In theory, nobody pays you not to work. So why do so many of us have employers who send us monthly checks after we retire?
The answer isn’t as obvious as it might seem. That’s why so many conventional pension plans are in trouble. Too often, neither the workers nor the employer really understand what they are doing.
Retirees aren’t working, so they’re not producing value for their former employers. If their former employers are still paying them, it ought to be for value that the retirees created in the past, while they were still working.
This means workers have agreed, at least implicitly, to accept payment in the future, when they retire, for work they do in the present. In other words, the workers are using the employer to manage their savings.
Why would anyone want their employer to save for them?
It’s tax-preferred. Retirement savings managed by an employer can accumulate faster than savings managed by an individual because the employer gets bigger tax breaks.
Employers may have access to better investment opportunities than do individual workers. If nothing else, they can get better deals from financial institutions.
Most of us probably worry that we’ll spend money that we had planned to save for retirement. It’s harder to squander those savings when our employer has put them away for us.
This, then, is how well-functioning employer-sponsored pensions work. Employees defer some of the money they’ve earned and don’t start receiving it until they retire. Employers manage these funds on behalf of their employees because they can do it better.
What can go wrong?
First, many workers and employers simply don’t understand that retirement savings have to come from deferred workers’ earnings. If employers paid their workers everything they earned when they earned it, and then paid them a pension on top, their workers would cost them more than they were worth. These employers wouldn’t survive, and their pension programs would crash with them.
This has probably happened plenty of times in recent decades. Employers often, if short-sightedly, prefer pension increases to increases in wages and salaries. Pension increases don’t come due until the future, while increases in wages and salaries have to be paid now. Workers ordinarily would rather have higher wages and salaries.
Frequently, the compromise is big pension increases. Too frequently, they’re bigger than any possible deferred earnings. When it comes time to pay these pensions, there’s not enough money.
The second problem is that employers may not save wisely. Even if workers defer enough earnings to sustain the pensions that they expect, those pensions won’t be available if their employers are careless.
This has certainly happened many times in the past couple of decades. For example, many employers assumed that the money they held in their pension plans would enjoy ridiculously high rates of return. Predictably, it didn’t work out that way. These pension plans earned ordinary rates of returns, grew at an ordinary pace, and ended up short when retirements came.
American auto manufacturers are a particularly egregious example. Today, they ask for our sympathy, and even government support, because so much of the revenue from new car sales goes to pension payments. This is just an oblique way of confessing to the spectacular mismanagement of their pension programs. Their pension payments are coming out of current sales because they blithely ignored their responsibility to accumulate deferred earnings.
The third problem is that workers and employers may not understand the true cost of the pension payments they have agreed to. For most of the last half of the 20th century, the “defined benefit” pension was the most common form. In this pension, employers promised workers fixed payments throughout their retirements.
Most employers didn’t anticipate the dramatic increase in the length of retirement that occurred during the same period. Consequently, they severely underestimated the costs of their promises. Even if deferred earnings were enough to pay for the estimated costs of these promises, they weren’t enough to pay for what turned out to be the true costs.
The combination of all three problems – fundamental misunderstanding, careless saving and underestimates of pension costs – puts us where we are today.
So, lots of pension plans aren’t able to make their promised payments – and they turn to the government for help. Some of that help comes from the government-run pension insurance agency, a program financed by premiums paid by the pension plans. To that extent, they are paying to remedy their own mistakes.
But this program makes it less costly, and therefore easier, to make these mistakes. Moreover, the program may not charge enough to employers who have been truly irresponsible with their pension plans, encouraging irresponsibility even more.
The really bad news about this program is that it isn’t big enough. The number of pension plans that are claiming benefits from it far exceeds the number that the plan is able to accommodate. The larger danger is that, ultimately, the workers and employers behind these plans will have the impudence to ask the rest of us taxpayers to compensate them for their improvidence.
The defined benefit pension is just about dead. Employers did such a bad job guessing the cost of a worker’s retirement that they are no longer willing to try. Instead, employers just help workers accumulate their deferred earnings in a “defined contribution” pension and then give it back to them when they retire. Then it’s the worker’s responsibility to figure out how to make this money last through retirement.
Finally, many of us now have a more accurate sense of the uncertainties associated with our retirement prospects. The false promise of security through defined benefit pension plans gave us all an excuse to ignore the true risks associated with life after work: what our preferred standard of living will cost, how far our savings will go, how long we’ll live and how much of our retirements will be spent in good health.
These risks have become much harder to duck. Perhaps we’ll become more responsible about confronting them.
Jeffrey S. Zax is a professor of economics at CU-Boulder.
