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Pensions, Promises And Lies

Since the beginning of history, most people toiled, tilled or hunted from puberty to old age. Then, in the 20th century, they retired.

The idea of spending one’s golden years in comfortable leisure has evolved from a dream to an expectation to, in some countries, a constitutional right.  Now, we are going to discover whether the promise of perpetually funded retirement for the masses was only an exercise in self-delusion.

Public and private pension plans have not set aside nearly enough money to meet their obligations. The money that has been set aside will have to stretch further to cover life spans and health care costs that regularly outrun projections. Ultimately, future retirees must look either to themselves or to the next generation of workers for their support. That next generation, however, will have its hands full meeting its own needs for housing, fuel, health care, education and retirement funding.

The stage thus has been set for what I believe will be one of the great economic and political struggles of the 21st century: An inter-generational tug-of-war over society’s income. This struggle will play out in different ways around the globe, from America’s resource-starved Social Security and public employee pension systems, to French train drivers who demand to retire at age 50, to China, where a decades-old one-child policy may lead to a critical labor shortage down the road.

I asked my colleague Anna Pfaehler to write about Social Security from her generation’s perspective. Her column appears on Page 2. Anna is 22, is trained in economics and math, and is at the start of what should be an outstanding professional career. Having just turned 50 and not being a French train engineer, I think I have a fair number of good working years still in me. But Social Security will nevertheless permit me to collect a reduced retirement benefit just 12 years from now, or a full retirement check when I am 66½ years old. If I live to be 100, Anna will help pay for my pension and medical benefits for more than 33 years, and she will not stop paying until she is 72.

Then again, Social Security’s current scheme would make Anna eligible for full retirement at 67, five years before my presumed demise. The plan calls for Anna’s future children to help her support me, then to support her, and to support both of us during the overlap. The only way this could work would be for Anna’s generation to have a boatload of kids, or for the United States to import a lot of future workers to pay into Social Security and, preferably, not ask for anything back. Would somebody please tell Mike Chertoff to hold up on that border fence?

The oldest U.S. baby boomers, having reached Social Security’s early retirement age of 62, are receiving their first benefit checks this year.  Over the next quarter-century, some 70 million boomers will become eligible to collect retirement payments until death do them part. They also are entitled to lifetime Medicare coverage of doctors’ bills, hospital costs and prescription drugs.

The system is heading for a financial train wreck. The Medicare portion will run dry within about a decade, and the retirement portion within 25 years, according to the program’s trustees. But, as we noted in the April 2005 issue of Sentinel, Social Security’s cash demands will put pressure on the Treasury long before then, because the Social Security “trust fund” consists almost entirely of IOUs from Uncle Sam. America’s low savings rate means that the Treasury is going to be forced to borrow money from foreigners, at whatever interest and currency exchange rates the market sets, to roll over those IOUs and get the cash to pay benefits.

Given all the other demands that will be placed on Anna’s generation, there will be a lot of pressure to limit my group’s benefits, or to apply a means test to reduce benefits for more affluent retirees, or to raise my retirement age — not to mention Anna’s retirement age.  In all likelihood Anna’s generation will pay a significant share of the cost of my generation’s retirement, but it may not be as large a share as my generation is counting on. The adjustment is likely to be gradual because the political balance of power will only slowly move from my huge baby boom generation and our already-retired parents to Anna’s generation and her children’s.

State, Local Public Pensions In Trouble

Social Security is not the only problem. Across the United States, state and local governments have racked up what might be nearly $500 billion in pension obligations without setting aside the money to meet them. New accounting rules are only just now forcing public employers to disclose the magnitude of their unfunded promises. States with large pension deficits, especially in combination with slow economies and stagnant populations, are likely to find it difficult and expensive to borrow money until they get their houses in order. Already, Alaska and Michigan have switched to individual-account (“defined contribution”) retirement plans for new employees, who do not receive any guarantee that their retirement fund will outlast them, but who at least know that their benefits have been funded to some extent.

Defined contribution plans have become the norm in the private sector. About three-quarters of the nation’s private-sector pension plans have been closed down since 1985. This includes numerous large plans in the steel, auto parts and airline industries that were dumped on a government-sponsored insurance program that has a gaping financial hole of its own. In most small and mid-size companies defined contribution plans, which include employee-funded 401(k) plans as well as employer-paid profit-sharing arrangements, are the only retirement plans available.

We got into this position because the basic concept of a pension — guaranteed income for life — conflicts with a basic rule of politics and human nature, which is that most people want to get what they want today, not tomorrow.

I believe the pension system could be perfectly sound if it were “fully funded,” meaning money deposited by the employer, the employee or the government while the employee is working is invested to support the employee’s pension. Anna, more pessimistically, notes that unless retirement funds are invested in ways that boost society’s productivity, fully funded pensions might merely create inflation by supporting demand for goods and services without providing an offsetting source of supply.

