Semi-Daily Journal

Expect a rule change to protect the companies.

Expect a rule change to protect the companies.

How can this be? Paul Krugman said:

"...a little-remarked sea change
in America's retirement system. Twenty years ago most workers were in 'defined benefit' plans - that is, their employers promised them a fixed
pension. Today most workers have 'defined contribution' plans: they invest money for their retirement, and accept the risk that those investments might go bad. Retirement contributions are normally subsidized by the employer, and receive special tax treatment; but all this is to no avail if, as happened at Enron, the assets workers have bought lose most of their value.

[snip]

" And even when employees have real choices, one wonders whether they fully appreciate the risks. The shift away from old-fashioned pensions coincided with an enormous bull market; surely many workers who have never seen stock
prices fall since they became investors underestimate the risk of capital
losses."

The corporations were riding the bull market of the 90s to get away with underfunding their pension obligations. Pensions can dry up and blow away as has happened to retired steel workers when the company goes under. Most companies are going to defined contribution plans. I think that given the instability of sectors of the US economy, that workers on average will benefit more from defined contribution plans, but only if they are backed up by defined contribution plans like Social Security and Medicare.

Corporations are not the only ones with underfunded pensions. Many of the State workers pension funds are in the same boat. The Federal Government has borrowed all the money from SS trust fund, Medicare trust fund, military pension, government worker pensions, etc. No one believes that the US government will default on its obligations to its workers, but we are in a worsening position with regard to future pension obligations because of the fiscally irresponsible tax cuts.

What is certainly possible is the government would inflate away the debt and at the same time lower the cost of living adjustments on retirement benefits. That becomes more and more likely as we accumulate well over $1 trillion in new debt every two years. If this happens, what will an economy look like with a much larger percentage of retirees that lack the resources to fully participate in the economy? This question was not addressed by the SS commission or by our current administration.

Paul Krugman tells us that twenty years ago most workers were in defined benefit plans. Today, he says, most workers are in defined contribution plans.

Lies, I tell you, lies, all lies. I demand that Donald Luskin carry out another of his incisive inquiries into this blatant lie.

http://www.cbpp.org/

The Ways And Means Committee Pension Tax-Cut Legislation: Unsound Policy That Digs The Nation's Fiscal Hole Deeper

This analysis finds that pension legislation the Ways and Means Committee passed July 18 (which occasioned theatrics and the calling of the Capitol police) is dominated by costly tax cuts that would further enlarge the deficit and confer additional tax subsidies primarily on high-income people who already are better prepared for retirement than other Americans.

Re: risk in defined benefit vs defined contribution.

As it stands now, companies have minimum standards of funding. This is a certain amount of risk that companies have to bear. I've seen a number of announcements in the past few months that various companies will have to start paying in money to their pension plans, after riding the bull market for a few years. Note that companies *don't* have to pay money into 401(k)'s, because the employee bears all of the risk.

According to the excerpt from this article, the government is noticing that many companies have been running an unacceptably high risk (for their pension plans, employees and retirees), and is asking for the current 'floor' on funding to be raised. For pensions; when 401(k)'s tank, it's purely on the employee/retiree; the company does not take a loss.

This doesn't mean that there is *no* risk in defined benefit plans, just that it is much, much smaller than for defined contribution plans. It takes widespread problems to take down a defined benefit plan.

BTW, Bakho, last I heard, SS was a defined benefit plan, not a defined contribution plan.

Re: risk in defined benefit vs defined contribution.

As it stands now, companies have minimum standards of funding. This is a certain amount of risk that companies have to bear. I've seen a number of announcements in the past few months that various companies will have to start paying in money to their pension plans, after riding the bull market for a few years. Note that companies *don't* have to pay money into 401(k)'s, because the employee bears all of the risk.

According to the excerpt from this article, the government is noticing that many companies have been running an unacceptably high risk (for their pension plans, employees and retirees), and is asking for the current 'floor' on funding to be raised. For pensions; when 401(k)'s tank, it's purely on the employee/retiree; the company does not take a loss.

This doesn't mean that there is *no* risk in defined benefit plans, just that it is much, much smaller than for defined contribution plans. It takes widespread problems to take down a defined benefit plan.

BTW, Bakho, last I heard, SS was a defined benefit plan, not a defined contribution plan.

Re: risk in defined benefit vs defined contribution.

As it stands now, companies have minimum standards of funding. This is a certain amount of risk that companies have to bear. I've seen a number of announcements in the past few months that various companies will have to start paying in money to their pension plans, after riding the bull market for a few years. Note that companies *don't* have to pay money into 401(k)'s, because the employee bears all of the risk.

According to the excerpt from this article, the government is noticing that many companies have been running an unacceptably high risk (for their pension plans, employees and retirees), and is asking for the current 'floor' on funding to be raised. For pensions; when 401(k)'s tank, it's purely on the employee/retiree; the company does not take a loss.

This doesn't mean that there is *no* risk in defined benefit plans, just that it is much, much smaller than for defined contribution plans. It takes widespread problems to take down a defined benefit plan.

