Professor Barnhardt: “So it was only when your world was threatened with destruction that you became what you are now?” Klaatu: “Yes.” Professor Barnhardt: “Well that’s where we are. You say we’re on the brink of destruction and you’re right. But it’s only on the brink that people find the will to change. Only at the precipice do we evolve.”
-The Day the Earth Stood Still, 2008
One might paraphrase Professor Barnhardt’s plea, excerpted from the 2008 movie potboiler “The Day the Earth Stood Still,” to suggest that pension plans will evolve once it is clear to a sufficient number of participants that they are truly on the precipice.
In the private sector, where fewer laws shield employers and their workers from financial reality, evolution is well under way. And what has emerged is is a mutation of the Defined Benefit Plan that preserves many of its virtues, while avoiding most of the financial risks. Being pioneered by the east coast actuarial consulting firm, Cheiron, Adjustable Pension Plans can be structured in various ways, but all of them share certain characteristics:
- They professionally manage a pension fund that pools contributions from employees and their employers. This pooling eliminates the mortality risk that is a huge problem with individual 401K plans, but becomes a trivial risk with a pension.
- They calculate benefits based on career earnings instead of based on the final year, or final few years, of employment.
- They apply “multipliers” to each individual year of earnings, with higher multipliers in years when plan performance exceeds expectations, and lower multipliers in years when plan performance falls below expectations. By immediately lowering multipliers when investment returns are down, the plan’s accrued liabilities expand more slowly, allowing the assets time to catch up.
- Contributions are maintained at a constant percent of pay, with no “contribution holidays,” and funds are managed in relatively risk free investments. The target return for active employees is 5.0% per year, and the target return for retired employees is 4.0% per year.
Richard Hudson, a principal consulting actuary with Cheiron, with the measured understatement one might expect from an actuary, had this to say about the typical 7.0% per year (or more) long-term rate-of-return projections that are still being used by public sector pension plans: “Is it appropriate to take the level of risk necessary to reach that return when you are managing retirement plans?”
It is instructive to examine the benefit scenarios that are financially feasible under an adjustable pension plan, because they reflect a thoughtfully constructed middle ground between a defined contribution and a defined benefit. They also provide a sobering look at the limits to what a truly low-risk, financially realistic pension plan can deliver.
A participant in an adjustable pension plan who contributes 6% of their pay, with 6% matching from the employer, can expect to apply a multiplier to each year’s earnings of between 1.0% and 1.2%, based on a rate of return of 5.0%. If they want their pension to feature a COLA fully indexed to inflation, that multiplier will drop to somewhere between 0.7% and 0.8%. It is important to recognize each year’s multiplier applies to each year’s earnings, unlike a typical defined benefit, where the multipliers for each year are added up such that a person who works 30 years with a multiplier of 3.0% per year will have 90% applied to their final year’s salary. Attaching the pension benefit calculations to career earnings instead of final year earnings further reduces how much someone may expect to collect with an adjustable pension plan.
Whether or not public sector defined benefit plans are all doomed in their current state is still the subject of intense debate. But if the cities and counties that feed these plans do end up defaulting, there is an alternative to the 401K. An adjustable pension plan that invests member contributions conservatively may – with the same level of contributions – only be able to provide a defined benefit that is about half as generous as the current defined benefit plans promise. But in the event of defaults, it will become painfully clear that these promises should never have been made. What adjustable pension plans offer is something with far less risk than either individual 401K plans or defined benefit plans.
The concept of adjustable pensions was floated last year in another form by Dan Pellissier, formerly of the Office of Gov. Schwarzenegger, in an ingenious state ballot initiative proposal entitled “Government Employee Pension Reform Act of 2012.” One key provision of the proposal was to declare a fiscal emergency if a pension plan were less than 80% funded, wherein benefits would be reduced and employee contributions would be increased until the 80% funded level was regained. What is appealing about this plan, along with the fact that it preserves the defined benefit, is that by invoking a fiscal emergency, it permits the necessary adjustments to save the plan.
There are many mutations to defined benefit plans that may evolve, sooner if there is recognition by politicians, public employees, union leadership, and pension fund managers, that we truly are approaching a precipice. The difficulty with recognizing an actuarial liability is that so many assumptions are necessary to calculate the liability, it becomes very easy to obscure the urgency of the problem. Nobody can say with absolute certainty that the roughly $3.0 trillion in public sector pension fund assets won’t exceed their 7.0% annual earnings targets for the next several years. But these plans must hit returns of 7.0% or more for the next several years, if they are to avoid a Darwinian plunge into the abyss. Adjustable Pension Plans, i.e., Adjustable Defined Benefits, offer a solution to the financial challenges facing traditional defined benefit plans, and they offer an alternative to individual 401K plans. They should be seriously considered while there is still time.
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Ed Ring is the executive director of the California Public Policy Center