Ten Steps to Reforming Baby Boomer Retirement
Thursday, March 23, 2006
by John C. Goodman, Devon Herrick, Matt Moore
Table of Contents
- Executive Summary
- Step 1. Improving Traditional Pension Plans
- Step 2. Improving 401(k) Plans
- Step 3. Expanding IRAs
- Step 4. Removing Penalties on Work
- Step 5. Repeal the Social Security Benefits Tax
- Step 6. Using the Roth Method of Taxation
- Step 7. Making Health Insurance Portable
- Step 8. Tax Relief for Post-Retirement Health Insurance
- Step 9. Creating Health Savings Accounts for Seniors
- Step 10. Paying for Long-Term Care
- About the Authors
Step 1. Improving Traditional Pension Plans
Since World War II, the dominant form of retirement plan provided by employers has been the defined benefit pension. Under these plans, employees acquire pension benefits based on their wages and years of service to the company. The plans make a promise - backed by the employer - for a specific amount of money to each employee. Pension benefits for employees who remain with an employer for their entire work lives are typically 60 percent to 70 percent of final salary. Although millions of employees still participate in such plans, virtually no new defined benefit plans are being established today.
Problem: Unfunded Promises. For most of the post-war period, employers were not required to fund their pension plans. Like today's Social Security system, pension promises often were not backed by any saving or investment. This meant many pension plans were only as secure as the company that established them. If the employer went broke, employees could lose some or all of their benefits. For example, after Studebaker filed for bankruptcy in 1963, its autoworkers received only 15 percent of the pension benefits they had been promised.5
In response to the problem of bankrupt companies defaulting on their pension promises, Congress passed legislation that required all employers with defined benefit pension plans to begin to fund those plans.6 The act also created the federal Pension Benefit Guarantee Corporation (PBGC), which provides insurance for private pension plans. This insurance does not work like insurance in a normal market, however. All companies with defined benefit pension plans are required to pay premiums to the PBGC. But the premiums paid by those who are at risk of default are much lower than their actual risk warrants. Fully-funded plans at virtually no risk of default are charged premiums that are too high. Thus, one way to think of this system is to see it as socializing the risks of pension default by overcharging healthy plans and undercharging sick plans.7
"Traditional pension plans are underfunded."
In 2004, PBGC insured more than $1.7 trillion in pension benefits. It paid $3 billion in benefits to more than 514,000 annuitants whose plans had been terminated and currently owes benefits to another 440,000 workers when they retire. While the PBGC has provided pension insurance for more than three decades, the agency's financial situation has deteriorated rapidly over the past several years. [See Figure I.] According to the Congressional Budget Office, the underfunding of all insured corporate pension plans (not just those currently administered by PBGC) amounts to more than $450 billion.8
"The federal government insures more pensions than it has the ability to pay."
Under current funding rules, even sponsors of badly underfunded plans can continue to allow employees to accrue additional benefits, and can even make benefits more generous. Plan sponsors in financial trouble and nearing bankruptcy can promise larger pension benefits instead of pay increases, and employees may go along because of PBGC guarantees. Current rules also allow companies to substantially understate the financial position of their plans. For example:9
- Prior to declaring bankruptcy, Bethlehem Steel reported its plan was 84 percent funded, but when the plan was terminated it had assets adequate to cover only 45 percent of benefits promised; in fact, for the three years immediately preceding the termination of its plan, the company was able to avoid making contributions to its plan.
- U.S. Airways reported that the pension plan for its pilots was 94 percent funded, but the plan had assets adequate to cover only 33 percent of benefits when it was terminated; the company avoided making any contributions for the four years preceding the plan's termination.
Even if all plans were fully funded, problems would remain. Defined benefit plans work well for people who stay with the same employer, but they do not work well for employees who switch jobs. Almost all of these plans calculate benefits under formulas that are “back-loaded.” That means the 40th year is weighed a lot more heavily than, say, the 10th year.
To see what this means in practice, consider a man who works for four different companies — each for 10 years. All four have identical pension plans and the worker fully vests in each one. Upon retirement, he will get four separate pension checks, but his combined income will be less than half of what it would have been if he had stuck with just one company for the full 40 years.10
Under this system, people sacrifice substantial pension benefits if they switch employers frequently throughout their career, even though they remain fully employed for their entire work lives. Accordingly, these plans have become less attractive to employers who need to provide a benefit that is suited to the dynamic labor market and to employees participating in that market.
"Defined benefit pension plans should be fully funded."
Solution: Six Key Reforms.11 The defined benefit pension system needs six reforms to aid baby boomers as they near retirement.
- Full Funding. Congress is already taking steps to reduce the underfunding of plans by increasing premiums paid by plan sponsors, cutting the time required for companies to fully fund underfunded plans, and tightening rules for what constitutes a funded plan. Decision-makers should avoid the temptation to soften the rules or exempt favored industries. Taxpayers should not have to bail out companies that have over-promised and underfunded their pension plans.
- No Back-Loading. Historically, back-loading was adopted by employers both to reward long-serving employees for loyalty and to discourage job hopping. But this feature is inconsistent with the needs of a mobile labor market. To keep pace with today's dynamic workforce, federal policy should encourage employers to move as soon as possible to a system under which workers are not penalized because they change jobs. In general, employers and employees should be able to reach any agreement satisfactory to all parties through voluntary exchange. But taxpayer subsidies (through tax-free buildup) should not be available for plans with features that are inconsistent with good public policy.
- Immediate Vesting. Another tool employers have used to retain employees or reward longer service is vesting. Vesting means that employees must work for an employer a certain number of years before they obtain full rights to the promised retirement benefits. An employee who leaves before fully vesting in a defined benefit plan will receive a smaller pension as a result.12 Why have vesting at all? The issue is similar to back-loading. A short vesting period makes sense to allow the employer to recover some administrative costs for employees who pop in and out of employment. However, like back-loading, vesting penalizes people who change jobs frequently. Federal policy should eliminate vesting periods or make them as short as possible.
- Full Portability. Defined benefit pensions are generally not “portable,” which means that they cannot be rolled over into an Individual Retirement Account (IRA) or the employee's next plan to grow for the future. Benefits are typically “frozen” in the former employer's plan until the scheduled retirement date. This feature is not optimal in a labor market in which employees frequently change jobs. For example, workers who are currently ages 35 to 43 have held an average of 9.6 different jobs.13
- No Government Pension Insurance. Today, a company that wants to voluntarily terminate a defined benefit plan purchases private insurance. The firm pays a highly rated insurance company to assume its pension obligations. We should consider requiring all employers to contract with financial firms to provide the benefits. Companies usually have no special expertise in managing pensions, any more than they have expertise in managing health care. Competing insurance companies would conduct an actuarial analysis of each plan and its investments, and price their insurance accordingly. Insurance would be fairly cheap for fully funded plans with solid investments, but would be very expensive for severely underfunded plans. However, expensive insurance merely reflects high intrinsic risk — risk now being shifted onto other employers and taxpayers. During the transition, PBGC must keep collecting premiums from employers to meet their existing claims, but no new obligations should be taken on by this agency.
- Full Disclosure. The two groups with the biggest financial stake in the health of a company's defined benefit pension plan are shareholders and employees. Unfunded pension plans lead to lower shareholder equity and put employee retirement security at risk. Requiring companies to fully disclose the status of their pension plans serves both groups, in addition to company executives and government watchdogs.