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Defined Benefits The Long Goodbye

Defined Benefits The Long Goodbye. David Lindeman* Senior Analyst (Pensions), OECD World Bank-OECD-INPRS Conference on Contractual Savings 1 May 2002 *with deep thanks to Richard Ippolito’s many insights, as well as kudos to Richard Hinz and his office. The DB Bargain.

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Defined Benefits The Long Goodbye

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  1. Defined BenefitsThe Long Goodbye David Lindeman* Senior Analyst (Pensions), OECD World Bank-OECD-INPRS Conference on Contractual Savings 1 May 2002 *with deep thanks to Richard Ippolito’s many insights, as well as kudos to Richard Hinz and his office.

  2. The DB Bargain • Nature of the DB bargain • Big rewards to “loyal” long tenure workers; not much to mobile early-leavers. Employer’s contributions focused on those workers who contributed most to the firm. • Lock-in effect: benefits based on final pay or career average pay. Erodes in value if worker leaves much before retirement. • In exchange for investing in specialized human capital valuable to the firm, the employer locks-in the potentially loyal worker and recaptures costs of such training. • Lock-in effect often depends on inflation. • Growing inflation in 1960s increased the “lock-in” effect. Employers stopped fighting ERISA’s enactment with rules on portability, backloading and coverage. • Decreasing inflation in 1980s eroded the “lock-in” effect.

  3. Why the DB to DC shift ? • Sectoral changes: about half of shift from 1980 to early 1990s traceable to change in relative sizes of manufacturing sector (that wanted lock-in effects) and service sector where large turnover is normal. • This effect probably continued throughout the 1990s. • In parallel, inflation declined in 80s and 90s. Hence, smaller “lock-in” effects. • Growing awareness among workers of job changing “risk” in DB plans. Employers may have experienced too much lock-in during high inflation years of 1980-90. Both sides may have reanalyzed the DB bargain. • Requirement for post-separation índexing (up to limit) enacted in the UK. Interaction with SERPS liabilities. • Similar changes strongly resisted in the US, partly because of DC shift already underway.

  4. more reasons for the shift… • Increased recognition of latent costs • “Regular” minimum funding rules enacted in 1974 “ERISA”. Unfunded liabilities had to be amortized and backed with non-firm assets. • PBGC guarantee and fee (and regulations). • Ever changing rules in the 1980s on maximum funding, both in the aggregate and on an individual basis. • “Minimum-minimum” funding rule add-on in 1988/1991 to limit PBGC exposure. Increasing use by PBGC of the “reputation” publicity club – Top 50 List. • “Metzenbaum” excise tax effectively eliminated employers’ access to “reversions” and made risk sharing more asymmetrical.

  5. yet more reasons … • FASB 87 accounting rule made sponsoring firm’s exposure much more transparent to shareholders and financial analysts (now followed by IAS 19 and FRS 17 in UK). • Reinforced already incentives for fixed corporate pension and retiree health liability. (Very similar parallel imperatives in state PAYG schemes – e.g., NDC model.) • Growing criticism from public policy circles --including IMF, World Bank and OECD -- about portability losses in DB regimes. Basic attitude develops -- “DC good; DB bad.” • Parallel emergence of partial substitutes • Cash Balance plans (DB with DC attributes) • 401-k plans

  6. Cash Balance Plans as Transition Device • DB in the accumulation stage: employer guarantees return on contributions. Equivalent to indexed career average DB scheme. • Some similarities to Swedish NDC PAYG reform. • But, DC-like at time of withdrawal. Longevity factor determined only then. Like DC plan, actuarially neutral with respect to working longer. • Transition strategy for employer to move from final pay DB plan to regular DC plan. Some “smoke and mirrors” about losses to mid-career workers.

  7. 401(k) Plans – “The Accidental Pension System” • Usually no employer funding except in the form of matching contributions  employer’s resources are focused on those “low discounters” who choose to contribute from their own pay. These low discounters are those who are most likely to become loyal long tenure workers. • Tax-advantaged savings and portfolio choice. • Sometimes a minimum employer contribution in every account. Some firms use employer stock as matching contributions. Links workers interests with firm’s. • But diversification, conflict-of-interest, adequacy and equity concerns may limit or even eliminate some or all of these design options.

  8. Lingering Question… • Yes, some workers may value “tax favored” retirement savings. But do enough workers value such savings enough of the time so that employers have enough reason to offer “plain vanilla” DC occupational schemes? That is, plans without the complex labor market incentives of DB or 401-k plans. • In some countries, unions or social partner traditions achieve coverage through government “encouragement” (‘negotiated compulsion’). In other countries, is government compulsion of simple DC arrangements inevitable? • If so, how much “insurance” and how much “self-directed”?

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