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

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    7 Responses to Saving Defined Benefits Requires Lower Pensions for Existing Workers and Retirees

    1. Tough Love says:

      Quoting just this article’s Title …”Saving Defined Benefits Requires Lower Pensions for Existing Workers and Retirees”

      NOW you’re Talking !

      Just insert the word “significant” (e.g., by 50+%) before the word “lower” and it’s PERFECT.

    2. Tough Love says:

      Ed, You stated the following as one of the two distinct virtues to defined benefit plans … “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.”

      I particularly noted your inclusion of the word “guarantee”. While that benefit tends to work for Private Sector Pension Plans because of strict ERISA/IRS funding requirements, it does not work (or works marginally at best) in Public Sector Pension Plans because of the lack of any “required” funding under GASB “recommendations”.

      The actual “funding” of Public Sector Plans is not a legal requirement, but a governmental policy decision, and few governments take that responsibility seriously as evidenced by the almost universal lack of adequate (and sometimes ANY) funding … even of actuarially calculated ARCS woefully understated do to the use of aggressive assumptions (that would not be allowed in similar Private Sector pension Plan calculations).

      • Ed Ring says:

        Tough Love – I couldn’t agree more. Hopefully GASB is going to start making public sector pension funds adhere to the same rules that private sector funds have had to follow. Let’s not hold our breath, however. The challenge for GASB, of course, undoubtedly the topic of intense deliberation behind closed doors, is that if GASB starts regulating the public pension funds the way they should be regulated, the funds will be rendered insolvent overnight. They waited too long. Hence the need for, as you put it, “significant” reductions to pension benefits for existing employees and retirees in order to keep the pensions solvent. By prorating reductions according to proximity to retirement, degree of underfunding, and size of pension (with larger pensions reduced more than small ones), these tough reforms can hopefully be implemented in a humane and equitable way.

    3. Tough Love says:

      Ed, I can’t wait (for the Public Sector workers) pension reform opponents to chime in on your suggested reforms. While financially necessary, and morally defensible, these suggestions clearly violate innumerable Constitutional Provisions, as well as Contractual Rights Provisions, State Regulations ,and Case Law history.

      That being said, how did we wind up with such impenetrable legal barriers to reform PUBLIC Sector Plans when under ERISA for PRIVATE Sector Plans, nothing but the already accrued benefits for PAST service are sacrosanct, and then with amounts in excess of PBGC limits subject to forfeiture when a Company is insolvent and can no longer fund the Plan ?

      Might the reason for these impenetrable barriers be the unholy relationship between the Public Sector Unions and the politicians who make our laws, a relationship that also explains why Public Sector Plans as so VERY VERY generous (FAR FAR in excess of what comparable employees of Private Sector Corporations get), that relationship being the trading of campaign contributions and election support for favorable votes on pay, pensions, benefits, and laws/regulations impacting pension reform ?

      Perhaps these barriers need to be eliminated … so the necessary and appropriated solutions can be addressed.

    4. Tough Love says:

      Ed, Continuing on my thoughts from my last comment above:

      While removing those legal barriers to reform (to the level currently afforded workers in Private Sector Plans) would allow the VERY NECESSARY reductions to the pension accrual rate for FUTURE service of CURRENT workers, and this would stop digging the hole deeper, it would not address the existing underfunding associated with pension accruals for PAST serve (of both those already retired and current “actives”).

      This is a much bigger problem, with all options financially painful to those contributing to the solution. Since FULLY eliminating those options seems highly improbable (if not impossible), I feel that material reform will not occur without a City already being insolvent (and perhaps having already started the bankruptcy process). This is where the many many possible options (a few of which you enumerated) can be hashed out by the various stakeholders).

      Effective discussions mandate a full and accurate reporting of the City’s current financial position, certainly including a 5-10 year protections of revenues and Status-Quo-basis expenses assuming best-guess assumptions as well scenario testing with more aggressive and more conservative assumptions. Such analysis answers the question of HOW DEEP the overall reductions need to be. From there, discussions of how to divvy up these reductions can begin in earnest.

      This is clearly the most difficult part, as even IF there is universal buy-in that reductions are unavoidable, each of the participants will be looking to minimize THEIR contribution. Addressing this complication via outside benchmarks might be helpful.

