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
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
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
has to offer for retirement income.