Ah the Pension. A long sacrosanct retirement vehicle known for its rigidity and stability. The anchor that led many American's into a comfortable retirement. That was, until the late 70's early 80's when a few pieces of legislation dramatically changed the retirement planning landscape and gave way to a new (and much cheaper for some people) focus to retirement planning.
We'll ignore all of that for a minute, and instead focus on what exactly a pension is, and then come back to why it has sort of gone the way of the dodo.
You may wonder why anyone would go through the cost of offering a retirement plan at all. What with all the expenses associated, why on earth would I (the bourgeoisie) impoverish myself to brighten the retirement prospects of the proletariat (ok I'm done with the Marx references)?
Well, ignoring for a minute that modern day retirement paradigms are more a function of someone's inability to recognize that you have to adjust for all the variables, lets talk a little bit about incentives.
Most of the people who read this blog have a job that they perform on a regular basis for which the remuneration occurs. No matter how much we'd like to pretend, if it weren't for the paycheck, we wouldn't do what we do everyday (at least not to the same degree). Most of people can empathize with the notion that paychecks keep them coming back.
Now lets take this a step further and look at from a more strategic stand point.
Some of you may work at your current employer because you really like the atmosphere (i.e. the people). A lot, however, would leave at a moments notice if the gate opened to a new pasture with greener grass.
Statistically, this becomes even more likely the higher up the talent ladder an individual tends to be. “Shirking,” as its sometimes known, is a relatively costly problem.
So, as a way to induce loyalty (or at least keep fannies in chairs) employers have employed various benefits packages to attract and retain quality talent.
Now that we have some vague idea as to why someone would offer you a retirement plan, let's dive into the details of how pensions work. For this, we'll need a little bit of math, and some labor economic theory (run and hide now).
First, let's understand that there are two types of retirement plans, and they are categorized by their “focus” (huh?). The two types are Defined Benefit Plans and Defined Contribution Plans. So in a defined benefits plan the focus is on the benefit that will come out of the plan and on a defined contribution plan the focus is on the amount that one puts into the plan. Pensions are defined benefit plans. Remember in Brantley's last post we pointed out that for years retirement planning was a function of planning an income, and working backwards; this is the quintessential element of a defined benefit plan.
What the pension does, is work out a required contribution on the employees behalf given an assumed investment rate of return within the pension fund to get to a future value that will support the required income stream.
How do they determine the income you ask? Companies that employed pensions typically had a wage curve that had a schedule of appropriate wage levels based on 1.) the job 2.) the employee's age and 3.) the amount of years on the job. For example the director of product development commands a higher wage than a rank and file customer service employee and being on the job pays better in year 10 than in year 1.
Pensions use a formula to determine retirement benefits. The actual equation varies, but in a lot of circumstances it is a function of years of service and average income over a certain period (now you know why those wage curves come in handy).
Pensions plans are non-contributory on the behalf of the employee. All of the required funding is fronted by the employer. As a way to further retain talent (and retain some expenses) Pensions plans have vesting schedules. A vesting scheduling is a required period of time you must remain employed to have “full participation” in the plan. In other words, after becoming fully vested, you do not forfeit your benefits if you leave. Terminating employment for any reason prior to become fully vested in a plan means you will forfeit some (or all) of the benefits made on your behalf.
So now that you have a little better understanding of the mechanics. Let's back it up and try to make it so easy a man or woman from the Paleolithic Era could do it (I'm into averting the use of trademarks at the moment, we'll explain why in the very near future).
The pension simply looks at your income situation and makes an assumption about your likely earnings through your entire working years (remember the wage curve). It then makes an assumed income stream requirement based on the formula the pension uses to calculate required benefits (it's a defined benefit plan, so it's driven by the assumed benefit).
The required benefit will be based on an assumption (usually a really big life annuity akin to a structured settlement). So, the calculation is what is the future value needed to provide his benefit based on the life annuity payout (sound familiar?).
From there, the plan calculates the required contribution that the employer must make based on an assumed interest rate, in order for the pension trustee to generate enough money (through the pension trusts' investments) to create the future value required to generate the guaranteed income benefit. This is how pensions operate.
