Is There A Pension Crisis?
Our guest author today is David Cay Johnston, a distinguished visiting lecturer at the Syracuse University College of Law and a former Pulitzer prize-winning financial reporter at The New York Times. This article is adapted from his remarks to an ASI-sponsored conversation on the topic in March, which also included remarks from Chad Aldeman, Teresa Ghilarducci, and Dan Pedrotty. A video of this event can be found here.
So the question is whether there is a pension crisis. The answer is yes, absolutely. It’s just not the one that politicians always talk about.
Contrary to that you hear about on TV, in market economics, defined benefit pensions are the second most efficient way to provide for income in old age. The most effective way would be a national program that spreads risks to everyone. The least efficient way to do it is through defined contribution plans.
There is abundant evidence for this. Defined contribution plans work very well, but only as supplements for prosperous people such as me and my wife, who is a public charity CEO, they are not at all effective for most people. That’s be because defined contribution plans violate specialization, one of the most basic tenets of market economics as taught to us by Adam Smith, the man who first explained market economics.
How many of you would perform surgery on yourself or your spouse? Or dentistry? How many have learned the hard way that doing your own plumbing makes for inefficiencies and creates a mess? But when we move to defined contribution plans, if retirees have any plan at all, we make the assumption that everyone is competent to be an investment manager, and they are not.
In fact, retirees managing their own plans tend pay higher prices than necessary and their investing performance is atrocious. In down markets, defined contribution plans lose about 25 percent more than professionally managed defined benefit pension plans. And in up markets, they earn about 25 percent less. To think that most people can be specialists in every field is to defy one of the defining principles of modern wealth creation.
So why are defined benefit pension plans being described everywhere as being in a state of crisis? The answer is very simple: systematic theft.
Pensions and other retirement benefits are nothing more than wages. They are wages that could have been taken today, but instead are deferred for old age. We often hear politicians talk about “contributions” to the plan, and this creates the misimpression that they are a gift or a gratuity. They are not. Workers receive a certain level of compensation, often referred to as a package. How that package is divvied up – how much is paid immediately in cash wages, how much goes for vacations, how much goes for sick leave, how much goes for health insurance, and how much goes into a retirement plan – is mere semantics, it’s not economics (for more on this, see here).
As both a legal and an economic principle, all the money in any pension plan has been earned by the workers. Now, I’ve talked about this before and people immediately respond “But the taxpayers put the money in for teachers, now didn't they?” No, they did not.
Taxpayers exchanged their dollars for the work of the teachers and, once the teachers are paid, it is their money. They earned it. This is true for bridge engineers and state troopers and everybody else who has a job. Pensions are earned. If they were not the system would be a huge criminal enterprise in which gifts of public money were made to the workers.
Accounting systems are often set up to disguise this fact. Congress participates in this confusion through how it handles the payroll tax – people believe that there is a matching contribution to their Social Security fund. The law is even called FICA, the Federal Insurance Contributions Act. But in fact, that is just a portion of wages that are stealthily paid and which are taxed away at a rate of 100 percent. From the point of view of an employer (and, by the way, I've been both the head of a union and the cofounder of a successful and very small corporation), a $100,000 worker costs $107,650 and the worker actually pays the entire $15,300 going to the Social Security and Medicare systems.
So the most important concept to understand is that defined benefit pensions plans consist solely of workers’ earned income.
The second is that they're efficient. The idea that they are risky is the result of a serious error that our government made in allowing corporations to put their pension plans on the books of the company. Defined benefit plans are not asset to the company, yet they appear on its financial statements. They are separate trusts. I believe that the only part of a defined benefit corporate plan that should appear on the books of the company is the shortfall, if any, in that plan. The trust itself should be entirely separate just as a defined contribution plan trust is entirely separate.
Companies often report that they made a big profit, but when you look, sometimes it turns out that the only money they made was from the pension plan, not from the market and the products they produce. But this pension money is not the company’s money.
