The "solution" to underfunded pensions? .. underfund them even more!

There has been a lot of discussion in recent months about an impending public pension disaster. Unfortunately, as appears not to be uncommon in other topics of discussion in society today, the solution is to look for the 'silver bullet', or perhaps more appropriately, for a way to kick the can down the road. In the context of 'pension reform' this invariably has become a call to move everyone to an undefined type of retirement plan, i.e., 401k. Such a call has the political advantage of appearing to move the responsibility for one's retirement and life onto the employee (as if this were really the goal), ignoring the fact that the public generally does end up taking responsibility for members of our society who fall into poverty, paying for them with direct subsidies once they reach that point, as well as indirectly in the form of reduced participation (investment and tax base) in society, and increased need and costs for prisons and schools and other public services.

My impulse is to provide a long, detailed argument for why this call to a move to 401ks is flawed, because I think it would help people understand what the real reason for such a call is, however, it may be more effective to simply start at the conclusion and work my way backwards.

Simply put, research shows that retirement that is based on an undefined and voluntary investment plan will result in a significantly lower level of funding than one that is defined and non-voluntary. So, as the title of this post suggests, the proposed solution will in fact make the problem of underfunded retirements worse, not better. Furthermore, assuming for a moment that employees even were to fund their 401ks at the same rate as pensions are funded by the employee and employer today, they are significantly less likely to have anywhere near a similar return on investment than is achieved by pension fund managers. Ironically, those who earn the least tend to have the lowest rate of return on any investment they have made, often times actually losing money.

So why are these types of retirement plans funded less than traditional pension plans? The first reason is surely due simply to the fact that they are voluntary. We are a society that does not think about the long term much at all; probably a function of both the reactionary politics that has been brought on by our sensationalistic media and the strong individualism that helps to define our culture. But more pragmatically, there is financial incentive not to. In an economic system that relies heavily on the influence of profit to drive behavior, costs for goods and services (and wages) are 'streamlined' to remove all but the essential (this is one of the true advantages of capitalism). Unfortunately, retirement (and generally speaking, anything longer term or that doesn't have a direct impact on current output) is rarely if ever seen as one of those essentials by much of society and so its costs are not factored into the equation.

The reasons why lower income earners tend to have a lower rate of return should be obvious (they also tend to have a lower level of education, means for proper research, amount of money invested to make it imperative, etc, etc..). What may not be obvious, however, is that one of the reasons that companies find 401ks so appealing (besides the fact that they significantly reduce cost--and responsibility) is that the people making the decisions to implement them generally gain more from them than the general employee population.

Required reading for this topic is this interview with Brooks Hamilton (one of the pioneers of 401ks, by the way so its not like he's coming at this from an unreasonable point of view). Note especially the parts that talk about the level to which overall funding in pensions changes when moving from a defined pension plan to a 401k. Can you say über-under-funded? It almost makes me glad people pushing this move use the terms 'underfunded' and 'unfunded'.

The furor over the fact that public pensions are underfunded ignores the question of why they are in that position today. Surely, one aspect of that is the nature of the benefits that have been promised (all provided and/or approved by elected politicians and/or the electorate directly), but the other is the economic environment we find ourselves in today. The stock assets of CalPERS (the California Public Employee Retirement System), for example, lost approximately 40% of their value as a direct result of the recent market crash (something 401ks were also not immune to, and in fact, which likely suffered worse due to lower level of diversification). While it does not necessarily help the problem to talk about why we are here, it does beg the question as to why so much of its assets (public money, after all) were invested in stocks. The answer, of course, is that the electorate passed a ballot measure back in 1984 that allowed it to do so, and then, based on the gains it was getting in the roaring 90's as a result of that reallocation, led directly to a legislative bill in 1999 that increased public retirement benefits in a way that seemed to make sense at the time (at least to those with stars in their eyes). Some of this context is described here. Its ironic that the call today is to move to more of a privatized system, because if you want to see what moving to 401ks would look like from an investment/return standpoint, these things are a direct result of having done just that over the past few decades.

And if that is not enough of an indication of the public's responsibility in this disaster, lets bring to the discussion perhaps the primary reason public pensions are underfunded today, which is, of course, that state governments have simply not been funding them. Lucky for us, the Pew Trusts has been gathering data on this issue and in its Trillion Dollar Gap report we see that only 21 of the 50 states have adequately funded their public pension funds over the past 5 years. New Jersey is particularly notorious for not making any of its pension contributions during apparently 13 of the past 17 years, and they are not the only ones. Even worse, there are reports that deductions that have come out of employee paychecks and given to municipalities/states with the intent of funding pensions have instead been used for other things. So again, if you want to see what the move to 401ks would look like in terms of funding level, look no further than what is happening today in most states. The only difference would be that we wouldn't know that retirement is being underfunded until those employees try to retire. A minor consolation--if there is any to be had--to the nature of today's problem is that at least these liabilities show up on our states' balance sheets and thus we are aware of the problem. One might argue that in fact that is no consolation, however, when it comes to retirees, what doesn't show up on our balance sheets today will not simply disappear. In the Brooks Hamilton interview, he estimates that over 90% of 401k holders will retire into poverty. This is not just a problem for them, but those retirees (an ever-increasing portion of our population) will, in effect, simply stop consuming (remember that whole capitalism thing that relies on consumption?), and perhaps worse, they will disappear as a tax base--what will that do for our government services?

This last point brings up a subtle twist to the basic premise of 401ks. Their tax benefit appeal is designed explicitly on the assumption that a retiree will make less income upon retirement than they did while working (what is an appropriate level of retirement income is a discussion that needs to be had, but not here or now). That seems to make sense for the most part, though increased health care costs for seniors and an increasing percentage of them retiring while still owing on their mortgage should lead to questions about that. But think a moment about the lower tax rate assumption. This, by definition, means that 401ks provide an incentive to underfund the future. While I wont try to argue whether this is inherently good or bad, I will, however, point out that there will be a clear and direct economic and social impact as a result of an increasing portion of our consumers becoming less and less of a tax and consumer base, while the share of people who represent the stronger portion of that base become smaller and smaller.

One other critical aspect of the Pew report is the fact that pensions are only one part of the underfunded problem. Health care and other non-pension retirement benefits are in even worse shape. Not a single state has adequately funded this liability over the past 5 years, and overall they currently stand at a 3% funded rate today. Yes, that's a single digit number. Admittedly, the total liability for those is a much smaller number, but I believe this issue makes the need for some kind of health care reform much more pressing.

Although much of this information is available here and there by simply looking around, one thing that I have yet to see discussed is where all the currently public 'funded' money is residing, and what will happen when that money stream goes away. This should not be part of the question of how retirement (assuming we still care about that) should be properly funded, but it would be useful to understand how such a move would impact other parts of our economic system. Brooks Hamilton made the point about the change in mutual fund share of 401ks as laws were eased to reduce liabilities for failures. It could even be argued that this increase is part of what led to the bubble that caused the crash.

Our society needs to stop blaming people and have some public discourse on whether we still value retirement, and, if so, make a real effort to properly fund it. Shirking responsibility will get us by for only so long. Recently a small southern town simply decided to stop sending out its pension benefits. The direct result was that some of their retirees died and most of the rest went bankrupt. We, as a society, cannot afford to have something like that happen on a national scale, and, I can pretty much guarantee that those retirees as a growing--and more importantly--voting block, will not stand for it. We can either take responsibility and invest in our future now, or we can ignore the issue and really pay for it later, when it will cost us a whole lot more.