Friday, August 2, 2013

Annals of American Idiocy – Defined Benefit Pension Plans

Celebrating All The Bad Ideas in American History, Politics and Economics

[Editor’s note:  There are innumerable writings about how great America is and what wonderful things have been done in this nation.  This is one of an irregular series whose topics are all of the things America has gotten wrong.] 

The idea that a person should be able to retire with a decent income for the rest of their lives is very appealing.  And it is very logical that employers as part of the compensation of their employees would set up and sponsor such plans.  In the 20th century one such type of plan, the defined benefit pension plan had great popularity.  It turns out to have been maybe the worst financial idea of the century.

Simply put, a defined benefit pension plan is one in which a sum of money is deposited each year into a pension fund.  When the employee retires the fund provides an income, usually fixed, sometimes variable, for the rest of that employee’s life.  The employer, if a private company, gets a tax deduction when it puts its contribution into the fund and the employee doesn’t pay taxes until he or she gets the income.  Sounds too good to be true, and it is.

So what’s the problem?  Well in order to determine how much to put into the pension fund to provide a specific monthly benefit for the entirety of the employee’s retirement, one must know a bunch of things about the future.  These include how much the employee will earn while he or she is working, how long the employee will live after retirement and the rate of return on the investments in the pension fund.  None of these items can be determined with any accuracy, put them altogether and it is impossible to determine how much to put into the pension plan.

Now a reasonable person might say, given all this risk and uncertainty the pension plan contributions should be very high to cover all contingencies.  If it turns out the plan is overfunded, great, it is easy to correct with lower contributions later on.  But that’s not the way life works.  Since for private employers the pension contribution is an expense which they would like to minimize, and since for public employees the pension contribution is funded out of tax revenues, which elected officials would like to minimize, all of the incentives are to underfund the plan.  And this of course is exactly what has happened lo these many decades.

The result, retirees are at huge risk to lose much of their expected pension benefits.  Private employers may find it is easier to go bankrupt and let the pension guaranty company (your tax dollars) fund the liability ro to go to court and modify the plans so that benefits are less than was previously guaranteed.  And government lacking the resources to pay the promised benefits may simply cease to do so (see Detroit). 

Even worse, many pension plans have not even faced up to their shortfalls.  They continue to believe that they can earn 7% or 8% or more on their investments and compute their required contributions accordingly.  Think of defined benefit pension plans as a financial time bomb, set go to off at some time in the future in a community near you.

Defined Benefit Pension Plans – The worst America has to offer for retirement income.


  1. Hello, I love this blog usually but on the topic of retirement and pensions, particularly defined benefit plan, the author shows an strange lack of basic understanding of what is after all an insurance issue! Let me stress this as it is the core issue that must be understood to have a reasonable conversation: A pension is an insurance product! An insurance against poverty in old age to be precise. It is not a saving product. Now, why is it an insurance product? Because we don't know when we will die. Now, when there's an unknown, that is, a risk, any good economist should realize that the solution must be configured as an insurance in order to spread the risks. This is why we must have pension plans covering large groups of people: even if we do not know each individual lifetime, we do know the group's average life expectancy. Thus, it becomes trivial to design a pension plan by using that average life expectancy to decide the level of contribution needed from everyone to provide the desired benefits. Note that by definition this is a "defined benefit" plan! You decide the desired benefits, multiply by the average life expectancy, divided by the number of participants, and you are done: you have a "defined benefit plan" with very clear benefit, very clear contribution level, and financial sound as long as the average life expectancy is correctly computed or correctly (that what actuaries are paid to do!). Now, try to think of a system that is NOT designed around defined benefit. How could that work? The only way is for everyone to assume that they would live as long as possible and save enough money to live all that time. In other words, you are asking that everyone try to save enough money to live to , say let's be optimistic here and say to 100!? It just doesn't make sense.

    Now, obviously, the pension plans must be soundly managed. If not, then yes there are problems. But that would be true for any type of insurance/saving product. So saying that defined benefit is a bad idea is just silly! Sorry but defined benefits is the only way to make realistic pension plans on a society-wide horizon. Anything else will end up either sacrificing large segment of the population or just being terribly inefficient.

  2. While I would disagree with the comment (for example basing the contributions on the average life expectancy of the group would subject the plan to a probability of 50% that it would be underfunded), the comment is correct that these plans are insurance policies and should be treated as such.

    And the comment did trigger a solution to the problem of Defined Benefit Pension Plans. Any company or governmental unit could have one, but they would have to be operated by a third party insurance company. That company would administer the plan, collect the contributions, invest the contributions and pay the benefits. The third party would also have to guarantee the benefits, if the plan did not have enough funding the third party would have to make up the difference out of its own pockets.

    The key to making this work would be that the third party and not the employer would determine the level of annual contributions to the plan! (Competition and bidding with fixed fees for operating the plan could insure that the third party did not require excessively high contributions relative to the needs of the plan.)

    Of course this would result in much higher contributions for almost all plans than were made in the past for will be made in the future for reasons this Post has already stated. The problem with Defined Benefit Pension Plans is not that they cannot be done. The problem is that employers, both public and private, are not willing to make the contributions high enough to reduce the risk in the Plans to acceptable levels.