BTW, Bakho, last I heard, SS was a defined benefit plan, not a defined contribution plan.

Barry thanks for the correction. SS is defined benefit. My sleepy brain misfired and I miswrote.

The main thing at work here is that when interest rates are low the discount rate applied to the assumed future cash flows becomes correspondingly low. Hence the present discounted value of pension fund payouts -- being less discounted -- goes through the ceiling.

You see the opposite effect when interest rates are high. A few years ago, in Paul Volcker's day, high discount rates applied to pension funds' assumed future liabilities produced some huge pension fund surpluses. Two of my classmates, Conrad Black and Paul Finklestein, took advantage of the moment to raid Dominion Stores' and CN Transport's employees' retirement funds for about $80 million apiece. Conrad then sold Dominion to the German owner of A&P; I believe Paul simply walked away from CN Transport.

What ever happened to hanging, drawing, and quartering? I don't know what should be done about Conrad and Paul, but surely something needs to be done to give actuaries a deeper understanding and appreciation of long term futures.

The main thing at work here is that when interest rates are low the discount rate applied to the assumed future cash flows becomes correspondingly low. Hence the present discounted value of pension fund payouts -- being less discounted -- goes through the ceiling.

You see the opposite effect when interest rates are high. A few years ago, in Paul Volcker's day, high discount rates applied to pension funds' assumed future liabilities produced some huge pension fund surpluses. Two of my classmates, Conrad Black and Paul Finklestein, took advantage of the moment to raid Dominion Stores' and CN Transport's employees' retirement funds for about $80 million apiece. Conrad then sold Dominion to the German owner of A&P; I believe Paul simply walked away from CN Transport.

What ever happened to hanging, drawing, and quartering? I don't know what should be done about Conrad and Paul, but surely something needs to be done to give actuaries a deeper understanding and appreciation of long term futures.

http://epinet.org/content.cfm/webfeatures_snapshots

The decline in interest rates has resulted in less funding for pension funds, and a new proposal by the Bush Administration would make pension funding even more vulnerable during recessions. Pension funding is becoming more expensive, especially for older workers, which may prompt employers to reduce or eliminate these pensions.

i know next to nothing about this, but, two smart colleagues of mine (Dean Baker and Christian Weller) have a paper on it.

http://www.lights.com/epi/virlib/Technical/2003/smoothingt.PDF">http://www.lights.com/epi/virlib/Technical/2003/smoothingt.PDF">http://www.lights.com/epi/virlib/Technical/2003/smoothingt.PDF

Informal conversations w/ Christian lead me to believe that there's actually little to the 'corporate malfeasance' angle of this. And, it should be said that neither he nor Dean would ever be shy about hammering on this angle if it applied.

*sigh* Punch post once, but don't leave the page, and it multi-posts.

Patrick R. Sullivan writes:
>
> How can this be? Paul Krugman said:
>
> "...a little-remarked sea change
> in America's retirement system. [..."]

I'm confused by your confusion. The fact that many or most younger workers don't have defined benefit plans doesn't mean that the plans that exist aren't in big trouble. As it turns out, one of the big problems is that most of the people covered by the old-fashioned defined benefit plans are older, vested, and on the brink of retirement or "down-sizement". Indeed, there would be less of a problem if the workers being covered were younger and further away from retirement. But they aren't that far away and the money isn't there, since the plans are under-funded after the bursting of the asset bubble. I don't think anybody disagrees that there is under-funding and that this is a problem, it's just what and how much to do about it. And, in the case of the recent House bill, how much more you can do for wealthier citizens.

Warren Buffett has repeatedly complained about the massive under-funding of defined benefit pension plans. This was a regular complaint from 1998 on....

Jonathan King:

Great point. The PBCG crisis is akin to the S&L crisis. Let's suppose that are two kinds of banks: traditional commercial banks and old fashion S&Ls. Let's optimistically assume that FDIC insurance was such that there was not a bankruptcy problem but FSLIC insurance was the mess that it was back in the 1980's (yes, FDIC insurance had problems and still does). Simply because most of the banks were commercial banks and not S&Ls did not say we had a looming crisis that would cost the Treasury hundreds of billions of dollars. So it is with PBGC. A few large defaults can mean enormous dollars.

When Patti Sulli sloshes radical right rubbish, just sneer and spit and move on.