      A few benchmark categories/questions to consider are: (a) If EQUAL Public/Private Sector “Total Compensation” (cash pay plus pensions plus benefits) is an appropriate goal, is Public Sector “Total Compensation” higher or lower than that of Private Sector workers in comparable jobs. (b) if yes, is it coming from the pension component of Total Compensation, (c) Do the workers get SS benefits, and if not, should we join now, (d) Should we consider the value of retiree healthcare subsidies (very common in the Public Sector but rare in the Private sector) as a basis for lowering OTHER elements of “Total Compensation” (e.g., pension) BELOW what comparable Private Sector workers get (e) Is it the gov’ts obligation to provide a reasonable minimum standard of living in retirement for IT’S workers when such is not the obligation of Private Sector employers, especially when much of the cost of doing so would fall upon PRIVATE sector Taxpayers.

      Indeed it’s complicated.

      More later.

    5. David Peery says:

      very interesting discussion to be sure. I would point out that the finger of blame wagged at unions who use political action to enhance benefits are doing nothing more and nothiing less than Wall Streeters and K-Street lobbyists do on an everyday basis. The problem then could be viewed as one of the general public NOT having anyone dedicated to looking out for THEIR best intersts: Congress? Elected officials—where are you???

      The flaw appears to be in a system that allows people of responsibility (Congress – local, municipal and state officials) who ride herd on the public purse, to “vote in their own short-term interests (getting elected or re-elected) rather than looking out assiduously for the general public’s interests.

      I suppose the problem could even be viewed by some to be the failure of the public to pay enough attention to what their elected officials are doing with their tax dollars.

    6. David Peery says:

      Tough Love said:
      Might the reason for these impenetrable barriers be the unholy relationship between the Public Sector Unions and the politicians who make our laws, a relationship that also explains why Public Sector Plans as so VERY VERY generous (FAR FAR in excess of what comparable employees of Private Sector Corporations get), that relationship being the trading of campaign contributions and election support for favorable votes on pay, pensions, benefits, and laws/regulations impacting pension reform ?

      I would respectfully point out that the relationship between political candidates and their supporters is legal. If you can make a case otherwise please do so. I would argue that the issue is one of human nature and again point out that what public sector unions do is exactly the same as what corporations and wealthy industrialists do when they wish to have their views supported; they lobby in washington and use money to influence legislation they believe favorable to their interests.

      If your target is simply “them damn public union guys” you’re overlooking the bigger problem that is human nature. If you succesfully disarm organized labor you will then have corporate America and its wealthier citizens dictating to Congress instead of at least having a little bit of a horse race about it with what’s left of organized labor.

      Just so you’ll know, I am a retired public sector retiree whose social security entitlement is already reduced by my public sector pension (windfall eliminations provision). Many of my active brothers and sisters don’t even have social security elegibility. You should keep that in mind when trying to make decisions regarding potential changes to current and future pension benefit changes.

      And one must also point out that our pension rights are codified in law. If you find some of those laws inconvenient and wish to change the provisions of those legal contracts unilaterally after the fact perhaps you should ask yourself why anyone would wish to continue honoring a contract that they feel is no longer in their self interest?

      If you have a current mortgage on a home whose value has plummetted in value drastically perhaps you would then support the right of the mortgagee to simply walk away from the contract?

      Who gets to decide what laws are no longer binding? And based upon what criteria?

      I would make the observation that the contracts that were agreed to were negotiated between duly elected/appointed representatives from both sides of the issue and reviewed by numerous attorneys, actuaries and others.
      I would suggest that any changes should be made to the process in the future, not made retroactive unilaterally.

      The fact that unions and their members are being blamed for representing their interests to the best of their ability. If that is considered wrong, why then do K-Streeters and their minions wield the level of influence that they appear to do?

      One facet of the problem is that unions who support political candidates provide their support in the here and now. The politicians often delay the repayment in “future benefit enhancements” that only come due in the future. They will have their pound of flesh now and the other beneficiaries to those bargains will have to await the future to enjoy their part of the bargain.

      Unfortunately, those same politicians often fail to adequately provide the necessary funding to meet the obligations that they agreed to.

      I would agree that there is a problem. Again, I wish to point out that hobbling organized labor without providing the same checks and balances for those who willingly agree to valid contractual pension/benefit agreements as well as those at or near the top of the economic pyramid is missing the underlying issue of human nature that far too often adversely impacts the interests of a majority of the citizens of this great nation.

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