TCS Daily

Good Riddance to Traditional Pensions

By James K. Glassman - January 13, 2006 12:00 AM

IBM announced last week that it would freeze the old-style pension plans it provides to more than 100,000 employees and instead offer an improved version of its 401(k) plan. This is no run-of-the-mill accounting change or cut-costing measure. It is a major philosophical and economic shift for a bellwether corporation.

It means, in short, that International Business Machines is moving away from paternalism and giving workers more control over their own retirements. The U.S. government should do the same in reforming Social Security.

The IBM decision is good news as well for taxpayers, who ultimately could be left holding the bag if the Pension Benefit Guaranty Corp., a federal institution that insures pensions, can't meet the obligations of overextended companies.

Of course, IBM is in no danger of becoming the next Delphi. At last report, it had revenues of about $100 billion, after-tax profits of $8 billion and loads of cash. IBM's pension plan, with $48 billion in assets, is robust. But 40 years can pass between the time someone joins a company and the time he retires. Things change, as GM employees now know. It makes far more sense for workers to carry their retirement assets on their own backs, rather than counting on the company to ante up decades later.

There are two kinds of pensions. Defined benefit (DB) plans, or traditional pensions, involve a promise from a company to provide monthly checks to retirees at a specific rate, depending on how long they worked and at what salary. DBs are headed for the dustbin of history -- and good riddance. There were 112,000 of them in 1985 and just 29,000 today.

Second is the defined contribution (DC) plan. Its paradigm is the 401(k), named for an IRS provision. A quarter-century ago, 401(k) plans began sprouting. Some 43 million U.S. workers now have them.

A 401(k) allows workers and employers to put pre-tax income into an account that's mainly composed of mutual funds (IBM offers more than 200 choices). Dividends, interest and capital gains pile up tax-deferred, and the account is owned by the worker. IBM's 401(k), with $26 billion in assets, is the nation's largest.

IBM says that, starting Jan. 1, 2008, it will freeze the DB benefits of current workers and instead enhance the DC plan. New hires go straight to the DC.

Under the new 401(k), IBM will match, dollar for dollar, employee contributions of 6 percent of pay (the match is now 3 percent) -- and, in some cases, up to four points more.

This is not altruism. IBM figures it will save about $500 million a year through the changes. Probably more important, however, the company gains certainty (the funding requirements of DBs fluctuate), and it provides workers with a stronger sense of responsibility and more confidence in a comfortable retirement.

Some disagree. Lee Conrad, a labor organizer, said after the IBM news: "Employees are going to be losing out on all kinds of benefits. You've got to wonder what's going to happen to the next generation of workers."

No, you don't. A study released last September by the Employee Benefit Research Institute and the Investment Company Institute found that Americans do a fine job with their 401(k) plans. Even with the rotten stock-market conditions of the early 2000s, the average account balances of 401(k) participants rose about 40 percent, to $91,000. And remember, these workers still have two decades to retirement.

Employees have, on average, two-thirds of their 401(k) money in stocks -- an appropriate share -- and they are investing more in "life-cycle" funds, which shift to bonds as retirement nears. Loans from the plans are modest and declining.

More financial education wouldn't hurt, but DC plans are working exceptionally well, and complaints that people are too stupid to manage their own money are dead wrong. After all, a record 69 percent of Americans own their own homes -- a far more difficult and risky purchase than the slow accumulation of mutual fund assets over 40 years.

IBM's decision offers a good model for reforming Social Security. Let new workers waive Social Security taxes and benefits and choose a 401(k); let current workers freeze their benefits and pay lower payroll taxes while boosting their 401(k) as a substitute. The U.S. government will have a sounder fiscal future when, like IBM, it stops treating adult American workers like children.



When I agree with Glassman,I'm usually wrong
This time, like a blind squirrel, he found an acorn. Nevertheless, he (you) passed over in silence at least one salient point: pensions were generally the subject of some bargaining whereby workers agreed to defer receiving some of the value of their work in exchange for a commitment on the part of management (owners) to pay them later. Now employers are saying: "We lied"; and having that confession blessed by the courts made up of those rich enough to have attended law school.

Workers relied on these promises and now often find them to be sweetness wasted on the desert air with no more value than that.

Government's particularly cowardly yielded to the promise of furure benefits because they could take credit for improved services and leave the piper to be paid for by another more hapless govenor later.

Even Social Security plays this "Now you see it, now you don't" game by reducing pensions that were previously earned by retired government or retired military because they earned a pension elesewhere. I worked two jobs; okay, one was a government job; to make sure that I earned enough to receive a benefit from my earlier contributions to social security.

Unfortunately, I now find that much of my social security entitlement (sic) has been untimely ripped away from me.

Good riddance to such judges.

Reality check time
Private pension funds may indeed – after decades of creative accounting – be unsalvageable, but don’t expect private investment in 401(k) and IRAs to make up the difference for middle class Americans.