Then there is the argument that this isn't a sound way to do things because we can't predict the future. That is utter nonsense. If you doubt it, call up an insurance agent near your home, anybody who sells a full line of products. Tell them “I want to buy an individual annuity. I am this age, this gender, and I want to collect starting on this date.” And they will tell you the price. Individual annuities are sold every day. But individual annuity plans are very pricey for the same reason that defined contribution plans are pricey and why they are bad economics: they require very large reserves.
It’s possible that you might die the day after you retire, but you might also live to be 110. If you depend on a defined contribution plan, you must reserve to support yourself until you are 110 or risk spending some of that time on welfare. On the other hand, if you have 500 or more people in a pension plan, we can actuarially estimate the life expectancy of that pool of workers very, very well. So the reserve that's needed is only slightly larger than the average expected age of those workers. Therefore, less money goes into the plan and more money is available for immediate consumption or for savings.
It is much more economically efficient to save for retirement this way. You also get professional management and record-keeping that is paid for on a wholesale level, not a retail level. And, after all, the difference between wholesale and retail is what makes the grocery industry work, right? Grocers buy food on the basis of eighteen-wheelers unloading at the back and mark up the prices to sell it on the basis of what goes out the front door in individual grocery bags. Retail requires a markup in groceries -- and retirement plans.
We also need to recognize that the extensive use of defined contribution plans is an accident of history. 401(k) plans came about when the financial services industry sought a way for highly paid executives to set aside some of their income without paying taxes immediately. With their growing popularity, they have become incredibly lucrative for Wall Street’s mutual fund houses, but remain inefficient and a disaster as the core vehicle for workers’ retirement savings.
So the pension crisis that we see is simply theft – criminal, unprosecuted, systematic wage theft.
In New Jersey, under every governor since Christy Whitman, the state has failed to put money into its pension plans while municipalities have continued to fulfill their obligations. In Wisconsin – where Governor Scott Walker famously said he wanted workers to contribute “more” to their pension plans, not understanding that the only source of money in those plans was the workers themselves – you have a very well-funded, well managed pension plan because the contributions were always made in a timely fashion.
We have a crisis – a crisis from the failure to fund, which is nothing more than thievery. Imagine that, when you get your paycheck, your employer says, “We’ve decided that we’re only giving you 94 percent of your money this week because, well, we're a little tight.” How fast would most people be down at the state or federal labor department, complaining that they had performed the agreed-upon work and were being cheated out of the agreed-upon wage?
Well, the only reason workers don't understand this in regard to pension contributions is that it doesn't appear on their paychecks as deferred wages. But whether it does or not is irrelevant as a matter of economics, because the fact remains that their wages have been reduced by the amount that their employers have agreed to pay toward their pensions. By hiding the financing of these plans, workers are unaware when the contributions they are owed are not being made.
We should be putting together massive criminal prosecutions in corporate America for this kind of wage theft. And we should be voting politicians out of office who don’t meet their pension obligations. We recently saw New Jersey Governor Chris Christie, a man who came into office saying, “I'm going to fix the pension plan our state,” embrace wage theft. As he said to the Washington Post, “well, promises were made that can't be kept.” That is thievery. It’s nothing less than thievery.
Now, none of this means that pension plans can’t be improved or that some are not, in fact, too lucrative. We allow police officers in some jurisdictions to retire at the age of 41, with a half pension inflation adjusted for life, which is tremendously expensive. We have plans with all sorts of rules that delay vesting in the plan for a very long time. And we have rules that tilt the benefits of pensions up the income ladder, subtle little rules.
But the principle remains. And the principle is that defined benefit pension plans are good market economics. They are efficient. And when they are under professional, competent, non-political management the only problems with them arise are from the failure to properly fund them, a failure that, in many cases, should lead to criminal prosecutions and imprisonment.
how exactly does a second grade teacher, on the job 8 months a year, retiring at age 55, SAVE 3 million dollars to buy an annuity of no risk government inflation protected treasuries to yield $60,000 no risk, inflation protected---for life
who pays your salary, the government workers union??
