By: Richard Shea
Richard Shea is an attorney and Chair of the Employee Benefits and Executive Compensation practice at Covington & Burling LLP, an international law firm headquartered in Washington, DC.
What’s wrong?
As the Baby Boom moves into retirement, confidence in our retirement system is waning, for good reason. Plan sponsors, including public and private employers, are rapidly freezing their defined benefit plans—those that promise a guaranteed level of income in retirement—by closing the plans to new hires or stopping current employees from earning additional benefits.
When legally permitted to do so, some plan sponsors are even cutting back benefits employees have already earned. Municipal pension cutbacks growing out of the Detroit bankruptcy offer one recent example where previously earned benefits already have been cut. Congress provided another example late last year when it authorized severely underfunded multiemployer pension plans to reduce previously earned benefits of collectively-bargained employees. Meanwhile, Washington is awash in proposals to cut back, tax away, or means test Social Security old-age benefits whenever a political opening makes that feasible.
At the same time, employees who are lucky enough to be in an employer-sponsored retirement plan—roughly half the U.S. workforce—increasingly find themselves in defined contribution plans, such as 401(k)s and 403(b)s. In contrast to defined benefit plans, these newer plans do not promise a guaranteed level of income in retirement. Rather, they typically permit employees to contribute their own money up to relatively modest limits to an individual account (sometimes with a modest contribution from the employer), to direct the investment of those contributions among a menu of market options, and to make withdrawals from the accumulated balance in retirement.
Despite recent improvements, many employees are nervous about whether defined contribution plans will provide them a secure retirement.
For one thing, many individuals lack the financial acumen to effectively manage the investment of their savings before they retire. More challenging still is the prospect of managing these investments during retirement when they also must decide how quickly or slowly to take distributions over their own unpredictable remaining lifetimes. Not surprisingly, many individuals have doubts about whether they’ve saved enough in their defined contribution plan, whether their savings will be ravaged in the next economic downturn, whether there’s a place to invest their savings that’s safe yet earns a return sufficient to beat inflation, and whether their money will last until they die.
How did this happen?
How did we—one of the richest and most financially savvy societies in history—come to this juncture? The answer lies in how our retirement system allocates risk and fails to be creative about new ways to structure retirement plans.
As currently organized, the American retirement system allocates most of the major retirement risks either to plan sponsors (generally, employers) in defined benefit plans, or to individual participants in defined contribution plans. Typically in defined benefit plans, the plan promises a guaranteed level of retirement income, regardless of how well the plan’s assets perform and how long participants live. As the party responsible for funding the plan, the sponsor bears all the risks of providing the plan’s retirement benefits. If plan assets perform poorly and are insufficient to meet the plan’s projected benefit obligations, the plan sponsor sooner or later must kick in additional money to make up the shortfall. Moreover, if participants outlive their projected life expectancies, the sponsor will need to make additional contributions to fund the extra payments.
In the wrong circumstances (such as over the past 15 years), these shortfalls can become enormous and quickly swamp the sponsor’s ability to pay. For a large company or municipality such shortfalls can easily reach billions of dollars; for a large state tens of billions; and for the federal government hundreds of billions, if not more. Not surprisingly, many plan sponsors have concluded that they are either unwilling or unable to continue bearing risks of this magnitude. If governments with the power to tax are increasingly turning away from defined benefit plans, it is hard to fault private employers—that, after all, have to earn their money the old-fashioned way—for doing the same.
When a plan sponsor turns away from a defined benefit plan, it has little alternative but to rely on a defined contribution plan to provide retirement benefits under our system. Yet defined contribution plans shift the capital market, longevity, and inflation risks to the other extreme, laying them entirely on employees and retirees. While a plan sponsor can join with participants in contributing to their individual accounts, there is no guarantee that any particular level of retirement income will be payable. This is because a participant’s benefit is limited to what his or her account balance will buy. When the investments in the account do poorly or the participant lives “too long”, the benefit payouts can shrink or even disappear. Yet individual participants are often in the worst position to manage these risks.
What can we do about it?
The extreme bipolar allocation of risk in our retirement system described above has become increasingly dysfunctional. The assumption that plan sponsors must assume either all or none of the major risks of providing retirement benefits is driving many of our largest institutions—both governments and businesses—from assuming any retirement risks at all and causing them to shift those risks entirely onto individual participants.
An obvious alternative would be to share those risks rather than shift them. Many plan sponsors are capable and probably willing to share some of the risks of providing retirement benefits, just not the extreme level required of them under current defined benefit plan designs. Furthermore, most individuals would gladly bear some retirement risks, especially if they were relieved of the extreme level of risk imposed on them by current defined contribution plan designs.
What’s standing in the way is our collective conception of how retirement plans are supposed to work.
In fact, so-called “shared risk” pension plans have been functioning smoothly in other countries for some time now. For example, the Swiss equivalent of our Social Security system includes a simple risk-sharing mechanism; because of it, the Swiss enjoy among the world’s highest standards of living in retirement with a social security system that is fully funded. Other countries, like Denmark and the Netherlands, have taken slightly different approaches to risk sharing, but with much the same result. And new designs have been developed here in the United States that offer important possibilities for our retirement system going forward.
In future blog posts, I’ll explore the pros and cons of these various shared-risk pension plan designs, which are out there for us to consider here in the United States. Stay tuned!
NOTE: None of the above is to suggest that we get rid of the many existing defined benefit and defined contribution plans that, through careful design, professional management, and some good luck, continue to operate smoothly for their sponsors and plan participants. After all, “if it ain’t broke, don’t fix it.” The point here is not to take away options plan sponsors already have. Rather, it’s to add new ones, so that sponsors and participants have more alternatives available to them to build less risky retirement arrangements that are sustainable for both sides over the long term.
This piece was originally posted on June 25, 2015 on the Pension Research Council’s curated Forbes blog. To view the original posting, click here.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.