Most defined contribution plans were created from defined benefit plans. The conversion is done by discounting the benefit using current acutary rules and expected rates of return for the next decade, modified by the assets in the fund.
The reason for taking all three factors into account is two rules in law governing conversions; the first rule requires using the same formula that is required to allow an employee to withdraw their "cash", and the second requires that the rate be the same for all employees, but that if an employee who was older than 50 at the time of conversion leaves the fund by death, retirement, etc., or at the end of the decade, the calculation is done again and if this value is higher, the benefit is adjusted upward.
The reason for adjusting the benefit upward based on the apparent fund balance is to avoid employee action against the company, as happened at IBM. As might be expected, the employees with the most at stake have been with the company for many years and thus have many friends in management. In fact, many involved in the conversion have vested interests in seeing a high value assigned.
Once the conversion is done, a rate of return is assigned, and that is typically T-note+1% or something. I'm not sure of the requirement. However, in the 90s when most conversions took place, the funds saw double or triple that rate of return. Projecting that rate of return toward the end of the fund's life, funds in high tech were "overfunded" and companies like IBM withdrew cash from the funds.
Of course, in the 90s T+1% was much lower than mutual funds promised, so companies were pressured to switch to 401K plans by employees and by the attraction of eliminating that as a risk. Rules prevented forcing employees over the age of 45 from switching immediately, but generally companies with well funded pensions wanted to close the plans as quickly as possible to recapture the excess assets. IBM has tried to move closer to closing its plan multiple times by forcing employees still in the pension plan to retire - all are over 60 or 65.
I suspect that given the significant drop in value, companies like IBM are not as interested in having funds withdrawn as they were - if half the funds were withdrawn today, the percentage shortfall would shoot up significantly.
I believe most companies emphasize that defined contribution pension plans are not "defined contribution" plans because the company still bears the risk of ensuring that the funds exist when the employee is entitled to them, but the company is not required to actually contribute the funds as the employee accrues the benefit. In fact, during the 90s, companies were prevented from contributing to some funds because the growth forecasts dictated by the government showed excess funds; in fact, so companies withdrew funds. Now in a period of slow growth, the calculations show a deficit and the companies are being asked to add to the funds at a rate significantly greater than employee are accruing benefits.
And I'm not sure that if a company goes bankrupt that the PBGC is required to honor the promised benefit calculation.

Defined benefit plans can hurt corporate viability if conditions change. No where is this problem more acute than in the steel industry. There are 4 times as many retirees as workers. The industry faces intense competition from foreign sources that don't have pension liabilities. Instead of steel tariffs, the dinosaur steel industry wanted the government to assume some of the pension liability to make them more competetive. That did not go anywhere, but the pressure to pass off industry inability to meet pension costs onto the government will grow as other industries mature.

Bakho

Your post notes that companies face downside risk from defined benefit plans but doesn't this also imply upside potential if "conditions change" in the other direction. Isn't the point of a pension benefits guarantee (PBG) program to diversify such risks? Of course, I'm assuming this PBG insurance is properly priced, which may precisely be the PBGC problem as it was the problem with FSLIC insurance.

The problem with defined benefit plans is nobody ever wants to fund them properly. It's a lot more in their interests to tell you that you're taken care of and then not.

When you can't find regular insurance companies that are willing to take on the risk of a failure, it is almost a given that "pricing" of the insurance by the "quasi"-government agency will be wrong.

I thought Social Security was a pay-as-you-go system. Neither the benefits nor the contributions are defined, i.e. set. Congress can change both whenever they feel like it. Or I guess you could say that the benefits and contributions are both defined, Congress can just change it whenever they want to. Notice that the government and businesses both don't won't to fund their liabilities as SS is due to go bankrupt, with current law, about the time I'm supposed to retire.

achilles, Luskin already has jumped on the inanity of this Paul Krugman column, a year and a half ago:

http://capmag.com/article.asp?ID=1273

Unlike you, he didn't miss the point.

" I'm confused by your confusion. The fact that many or most younger workers don't have defined benefit plans doesn't mean that the plans that exist aren't in big trouble.'

You mean you're confused by Krugman's confusion. I've known all along that both plans INVEST.

Ah yes, Paul Krugman does not understand that defined benefit plans carry attached risks. Proof for this claim: he once said that defined contribution plans are risky.

Wow, when you learn history from Ann Coulter and your economics from Donald Luskin the world does seem a different place: a parallel universe in fact.

mulp's post is a bit garbled. mulp, I think you're talking about cash-balance plans, which are a form of defined benefit plan that's designed to act a lot like a defined contribution plan from the employee's perspective. True defined contribution plans, such as 401(k)s, are a different animal entirely.

SS benefits are defined in terms of inflation adjustments, etc. It takes an act of Congress to change them. SS is no less a defined benefit plan than steel worker pensions or railroad retirement. With these plans, there is a risk that the companies will go bankrupt and default on the pensions.

SS is less risky because NO ONE thinks the US government will default on its obligations. This is why US treasury bonds are considered the least risky, blah blah blah. Why don't you and Luskin make a coherent argument at least once?

An interesting (or should say odd) addition to this risk issue (DB plans having risk borne by the employer v. DC plans having risk borne by the employee) is Victor Canto's piece at National Review Online today. He favors DC plans in part because the employee gets to keep the upside and the downside of his investments. I have a portfolio that has significant risk. If Canto thinks risk is a good thing, I'll invite him to engage in a trade where he gives me its expected return as a guaranteed payment. That way - he gets all that lovely risk - and I'll even pay the transaction fees.