I should apologize in advance: this is a somewhat nerdy sort of article. I’m not jumping on some hot-button topic or sharing some outrage about Social Security or retirement readiness. But this is important background that I think most people don’t know, for understanding one of the keys of how pensions work, and the consequences of the shift from traditional Defined Benefit pensions to Defined Contribution retirement accounts.
In 1996, 79% of large private-sector employers offered defined benefit pension plans. In 2017, 19% did.
That’s a statistic that I pulled out for my article last week. For clarity, the number of private-sector workers, over all types of employers, who had pensions, and, of those, who received a significant portion of retirement income from those pensions, was smaller, but this dramatic drop effectively illustrates the decline of traditional pensions, a decline which, as I’ve previously written, was inevitable because it was not sustainable for employers to offer pensions as conditions changed from when they first established their plans.
But let’s take a step back and think about why it matters, and what the key differences are in the first place between traditional defined benefit pensions and defined contribution retirement accounts, in the impact they have on workers’ retirement preparedness.
Two of these differences are straightforward and well-known.
First, employers bear the risk of investment losses and unexpectedly-long longevity in a traditional pension; employees bear all the risks themselves in a retirement account.
Second, employers typically only fund accounts as matching contributions, and even then often with amounts that are less than what they’d typically spent on traditional pensions. There are multiple reasons for this and I’m not aiming to discuss this now.
But the third difference is less well-understood: pension plans are backloaded.
What on earth, you ask, does this mean, and why should I care about arcane matters of pension plan accounting and funding?
If you asked a pension actuary, you might get a technical definition: backloading is when a pension plan formula has benefit accruals that increase the longer one continues working, for instance, 1% of pay for the first 10 years of service and 2% of pay afterwards. There are IRS regulations that prohibit, or substantially limit this sort of benefit because it’s unfair to workers with shorter service.
But there’s a broader meaning: annual pension accruals are much greater for employees the closer to retirement they get.
A seemingly “fair” traditional benefit formula, like 1% of final average pay, provided significantly higher benefits, in terms of real value at the time the benefits are accrued, for older than younger employees, and for workers who leave at retirement vs. workers who work the same number of years for an employer earlier in their career. Why?
First, benefits are based on highest average salary. Due to the impact of inflation and continued salary growth over one’s working career, a worker who leaves an employer at a young age to work elsewhere would have a benefit at retirement, for those years of service, based on the pay earned at that young age, which would be much less than retirement-age pay.
Here’s a quick example: imagine that one worker worked at Company A from age 25 to age 45, then had another job until retirement at age 65 retirement. A second worker took that job starting at age 45. This second worker’s retirement benefit would be 80% greater than the first worker’s benefit at the same company, even if the average pay increase was as low as 3%.
(The United Kingdom attempted to solve this problem by mandating that employers index, or adjust-for-inflation, their former employees’ pay when calculating retirement benefits, for the time period between when they left and when they started to collect retirement benefits, which had the result of adding to employers’ costs and contributing to the switch to DC plans even faster than in the U.S.)
Second, due to the “time value of money” effect, an accrual for a young employee, to be paid out beginning 30 or even 40 years from now, is worth less because of the discounting factor applied, than a benefit accrual for an employee close to retirement. It’s the same math that says that it’s “cheaper” to start saving for retirement when you’re young, than it is to try to reach the same retirement income goal if you start saving when you’re older.
And why does the backloading effect matter?
In the first place, this characteristic of pension plans was originally highly desirable for employers, because they didn’t much care about the retirement income of workers who left when they were far from retirement, but primarily wanted to reward those employees who worked with them for a full career. A traditional plan design enabled them to do this comparatively cheaply.
But once it became important to be able to recruit younger employees who didn’t necessarily intend to stay for their full career, and who liked the ability to accrue money in a retirement account much more than a distant promise of benefits in the future (and, yes, generous 401k contributions were more attractive for young employees), these traditional plans got in the way of offering benefits that accrued evenly for young and old employees alike. They became albatrosses.
Due to the backloading, it isn’t — and wasn’t — possible to switch from a traditional pension to a 401(k) that offered the same benefits at retirement, while spending the same amount of money. Younger workers and job-switchers gained from the switch, but older and full-career workers lost.
What’s more, the backloading had the result of leaving in the lurch that generation of employees who were too young to benefit from grandfathering provisions but too old to accrue solid retirement savings in the same way as workers who started their careers with 401(k)s.
And, finally, backloading is equally an issue for public pension plans and public pension plan reforms — and even more so, when so much of the richness of the benefit formula is contained in the early retirement benefits available upon attaining long service records. Especially for states and plans in which the participants depend wholly on their public pension for retirement, because they receive no Social Security benefits and did not have 401(k)-like savings opportunities, or, if so, didn’t have the incentive of an employer match, it is a bitter pill to swallow when the anticipated late-career benefit accruals are at risk due to pension reforms, and all the more so in cases where workers themselves have been contributing according to the plan requirements (as opposed to nominally having a contribution that the employer actually pays instead), and had counted on those late-career benefit boosts.
To be sure, the unions representing these employees should not have agreed to generous future benefit promises in lieu of more competitive salaries, and certainly should not have done so without timely funding of those accruals. Plus, a pension plan reform can mitigate the impact by grandfathering employees close to retirement. And, in any instance where a state or town simply cannot pay these pensions and the promised future accruals, without sacrificing essential services, unhappy employees may be an inevitable fact of life. But we should at least understand that they have reasonable grounds for their unhappiness.
Armed with an M.A. in medieval history and the F.S.A. actuarial credential, with 20 years of experience at a major benefits consulting firm, and having blogged as “Jane the Actuary” since 2013, Elizabeth Bauer enjoys reading and writing about retirement issues, including retirement income adequacy, reform proposals and international comparisons.
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