Up through the mid 20th century, a large portion of employers had an employment model that expected life-long employment commitment from employees. These companies used fixed benefit retirement programs as an incentive to encourage long term commitment to a company and at the same time defer income expenses to be more competitive in the short term. I am defining fixed benefit retirement programs as those that guarantee an absolute value of income post-retirement based on the individual’s final years of salary and the number of years spent in the company.
The fixed benefit retirement plan were attractive to workers whose primary financial goal was to be cared for during retirement. In effect, the fixed benefit retirement plans allowed workers to separate concerns for retirement financial security from the their day to day work. They accepted lower immediate incomes because they knew part of their income would deferred to retirement.
The arrangement allowed companies to offer lower productivity jobs because they could offer lower immediate incomes. Even for companies that ethically set aside funds to invest for the deferred income, their immediate costs are lower because they can enjoy high rates of return from the larger investment pool available.
This concept began falling apart around 50 years ago for a variety of reasons. I recall the news reporting of the time complaining about the impracticality of continuing this model of deferred income. Older companies burdened with a growing population of retires became less competitive because of their costs to fund pension plans for the defined benefits. Also, the increasing competition meant many companies simply failed to survive long enough to deliver these benefits. From the employee perspective, many employees who did not enjoy long enough tenure to qualify for the plans ended up working for lower wages with no prospect of deferred earnings. From a financial perspective, life expectancy was increasing so that a person who is healthy at retirement age can expect to live for several decades longer than his ancestors.
I recall stories of factory closings where there was concern about the retirees who suddenly lost their promised benefits or had those benefits drastically reduced. The conclusion was that this was not fair.
At that time in my youth, I hadn’t really thought much about the nature of different careers. I readily accepted the notion that deferred income was fundamentally inferior to an immediate income for the hours worked where that income would include a contribution to a retirement fund that the individual would control. I reasoned (perhaps naively) that the company’s expense should be about the same where they provide the investment contribution directly to the employee’s retirement plan instead of the company’s internally managed pension fund. This allowed short term employees to build a portable retirement package and for long terms employees to have the additional security of not being tied to the later fate of their employer. This also allowed companies to more easily compete because its current expenses did not have to include funding no-longer productive retirees.
At least at that time, the argument seemed very overwhelming in favor of the individual retirement plan. I understood that investments are inherently risky so that the individual plans still had the risk of major losses that could ruin the retirement plans, but this loss would be on an individual basis. Because some may experience losses while others may not, this was still superior to a community wide loss when everyone loses if their prior employer (or the employer’s pension plan) fails. The odds seemed better to allow individuals to take the risk individually.
While some companies that did not adequately fund their defined-benefit pension programs, others did a good job in both contributing and managing those funds. When switching over to the individual retirement accounts, many companies did not make any additional contribution to the retirement fund and those that did generally invested less than they would have invested into their pension plans.
For individual retirement programs, companies replaced the defined benefit model with the defined contribution model. They would contribute money directly to the employee’s individual retirement fund. The usual practice allocates these contributions by matching the employee’s contributions (up to a certain percentage of income) to the same fund. If everyone took advantage of the company match, perhaps the company’s expenses may be the same as they would have contributed to pension plans. When employees choose not to contribute for the full matching contribution, the company enjoys a net savings.
I admit here I don’t know the details of the relative financial commitments of companies for defined benefit plans compared with the later defined contribution plans. I suspect that the commitments evolved over time so it is probably hard to attribute the cause of the change simply to the choice to move to a defined contribution model. In any case, I have a different point to make about the distinction of the two approaches to retirement planning.
I recently began rethinking about the consequences of rejecting defined benefit (deferred income) retirement plans after writing my recent posts where I observed that some people deliberately choose low paying jobs in order to have a more fulfilling work experience. In a recent post, I applied this same thinking to one particular profession where there is an implication that a lower paid lower productivity may be more attractive.
At some point, we collectively made a decision to abandon the concept of defined benefit retirement plans in favor of defined contribution individually owned plans. We made this decision over time starting about a half-century ago. Now that a half century has passed, we can ask whether we made a good choice. In an earlier post, I discussed the problem of comparing the consequences of historic decision with the consequences of the missed opportunity. The historic decision leaves hard evidence of its consequences while the missed opportunity leaves zero evidence of its consequences. Frequently, we relegate the evaluation of the missed opportunity as a form of well-informed fiction writing that sometimes is called counter-factual history: what might have happened if a key decision went the other way.
This post is an attempt at counter-factual fiction in terms of what we might have lost by rejecting the defined benefit retirement plan. The defined benefit retirement plans allowed people to separate financial security from their day to day work. In particular, defined benefit plans allowed employees to accept lower paid jobs because that pay was intended only to pay for immediate needs and not to gain financial security for retirement. Income and retirement were separate concepts. As long as the income met their immediate expense needs, they can concentrate on providing services that they agreed to perform (often with job satisfaction).