You missed the part about putting all of these workers into a pool which makes the financing of it all much more efficient. These are not individual annuities.
efficient ha!!!- you have bought into an efficient lie. it is you who have missed the economic truth
those of us who have to pay our own way , during our working lives and in retirement know this is total government welfare -at taxpayer expense- bs.
Defined benefit plans are extremely risky because you CANNOT trust others, whether corporations or the government, to manage and invest in those plans to your sole benefit. There will always be other considerations (funding for the poor, recessions, wars, pet political projects like green power, payoffs to unions to get labor agreements, or higher dividends to placate stockholders) that the government or corporations will use to justify deferring payments to a pension plan. This leads to them assuming higher rates of returns to make the deficit go away and riskier investments to try and achieve those unrealistic concerns.)
Government plans have additional risk since the politicians today will be long gone by the time the consequences of their decisions are felt. They get re-elected by promising higher benefits, but spend money for additional votes instead of funding those pension promises. If there is no money, the benefits can't be paid.
With a defined contribution plan, you know what you have and it can't be taken away by a company or government bankruptcy. Do you really think all those Illinois pensions are going to get paid once the funding runs out? By whom?
Why are you suggesting private employers are being held to a different standard than public sector officials who should be paying into the fund before hiring new employees et al. Public sector employer units have a .great lie in the assumed rate of return which is in the 7-8% range whereas the private sector employer has had to disclose their liabilities both retirement and healthcare since early nineties. THe public sector not only has no place to disclose .at least annually in a public balance sheet the liabilities the taxpayers are already committed. The beef is that the government has imposed thru the accounting conventions 2 different standards, let's make them equal full disclosure by the public sectors and its mutations and since the private sector is in a full withdrawal from both pension and retiree health liabilities This article and writer should be focused on getting the full public sector required to make full disclosures which will have an impact on their interest borrowing costs and make the tax paying community realize what a high cost the public sector employee community has become and whether we need to disrupt this cozy arrangement.
Very good opinion piece David. A cogent argument for defined contribution pensions that has given me a new insight on this politicized issue.
However I must take issue with one assertion: "They are wages that could have been taken today".
Here in Canada we tend to be more unionized. And the government unions have been extremely effective, on behalf of their members, to increase benefits over time.
However, the average garbage collector (to choose a typical unionized government-paid worker) averages $55k/year (see web link below). If we are to assume that people should be putting 15% of their incomes into a retirement program (ignoring gross versus net taxation implications), then what you're saying is that garbage collectors would (should) be earning $63k/year if they didn't have the DBP.
For a completely unskilled position that requires minimal education, you cannot with all honesty try to convince anyone that this position is worthy of $55k per year, never mind $63k. This means that for an indexed $40k/yr pension from age 65 to 90 (average life expectancy of Canadians) the institution is on the hook for $1.35 million, not including benefits.... per garbage worker.
This is where the private sector has had enough. I personally have had (and continue to have) difficulty building my own pension, without being forced to contribute to someone else's. Why is it my responsibility to fund a garbage worker's or teachers or any other person's retirement? I'd rather put that money towards my own. And I have been a professional my whole career.
Real wages are flat or actually decreasing. And even though marginal tax rates (MTR) haven't changed much in a long time, real taxation has increased due to the normal inflation of wages. A $22k income in 1982 with an average of 4% inflation per year, is now $83k (20% MTR versus 35% MTR). This makes it far more difficult for the average wage earner to actually save anything because now they only have $0.65 net dollars to put away versus $0.80.
Perhaps the DBP is the best and most efficient way of going about assisting people in making sure they have a reasonable retirement that's good for the general economy, but then a rationalization has to happen to both current wages and the benefit of pensions themselves (particularly for government workers) to ensure that they remain affordable and sustainable given changing demographics and life expectancies. This is where we've been caught with our pants down.