In 1978, something magical happened. Americans were looking for a way to defer taxes on their income. Investment vehicles existed, but none of them quite fit the bill. Keep in mind that the highest marginal income tax rate at the time was 70%.
So, the Revenue Act of 1978 amended the tax code and established IRC 401(k). This was the work of genius. The pitch was simple. Americans needed some vehicle to complement their pension benefits.
Despite the push for a plan to shelter income from taxes, the newly approved plan took a few years to take form, this was due in large part to regulation that prevented plans from starting until 1980. Major employers didn't roll out 401k plans to their employees until around 1982. But once it came about happy days were here…but not to stay
With a new plan in place to receive funds from high income earners who wanted to defer their tax liabilities (there was this guy running for president who talked a lot about lowering taxes) 401k's became a great place for higher climbers of the corporate ladder (they had the income) to throw in several thousand dollars and avoid income taxes on the income.
In fact, the issue became a slight “oops, we didn't see that coming” moment and Congress promptly acted establishing Non-discrimination Testing as part of the Tax Reform Act of 1984.
Well it was fun while it lasted…
At some point, someone somewhere made an incredible observation: the cost of these 401k plans…they are dirt cheap.
Remember in our last post about turning your retirement plan into a pension we used a 4% rate of return to make a $60,000/year income after 32 years and required nearly $15,000/year in contributions. If you double the assumed interest rate to 8%, the required annual contribution falls to a little over $6,000/year (and not one would do something ridiculous like assume more than 8%).
So, for the 30's something employee whose pension benefit is assumed to be $60,000/year at retirement I have to commit to something in the neighborhood of $6,000/year. Think about what happens if I have a a few hundred employees.
What if instead, I decided retirement was their responsibility and swapped out the pension for just a 401k plan? It wasn't the original intent for 401k plans, but whatever.
Now my commitment is what?
Well, today there's sometimes a match (but there wasn't always) so using today's benefit maybe $1,800 (assuming a 100% match up to 3%, which is the most common). Keep in mind this is optional (I don't have to offer a match) and not all employees will actually contribute.
The pension required that pretty much everyone who was full time had to be part of the plan.
Plus, I don't have to pay for a dedicated actuary to the pension (yeah I didn't explain that above, but trust me it's not worth getting into), and the TPA/Trustee fees are incredibly lower for a 401(k). In fact, I can pass those costs onto the employees if I don't want to pay them.
Oh, and if it turns out the assumed rate of return is incorrect (i.e. the pension trustee doesn't do as good a job managing assets as we thought) I don't have to go back and make up the difference for the shortfall, because there is no guaranteed benefit as part of a 401k. Remember a 401k is a defined contribution plan not a defined benefit plan.
When the board gets together next week to talk about cost savings measures, this idea might just be worthy of placing me in first place as candidate for CEO.
We talked a little while ago about failing pensions. What's worse is that employers who have forsaken the pension plan have forsaken the maintenance of the plans they put in place for employees. They are guaranteed by the Pension Benefit Guaranty Corporation, but it turns out that a lot of assumptions concerning cost, length of benefits, and investment yields were a little off.
There are a lot of reasons why the standard pension that grandpa and grandma are benefiting from today didn't make it through the 90's. Some of it has to do with mismanaged expectations about cost and investment return. But others have to do with a certain unscrupulousness we have as Americans (topic for another day).
Here's the best advice we can all take away from this.
For years, individual retirement planning followed the same foundational features of pension plans. We began with the end in mind.
Certain pieces of legislation have made some of this a little more difficult, but the end game should still be the same. Assume a retirement cash flow, low ball your rate of return (if I assume 5% and get 8% that's a lot better than assuming 8% and getting 5%), and figure out your required contribution. In other words, save with a purpose not just because someone told you it was a good idea.
The number you need to save might be daunting. Might even be unreasonable given your circumstances. Doesn't mean you run away. It means you do something to figure out how your going to deal with it.
And the best idea on how to deal with your retirement savings shortfall? That's coming next week.
I'll see you all then.
Brandon launched the Insurance Pro Blog in July of 2011 as a project to de-mystify the life insurance industry. Brandon was born in Northern New England, and he currently calls VT home. He attended Syracuse University and graduated with a triple major in Economics, Public Administration, and Political Science.