA.   We are starting to see how this grand experiment in retirement living is playing out.

And it is going to get ugly, and fast.   Why?  While the 401(k)/IRA plans solved many of the problems of the Defined Benefit Pensions (underfunding, vesting, etc.) they bring on a whole host of problems of their own:

1.  The plan is voluntary:   People have to have the willpower to save, and a lot of people chose cable TV, a latte espresso, and a new snowmobile over saving for their retirement.   Average savings in most IRA or 401(k) plans is a paltry amount - hardly enough to live on for a few years at most.

Young people think they need the money "now" and can save for retirement "later".  But due to the nature of compound interest, trying to play "catch-up" is a very expensive proposition.   A dollar put away at age 20 is worth two at age 30, three at age 40, and four at age 50 - or even far more.

And of course, some chose never to save.   Mark had to pitch his company's 401(k) plan to his employees back in the 1990s, and it matched dollar for dollar every dollar an employee contributed.   Most chose not to sign up.  The reason given was that they "needed" every dollar to live on, even as they bought new cars or put bling rims on their old ones.   Of course, they will need money to live on when they retire, but they just chose not to think about that.  People are irrational.
2.  People make poor choices: Others chose to save, but did stupid things with their investments.  They put it all into high-risk stocks and then lost it all.  They put it all in low-paying government bonds, and then got frustrated when it didn't increase in value magically overnight.

Others borrowed against their plans to pay off debts.   During the recession, many folks decided to tap into their IRA or 401(k) to make mortgage payments on their upside-down house - taking away the only asset they had that was protected in bankruptcy.  Not only that, they ended up paying more taxes on their money, due to the 10% penalties for early withdrawal.  Even today, these folks are hanging on in upside-down mini-mansions, and when the 401(k) money runs out, they will be evicted and have no retirement savings whatsoever.  A rational thing would have been to keep the 401(k) and ditch the house.  People are irrational.
3. You can outlive your money:   Even if you save what you think is "enough" money, you can outlive it by either spending it too quickly or just living too damn long.   On the other hand, you save a boatload of money for retirement, die early, and then ungrateful heirs get a windfall.   Not a very efficient use of money, is it?
4. Stock market crashes or inflation can wipe you out:  As noted above, even if you save up a million bucks (which is enough for a $50,000 a year income for 30 years) you may end up wiped out if we have hyperinflation or the market crashes (and you are in high-risk investments, which would be foolish.) 
5.  It forces us to be investors:  Joe Lunchbucket has no idea how stocks, bonds, or mutual funds work.   But thanks the 401(k) plan, he now has to educate himself on these concepts and be an investor in the marketplace, whether he likes it or not.   Again, people may make poor choices.  But it also puts an awful lot of money into mutual funds and investment houses, and this provides opportunities for investment bankers and investment advisers to do a little hanky-panky with other people's money - and all of it is perfectly legal.

Your local "investment adviser" who is "such a nice man" advises you to put all your money into his funds, and he takes a 5% load off the top.  And unless you ask him point blank about this and use the right "Secret Words" he won't tell you what you are paying in fees.   It is like guessing Rumplestiltskin's name.   And I have had this happen to me before, too, and I thought I was a pretty astute guy.  I can only imagine how Grandma is doing.   Have you noticed that "investment adviser" shops are popping up like daisies after a summer rain?   There is one next to each "Curves" it seems.   It is a highly profitable business to be in.

So, the IRA/401(k) concept is flawed as well.  Some are calling for fixes, such as making participation in the plan the default option when you are hired (with an employee having to opt-out if they don't want to participate).  Other suggest making some kind of minimum participation mandatory.

Others, such as the GOP, want to take Social Security and privatize it so even more money is thrown into the stock market - like chumming for sharks.    The problem with this concept is the same problem we are having with the IRA/401(k) plans - people will make bad choices, investment adviser will rip them off, and so on.

Only this time, they can't say, "Well, at least I have Social Security to fall back on!"

So what is the answer?

Well, you can argue about the unfairness of it all and blame Wall Street or the "Fat Cats" or the Democrats or the Unions or the Republicans, or whatnot.   That won't accomplish much except make you feel better, momentarily.

Or, you can deal with the new reality we live in, and realize that it is deadly serious - as life often is.   This isn't fun-and-games, this is your life and your future we are talking about.
The good news is, that even putting aside a few dollars a day, over a working life, can result in huge amounts of money socked away in savings, by the time you retire.   But this does require you to sock away the money, even if it just $5 a day.

And that, in short is how I started this blog.   Like most Americans, I was mired in debt, and thought of my financial life in terms of debt.   I was fortunate that I had saved early in my IRA and 401(k) plans and made some money in Real Estate.  I was lucky or smart or both.  Smart to save money and make money.  Lucky to see that I was driving off a cliff with debt and spending and taking action to correct course before it was too late.

But others - well, I know people my age who are taking out new mortgages to pay off credit card debt.  Folks who tell me they will "work until they are 70" because they have nothing saved.   People in their 50's telling me "I'm thinking I should start saving for retirement one of these days!"

And that is going to be the interesting thing to watch - how this all pans out for our generation.   Our parent's generation lived large in retirement communities in Florida, playing golf every day and never worrying about where the next pension check would come from.  

Some of our generation will do well, having saved for retirement - but will have a much different outlook about money and spending.   When we look at a purchase, it won't be in terms of "how much per month?" but rather overall cost.   And I suspect that $250,000 motorhomes won't be in the picture for most of us, as they were in the past for Defined Benefit Pension types.

But still others - the ones with little or nothing saved, may end up as the new impoverished elderly - trying to scrape by on Social Security alone.  And I have seen that happen and it ain't pretty, I can tell you.

Like I said, it is a grand experiment, and peoples lives are in the balance as to the outcome.


A reader writes:


To your point about the 401k being the new standard. And to think I joined the Guard as a hedge against 401k's.

I suspect in 10-20 years, defined benefit pensions will be no more.   State government unions have kept them going for a long time, but States are facing budget shortfalls as a result.   Something has to give...