The opposite of a fully funded plan is an unfunded “pay-as-you-go” plan, which uses today’s deposits to pay benefits to yesterday’s workers while accumulating nothing to meet future claims. When Social Security and most private pension plans were created, they granted benefits almost immediately to workers who had labored for decades before the plans were established. Nothing had ever been set aside to fund benefits for those workers. Writing in Harper’s in February 1950, Peter F. Drucker estimated Ford Motor Co.’s unfunded liability at $200 million on the day it negotiated a pension plan with the United Auto Workers. In a 2001 law review article, professor James A. Wooten of Buffalo Law School quoted a UAW actuary’s 1958 memo that asserted, “The primary purpose of a retirement plan is not only to provide pensions, but to provide them now.” Social Security followed the same principle when it began paying retirement benefits in 1940, only three years after it collected the first dollars intended to support those benefits. Collections were outstripped by benefits almost immediately and have never caught up.

Employers, unions and politicians who established these plans knew from the outset that, being underfunded, they could only be maintained through future subsidies. Companies could eliminate their pension plans’ deficits by diverting a greater share of cash flow into the plans, but employees generally did not want to give up the current income, nor employers the profits, that would have been necessary to do this. Plans muddled along until employers ran out of resources to pay benefits that came due.

Struggling automakers Packard and Studebaker tried to survive through a merger in the 1950s, but it did not work. Many workers lost their benefits when Packard folded in 1959 and Studebaker followed suit in 1963. This became the impetus, a decade later, for Congress to enact the Employee Retirement Income Security Act of 1974 (ERISA) to protect private pensions. ERISA required employers who had pension plans to contribute to an insurance fund that supports the Pension Benefit Guaranty Corp. The PBGC, in turn, backs private pensions up to a maximum annual benefit limit, which is $51,750 per worker in 2008.

Act Failed To Resolve Problems

Did we all live happily ever after? Not exactly. Employers with strong plans must, through PBGC premiums, subsidize employers with weak plans. ERISA required companies with underfunded plans to make up the deficits, but the accounting rules were so lax that many plans fell more deeply into deficit instead. Also, struggling employers could ask for relief from the funding requirements, and the financially stressed PBGC had strong incentives to grant the waivers, rather than have employers dump their underfinanced plans onto the PBGC itself.

With each wave of American industrial restructuring, particularly in the steel, airline and auto parts industries, the PBGC absorbed more underfunded pension plans. The government’s underpriced insurance created incentives that made the problem worse. United Airlines made no pension contributions from 2000 to 2002. It then granted 23,000 ground workers a 40 percent benefit increase in 2003, and promptly terminated its plan, making the PBGC responsible for the increase.

Congress reacted with a new law, the Pension Protection Act of 2006. Like ERISA a generation ago, the new statute purports to make private pensions secure. It requires most companies with pension plans to pay higher insurance premiums, demands that most underfunded plans be brought up to snuff within seven years, and restricts companies’ abilities to skew benefits in favor of top executives or favored employees.

But once again, Congress was unable to resist granting political favors in the pension law. Delta, which already had terminated a plan for pilots, and Northwest, which, like Delta, was under bankruptcy court supervision at the time, were given 17 years to fund their plans. Other airlines and some defense contractors were given 10 years.

History tells us that struggling companies will not make up pension deficits no matter how much time they are given. Strong companies, on the other hand, have no desire to fund the pension promises of weaker enterprises. The trend toward extinction of private lifetime pensions in favor of personal account retirement plans probably is irreversible.

Defined contribution plans have plenty of shortcomings of their own. Employees may not save enough, or they may invade their balances before retirement for other purposes. They may not invest their money with enough growth potential, or with enough diversification to avoid disaster (as befell many Enron employees). At retirement, they may not know how to manage their balances to make them last, although private insurers probably will always sell fully funded annuities for retirees who want such a safety net.

Still, when I consider Anna’s generation — when I set up my own company’s benefit plans for her and her peers — I think she is better off with all the cards on the table. Palisades Hudson has a profit-sharing plan but no pension. Every year, I put a substantial amount of money into an account in Anna’s name. If she leaves our firm, she can take her vested retirement money with her. She and her co-workers know perfectly well that their salaries are lower than they otherwise might be because I have to leave money available for the profit-sharing contribution. The trade-off is there for all to see.

At any point in Anna’s life she will know how much has been set aside specifically for her own retirement, even while she helps pay for mine. There is no guarantee of the final amount she will end up with, nor, unless she uses her balance at retirement to buy an annuity, that it will last her entire life. Then again, life does not come with many guarantees.

“The worst lies are the lies we tell ourselves,” said writer Richard Bach (Jonathan Livingston Seagull). “We live in denial of what we do, even what we think. We do this because we’re afraid.”

Bach was speaking of love, not pensions. But he sounds like a pretty good actuary.

Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book, Looking Ahead: Life, Family, Wealth and Business After 55. His contributions include Chapter 1, “Looking Ahead When Youth Is Behind Us,” and Chapter 4, “The Family Business.” Larry was also among the authors of the firm’s book The High Achiever’s Guide To Wealth.