In 2003, the median (a more realistic measure than the average quoted above) 401k account balance for Vanguard 401k participants 55 and over (presumably, those who had the longest period to invest and the highest balances) was about $46,000. One rule of thumb is that a retiree in their late 60s should withdraw no more than 4% of principle a year, so the median 401k will provide an income of around $150 a month.\

And the hope that average investors, left to their own devices, will do better - or even remotely as well - as pension funds is strongly contradicted by actual experience. For example DALBAR’s Quantitative Analysis of Investor Behavior (QAIB) has been tracking such returns since 1984, and as of 2003 the average equity investor had earned 2.57% annually; compared to inflation of 3.14% and the 12.22% the S & P 500 index earned annually for the last 19 years – relative to inflation, they lost money during one of the best market decades in history, a time when simply putting their money in an in an S&P 500 index fund and waking away would have returned better than 10% annually net of expenses (!)

And it wasn’t just that they were incompetent stock pickers, their timing in the purchase and sale of fixed income investments was highly inppoertune as well, the average fixed income investor earned 4.24% annually; compared to the long-term government bond index of 11.70%.

In any case, even given market returns for median income families the disposable income just isn’t there to save for sustainable retirement income while maintaining anything like current consumption patterns– do the numbers and you will discover that the median middle class American family, were they were saving at a level which could fund retirement entirely out of SS and private investment and savings, would be moving into a trailer, eating rice and beans, driving a 12 year old Toyota Corollas, and taking their vacations at a local park bench – which would, for starters, crater the ecconomy.

The problem is that ever component of a viable solution is unattractive:

1) You need to force people to save, and to start saving young.

2) You need to enforce some parameters on the sort of investment allowed.

3) You need to enforce some controls on the administrative costs allowed.

4) Beyond that, a lot of the realistic investment choices are going to be politically and socially unappetizing to a lot of the participants, for example overseas investment.

All this stuff is anathema to mnay readers here, but unless we are willing (and more to the point, it’s politically viable) to allow large numbers of people to spend the last few decades of their lives in abject poverty, we don’t have much choice.

Otherwise, one way or another, the rest of us are going to end up paying for the poor choice made by people who don’t start saving until late in life, invest in anti-gravity, moon-cheese and Enrons, are hornswaggled into paying 5% management fees, and insist on investing only in the US.

the money has to come from somewhere
If people get more money from pensions than if they invested it themselves, then where does the extra money come from? Either the company contibuted more to the pension than (in the case of this article) the 401K, or the pension plan basically screws people that die in favor of those who live.

I'd rather have the ownership of a personal account than the promise of a pension if I manage to live long enough ... even if the pension would have provided more money in the end.

If someone likes the pension model, they can buy long-term care insurance or some other similar product.


The Pension Mess
The pension mess has been DECADES in the creating. Having spent over five years in the late 90's researching every imaginable ERISA and Tax requirement of pensions as a compliance analyst, I've come to some conclusions.

When industrial America was immersed in the hubris of its own permanence, it figured out that it could buy off workers and their idiot "representatives" in organized labor with pension promises instead of equity interests that they might otherwise demand, where benignly remote trustees would rarely interfere (exception: in recent times, CALPERS and a few other activist funds) with the operation of the company, so long as they received a return that could be justified in the event of a suit for breach of fidicuary duty.

Of course back then, an employee often was developed and trained by the company, therefore they wanted to retain their investment, so it paid to create pensions that encouraged you to stay.

The seeds of the current problem date not to IBM, but Studebaker. When Studebaker failed in 1962, it resulted in a 12 year fight over pensions, which put the (Employee Retirement Income Security Act or ERISA) legislation on Gerald Fords desk in September 1974, precisely because he had no political capital to oppose it.

ERISA did little more than codify common sense and traditional trustee duty, its been wonderful for lawyers who specialize it federal benefits law, especially since it added on to the still-existing tax laws that cover pensions without harmonization. Hence, the Department of Labor and the IRS have completely different definitions of what is a "highly compensated employee". It was truly effective at creating a myth of the impossibility of insolvency. Like the FDIC that covered banks, it propped up the industrial pension system by adding federal guarantees to the risk of corporate failure.

But consider a pension:

Its a concentration of assets. It artificially encourages an employee to attempt to stay with one organization as long as possible, even though full vesting has been gradually required to be given over shorter periods of time. Without differing work experiences, the 55 year old employee whose company restructures is seen as stale and rigid. Nonetheless, I can't ever imagine living as well in retirement without worry like my relatives who put in 30 years with "MA BELL".

its a complete surrender of control of a significant part of ones assets. Money is sucked not into building small business but into publicly traded enterprises on public markets-where it is often observed that the least job growth and most anemic employment growth comes from.

Finally, it encourages the idea that wealth consists only of financial assets. The wealthiest people are those who have children to assist them in their older years, not those with the biggest balances in their portfolio. when you are 85-if you make it that long- and suffering severe arthritis and/or dementia, you'd be a damn bit better off having had a couple kids (granted no guarantees they'll be readily willing and able to help)than accumnulating a few hundred thousand more in your portfolio..

pension plans
Unlike Social Security, pension plans are invested.
So it is possible for them to pay out more than is paid in.

