All the attention being given to Obamacare is pushing aside another concern that will hit in the coming decade: the pension crisis.
This coming crisis has two parts, but it basically is a problem of lack of funding for aging baby boomers.
Part one is the ‘bait and switch’ that occurred with the move from defined benefit to defined contribution pensions. Under defined benefit pensions — the type that was typical and prevailed from the 1960s through the 1980s — employers, whether public or private, provided a defined payment to pensioners based mainly on their salary and years of service. This meant that the employer had to put aside and invest money to fund their pension obligations, and take the market risk of changing asset prices. Meanwhile, the employee enjoyed a fixed, or even growing (if inflation adjusted) annual payment for life. The reasoning behind these plans is that bearing fluctuating asset risks is hard for an individual. But for a company with growing profits, paying pensions to thousands of people over long time periods, the fluctuations will average out and the company can plan on its average costs more readily than an individual. So having companies manage the assets and bear the risks, which it averaged over its employees, made sense.
But things changed in the boom-boom go-go 1980s, when health care costs (and lifetime health care for retirees was often included as a benefit in defined benefit plans) shot up, while global competition forced American firms to slim their payrolls or shift jobs overseas. The result for large manufacturing firms was that they had fewer employees paying into their retirement plans, while the number of retired workers and their costs shot up. General Motors, according to one joke, was a health insurance and annuity company that also made cars.
In addition, even successful companies did not like having millions (in some cases billions) of dollars tied up for years in regulated pension plans that by law had to invest in ‘safe’ (eg. low risk, low gain) assets to protect the rights of pensioners.
So companies got rid of their risks by shifting responsibility for pension management to their employees. “Defined contribution” plans were increasingly implemented, and defined benefit plans abandoned. This was done first by private companies but public employers have followed suit (I started my career with a defined contribution plan from private Northwestern University, got the benefits of a ‘defined benefit’ plan from my years at the public University of California, but then was switched into a ‘defined contribution’ plan for my years at the state-funded George Mason University.)
In a ‘defined contribution’ plan employers still paid for pensions, but they did so by giving employees a monthly contribution (sometimes also adding matching payments to employees’ own contributions). These accumulate in individual asset accounts — known as 401(k) or 403(b) plans named for provisions in the US Tax Code that authorized them — which the employee can choose to invest in a mix of stocks, bonds, REITs, or other assets. Whatever that account holds when the employee chooses to retire becomes the basis for their pension.
Defined contribution plans were sold to employees as giving employees ‘more control’ over their own future (although the reality was more risk, not more control), and with the promise that since stock market returns averaged 8% in the long run (since the 1920s), employees only had to sit back and watch their pension funds grow.
However, no one in the 1980s or 1990s was warning people that there could be a long slump in asset values that would wipe out their pension plans. Excited by rising home values and an exceptionally long and large market bull run from 1980 to 2000, everyone saw their individual pension plans as rosy.
That started to change with the dot-com bubble burst in 2001-2002. The Nadaq fell from 5000 to 2500 (it is back close to 4000 today, thirteen years later). But that crash mainly hurt those speculators who invested heavily in dot-com and tech stocks. The broader market and the housing market continued to rise. Until 2006, when housing collapsed and 2007 when the housing bust crashed financial markets as well. Although the Dow Jones has recently hit new record highs, it is still only about ten percent higher than its peak in 2007 — a gain of not much more than 1.5% a year for the last seven years.
Of course, people have short memories, and stock funds can advertise double-digit gains by looking at the last 3 or 5 years, in the recovery from the market bottom. And if people project those double-digit gains for the next twenty years, they will be fooled into thinking they are OK. In fact, it seems unlikely that the market will return to an 8% return anytime soon, as we are in the midst of what is now being called “secular stagnation” — economist-talk for a long slump with low interest rates and low growth. If the ‘new normal’ is growth of 3-5% in most assets, then people will NEVER recover from the lost decade in the early 2000s and its effect on the cumulative worth of their pensions. People who were switched or started with defined benefit plans in the 1990s or early 2000s will find themselves with far fewer assets for retirement than they expected come the 2020s, especially if house prices also fail to return to fast growth.
That means people with defined benefit plans still do great, right? After all, if you have a defined benefit payment of $50,000 per year, that is like having $1,633,000 in the bank and getting 3% risk-free interest. So at today’s interest levels, people with defined benefit plans are doing great, probably much better than they could have by saving and investing on their own.
Except for Part two of the crisis. Those defined benefit plans are based on employers having put away sufficient assets to pay out the promised benefits. And many, even most, public and private employers did not do so, or did so assuming they would enjoy an indefinite gain of 8% per year on their pension fund assets. These public and private funds too have been affected by the asset slump of 2007-2008 and the decline in returns, and many are in bad shape and will be unable to pay.
The size of the gap is just becoming known. The city of Detroit and the state of Illinois are two of the worst, and public employees are watching anxiously to see if Detroit’s bankruptcy will allow it to reduce its pension obligations. Already many private companies have declared bankruptcy and used the courts to reduce their promised pension payments to defined benefit payees. So we are starting to see the beginning of a wave of reductions of promised pension payments to current retirees and those about to retire.
In 20 to 30 years, barring a new economic boom, we will have vast numbers of retirees facing reduced resources. They will be more dependent than ever on social security and medicare, and their spending will be cramped (contributing even more to the overall economic slowdown).
It is not a pretty picture. And there is not much that can be done except to get realistic about it, meaning that both employers and employees need to start putting more money away for their future, especially as current and future returns on bonds and other safe savings instruments remain so weak.
One has to hope that the recent decline in medical cost inflation continues. Or one happier option–allow Americans to retire to sunnier southern countries and take their medicare benefits with them. That might provide the cheaper living and medical costs to make retirement affordable again, even for a generation that will be increasingly pension-challenged. Viva Mexico, Viva Panama, Viva Belize!
The more you know, the more scary the future appears. I think one underlying cause is also the lack of American savings culture. One you haven’t lived through a civil war, a depression and a world war and have consistently seen your living standards improve, then it is hard to justify saving and being thrifty.