How Much Should the Young Pay for Yesterday’s Underfunded Pension Plans?

Recent stories about Chicago’s pension crisis represent only the latest in a long series of announcements about poorly funded state and local pension plans. Detroit’s declaration of bankruptcy shows one possible consequence of such neglect, with many of the city’s retirees fearing drastically reduced pension payments. This isn’t the first time that retirees and workers have found their financial stability threatened, either: many private pension plans have failed in such industries as steel production and airlines.

While there’s often no easy or right answer for who should pay for these uncovered burdens, as a society we’ve pretty much decided that in this arena, as in so many others, the young should get the shaft.

Often poorly funded or badly designed to deal with risk, many pension plans need only some catalytic economic change, whether from greater competition or an economic downturn, to start sinking rapidly. A promise for the future, underfunded from the past, shifts liabilities forward in time, where they get passed around like a hot potato. No one—employer, worker, or taxpayer—wants to get burned with the cost of past mistakes, or even part of it. But the money that should have been set aside has long been spent, so someone at some time must cover the shortfall.

Consider why government or private employers underfund a plan in the first place. In a private plan, underfunding allows higher wages to current workers, bonuses to top managers, and cash withdrawals to partners and dividend recipients. In a public plan, elected officials can give higher current compensation to workers or more services to the population while letting taxpayers off the hook–temporarily, of course.

When people see this inadequately supported edifice begin to crumble, they make a run on the bank. Given the increased threats to future wages, job security, and dividend payments, everyone has an incentive to get what they can while the getting is good. Keep wages up as long as possible, even if that means further weakening pension plans. Increase those bonuses to top managers, who suggest their skills are needed now more than ever to dampen the firm’s or agency’s fall. Lobby Congress and state legislators to allow employers to defer better funding of their pension plans so these other cash outflows can continue. And maintain pension payments for current and near-retirees regardless of the hit on those not yet retired.

Traditional actuarial calculations—the formulas by which actuaries determine whether employers adequately fund their plans—make matters worse. These formulas often allow employers to play Wall Street with their pensions. A firm or government borrows at low interest rates on one side of the ledger, then invests in riskier assets with higher expected returns on the other side. Even dodging the question of when such practices generally make sense, employers often push their actuaries to use outrageous assumptions about rates of return on those risky assets.

For instance, many state and local governments today assume a return of around 8 percent on a mixed portfolio of bonds and stocks in a world where interest-bearing bonds often yield only 3 or 4 percent at best and the earnings-to-price ratio (the effective rate of return earned by corporations relative to the price of their stock) is about 6 percent in real terms. If these employers want to play the markets with their pension plans, then the plans should be overfunded enough to handle the risk. Alternatively, governments and firms should make their projections assuming a less risky but lower rate of return. If the risk-taking strategy works, then future (not current) funding payments can be lowered.

When the firm or government declares bankruptcy, many bondholders, pensioners, and remaining workers deserve sympathy. Certainly the retiree who might have to rely on less than expected, the bondholder who accepted a lower rate of return in exchange for what she thought was a less risky investment, and the taxpayer who often gets caught covering everyone else’s problems. Sometimes these are the same people who benefited from the excessive payments (made possible, first, when inadequate funds were put into the pension plan, and then, during the delay between recognizing the problem and taking some later action such as bankruptcy). But often they are not.

While these claimants may battle each other, they almost always collude against the young. The use of unreasonable actuarial assumptions establishes this pattern by forcing future workers and taxpayers to cover shortfalls. In addition to covering some of those losses, new workers for the state or the firm, if it survives, will be granted far fewer pension or retirement plan benefits than even current workers, not merely those already retired.

Unequal pay for equal work becomes the new standard. Age discrimination against the old is illegal, but not the young. State pension plans now typically provide tiered benefits, with successively lower benefits for newer workers. In fact, states are now starting to provide negative employer benefits to the young by giving them back less in benefits than their contributions plus some modest rate of return.

The same holds in different ways in private industry. We are all familiar with the higher cash and pension benefits being paid to older airline pilots and automobile workers, among others. Almost no one addresses the consequences for wealth-building, including retirement adequacy, for today’s young. That’s tomorrow’s problem.

Or is it? Seems like we’ve heard that claim before.

2 Comments on “How Much Should the Young Pay for Yesterday’s Underfunded Pension Plans?”

  1. There has been too much in the way of actuaries saying a pension is underfunded so that the investment management side of the firm can earn money managing individual retirement accounts. Ideally, employees should be able to invest in insured employer voting stock accounts (with a third of the holdings in an insurance fund with other employee owned firms). The contribution to each employee should be equal – both in terms of a private pension and contributions from personal retirement accounts carved out of the Social Security employer contribution. Such contributions must be decoupled from income so as to not be counter-motivational to more junior and lower level employees.

    As for cities like Detroit, they should have been included in Social Security from the start – with or without an additional pension plan. Then the failure of the pension plan would not leave retirees destitute – nor would it be so large that it would be likely to fail. Any bailout should include Social Security buying out some or all of the pension plan and covering its retirees and workers. Quite a few cities and states need to do this. They talked about it during the Clinton conference on Social Security and it is sad it did not go further. We can blame Newt for shutting down the government and leaving Clinton with a certain female intern for why there was no good will to bring this forward.

    The most important thing about pensions and the young is that life is a Ponzi scheme – so you must always try to have more people in the next generation – and not poor people either. Welfare should be transformed to a paid education program (with a $12 per hour wage – which should be the new minimum) with a $500 per child per month tax credit, plus a matching state credit based on the cost of living in that state and health care through the education provider – the same plan that employees get. Workers should also get the child tax credit – which would likely both decrease abortions and increase the number of children. The more children you have, the less a burden pensions will be. Indeed, even a fully funded pension holding stocks requires that someone work for those companies and as importantly buy the products so that the stocks give some kind of return. We cannot rely on foreign labor forever, as they will soon demand more consumption than export and will resist funding the profits of overseas firms. We need our own children and that means paying people to have them.

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