Re: The wealthiest people are those who have children to assist them in their older years, not those with the biggest balances in their portfolio.

Children are important as sources of companionship and practical assistance for the elderly, but don’t look to children to provide very much in the way of financial support from them as most families cannot afford to do so and also raise children. Putting the burden directly on the children of the elderly (besides being unfair to those who for various cannot or do not have children) is a recipe for creating a birth dearth in future generations that will make Europe’s low birth rates look positive fecund by comparison.

Pensions and government
There are a number of problems with pension plans and needed government policy tends to make these worst.

For example, there are two federal agencies responsible for overseeing pension contributions, Labor and the IRS. Labor tries to increase pension contributions in order to maintain the solvency of such funds while IRS tries to limit these tax deductible contributions in order to keep tax revenues high. In times of market advances, responsible corporations will be limited in making contributions precisely at the time they can best afford to because paper gains indicate that their plans are funded. In good times, short sighted companies are tempted to use these funds, often to subsidize early retirement buy out plans. When the market turns, as all cyclical markets do, excess paper gains are erased and companies are forced to come up with additional contributions precisely when economic conditions are adverse.

The author mentions the PBGC. When companies terminate under funded pension plans, the PBGC guarantees certain minimum levels of benefits. In order to meet these obligations, the PBGC often asks Congress to raise premiums on all companies with defined benefit plans. Recently, the House passed a bill raising these premiums from $19 to $30 per participant in fully funded single employer plans with an additional variable premiums based on the amount a plan is under funded. A company such as IBM is not likely to default on its obligations but is forced to subsidize those companies that do. Plan participants include active employees, vested former employees and retirees. PBGC insurance is a vast improvement over the pre-ERISA system but its ever increasing premiums – after all, increasing insurance costs have to be spread over the population – make pension plans less attractive to companies. Even after freezing their plan, IBM will still be liable for these premiums for the fifty plus years the current plan participants are alive.

Glassman article on Pensions
I have been in the employee benefit consulting field for over 20 years. My company works with employers on administering both pension and 401(k) plans. 401(k) plans were originally intended to supplement, not replace,
pension plans. 401(k) plans are fine for senior, highly compensated people (who can supplement any shortfall in
retirement). But the low to middle income people get totally screwed.
Glassman's article "Pensions of the Future" is filled with so many inaccuracies as to be almost laughable. I say almost laughable because this is no laughing matter: the elimination of future accruals under defined benefit (DB) pension plans will result in future financial disaster for many workers. These workers will approach retirement age, only to discover they must continue to work because they
cannot afford to retire on their frozen DB pension (if they have one) and 401(k).

Glassman makes the same erroneous claim that many rich CEOs make: Replacing DB pension plans with 401(k) plans gives workers "more control" and is therefore a good thing. This is a smoke screen.

Glassman claims that pension plans require workers to count on the company to "ante up" decades later when the worker is ready to retire. Actually DB pensions are required by law to be prefunded throughout the worker's
entire career. One of the reasons employers are eliminating pensions is that the IRS and federal government have made the DB prefunding rules too
restrictive and complicated, and these rules have prevented employers from contributing more during "boom" periods. Legislation is pending in Congress to try to fix this.

Unfortunately Congress might be too late. Glassman claims DB pension plans are headed for the dustbin of history, and sadly, he may be right on that point. Glassman further says good riddance to DB plans, and he could not be more wrong.
Glassman quotes an IBM Labor Organizer who said employees will lose out, and you have to wonder what will happen to the next generation. The labor organizer is absolutely right, except you do not have to wonder: the next
generation will have a 401(k) account that is worth significantly less in value than if IBM had continued the pension plan.

Glassman points out that IBM will save about $500 million each year by freezing the pension plan and enhancing the 401k plan. That is $500 million less of prefunding, per year, that would have gone towards retiree DB pensions. No matter how Glassman (and rich CEOs) try to spin this, this
is not good for employees.

Glassman claims to disprove the Labor Organizer's claims by referring to a survey of 401(k) plans. This is ridiculous. First of all this only includes those workers who chose to participate in a 401(k), by electing
to contribute a percentage of their pay. This survey excludes employees who do not contribute, they do not get any employer 401(k) matching contribution. Typically pension plans include all full time employees who
attain age 21 and 1 year of service. Typically, for non governmental employers, no employee contributions are required to partcipate in a pension plan. All employees automatically participate in a pension plan.

Glassman claims IBM's replacement of the pension plan with a 401(k) provides workers with more confidence in a comfortable retirement. Really? The company will be paying $500 million per year less towards benefits,
but the employee will be more confident in a comfortable retirement? This claim makes no sense.
Glassman claims all of this is reason for the government to reform Social Security. Social Security is a much more complex system than an employer's pension or 401(k) plan. Glassman proves a little knowledge is a dangerous thing. To claim a move away from a DB pension to a 401(k) plan treats workers as adults is misguided at best and ignorant at worst.

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