Many people find reward in low productivity jobs in providing direct assistance to individual clients one at a time. In particular, these services are directed to needy individuals with very little financial resources to provide in exchange for the services. This low productivity work is also low paid work, and yet many people find this to be a satisfying form of work.
I am speculating the the defined benefit retirement programs made this kind of work more readily available. Organizations can offer lower cost services because the immediate costs only needed to meet current expense needs of the employees. The employees more readily accepted this arrangement with the promise that some of their income will be deferred to retirement age.
Currently, defined benefit programs are most prevalent in the public sector. This makes a lot of sense because many of these jobs are generally low productivity jobs that governments can only afford if they can pay lower wages. Recently, we have been criticizing these programs for not being properly managed because now we are seeing an increasing portion of our taxes to pay for no-longer productive retirees instead of providing services we need currently. There may be some failure to properly manage the funding of deferred income plans and this is raising some legitimate concerns for how we can fund these commitments.
Some of the criticism of these pension plans assert that the plans never should have been defined benefits in the first place. A defined contribution plan would have freed the future government from any obligation to allocate future revenues to retired employees. We could enjoy lower taxes and better services today if we didn’t have to invest so much to pay for benefits of the earlier employees who are now retired.
For defined contribution plans that pay out the entire income immediately, the employee will probably require a higher income to perform the work. As I mentioned earlier, often the defined contribution requires a matching contribution by the employee. Part of the immediate income must be set aside for something other than immediate expenses. Even for well managed defined benefit pension plans, the immediate cost of the employee was probably lower than what would be required for a defined contribution plan. The higher immediate costs for labor under defined benefit plans would require the organization to offer fewer services.
Part of the difficulty of defending commitments to retiree benefits is that fact that their services were only relevant for the time that the service was provided. For example, personal health aid services only have value for the moment the aid is provided. The public sector debt crisis confronts us with paying now for services that were delivered in the past. This is the consequence of deferred income when there was inadequate funding of managing of funds at the time of delivering the services. It is politically difficult to sell the need for paying taxes for historic services that are no longer and when we have present needs for additional services.
Defined benefit programs are working in those areas that had better stewardship of these pension funds. Unfortunately, many organizations did not benefit from such competent planning. Those areas are faced with the prospect of eliminating the defined benefit pension approach for public-sector services, or even to renegotiate the terms of prior commitments. This is the same misfortune that fell on industrial workers starting about a half century ago where they saw their employer go out of business and consequently they lost any commitment to their their deferred retirement incomes. In the industrial employment case, we decided it would be fairer if people were paid immediately in full for their services and allowed individuals to manage their own financial planning retirement. Now, we are considering the same conclusion for public workers.
I still wonder whether we are missing the benefit of defined benefit retirement plans to allow for lower cost delivery of low productivity services. There is a large demand for individualized services that are inherently low productivity and that are required by individuals of little or no wealth. This demand can only be met by low-income services. At the same time, there is a sizable pool of workers who prefer to provide individualized services over higher productivity services to a higher population of largely anonymous clients. In the above-linked recent post, I described this preference as an explanation for declining job satisfaction of doctors. There remains a complete market of supply and demand for low-cost low productivity services.
In an ideal world, the defined benefit retirement plan is a model for funding this low productivity market through the use of deferred income. Although this is not an ideal world for pension financial planning, we still have this market for low cost low productivity services. This recent US Today article lists five of the fastest growing job categories. Numbers 2 and 3 in the last are low productivity personal care givers. These jobs are growing fast despite the fact that their median incomes are about $20K, or less than half the overall median income of all jobs. Fast growing jobs implies a market of both a demand for the services and availability of labor to supply those services. People are willing to do these jobs. I suspect many of these people prefer this type of work.
Accepting a job that pays just $20k per year almost certainly means a concern for only funding immediate expenses. Very little if any of this money is going into a retirement plan with any promise of providing a comparable retirement income.
The benefit retirement program can be most relevant in being able to allow a person to deliver low productivity low paid work (performing services that they find rewarding) for clients who need those services.
Perhaps that was the benefit all along. The possibility of a lower immediate income with the promise of deferred retirement income may have permitted organizations to offer many jobs that were more rewarding despite the lower income potential. In contrast, the defined contribution plans place responsibility on the individual for retirement financial planning. This individual responsibility for retirement financing requires that the individual to perform higher productivity work that can compensate at higher rates. For some people (such as illustrated with the doctor example), this higher productivity may be less rewarding work experiences.
In conclusion, I still think that the modern concept of defined matching contributions to retirement is the better option. However, I think it may have the side effect of demanding people perform higher productivity work that can simultaneously meet current expenses and retirement financing. The higher productivity work is contrary to the demand for low productivity jobs for personal attention and a large population that desires to provide such services.