The defined benefit is dying. Barack Obama is struggling to keep it alive, but it’s apparent that it’s something that even as bounteously rich a society as ours can’t afford.
Yes, I know that “defined benefit” is not a common household phrase. But most people know what a defined benefit pension is. It’s when your employer promises to pay you a certain amount of money, pegged to your salary or according to some other formula, when you retire.
Some 30 years ago, most big employers had defined benefit pension plans. Some private-sector employees still have them, and many government employees do.
But a little-known provision of the 1978 tax law, section 401(k), authorized companies to offer defined contribution pensions. Instead of promising to pay workers specific amounts years later when they retire, companies would put certain amounts in the employees’ 401(k) accounts.
The employees would own the money and choose among investment options. The money wouldn’t be taxed until it was removed from the 401(k) accounts years later.
It’s easy to understand why employers prefer defined contribution plans. Once they’ve paid the employees, they don’t have any further obligation.
Many employees like them, too. They have actual money, not a claim on some fund someone else is managing. They can move from one job to another rather than stay with one employer for many years so their defined benefit pension will fully vest.
Pensions are not the only defined benefit system in our society. Social Security is a defined benefit system; you pay money in, and you get retirement benefits when you reach a certain age. Medicare is a defined benefit system, as well, though when you become eligible, you may be surprised to find it doesn’t cover everything; that’s why elderly people buy Medigap insurance policies.
Many on the political left decry the disappearance of defined benefit pension plans from the private sector and strive mightily to maintain them for public-sector employees. They argue that people with defined contribution plans often don’t save enough for a comfortable retirement or make bad investment choices.
They argue that defined benefit plans and defined benefit public policies provide you with absolute 100 percent security and eliminate all risk. Unfortunately, it’s becoming clear they don’t.
The people who put defined benefit plans and policies in place assumed there always would be someone able to pay for them.
There always would be enough new workers to pay for retirees’ Social Security and Medicare. Benefits were raised on the assumption that the baby boom generation would produce a baby boom of its own. Oops. Birth rates near replacement levels, which we have now, are not enough. The ratio of workers to retirees is in inexorable decline.
General Motors always would be a big enough company to pay for the pensions and health benefits promised to hundreds of thousands of retirees. Turned out it wasn’t.
Congress recognized the fact that both employers and employees have incentives to under-fund defined benefit pensions (it’s more fun to spend the money now) and passed ERISA in 1974. But when companies fail, ERISA’s Pension Benefit Guaranty Corp. doesn’t pay the full amount of many private pensions.
Defined benefit policies assume a static society. But we live in a dynamic society, and defined benefit policies cannot keep up with constant change.
Social Security and defined benefit pensions assumed that people wouldn’t live very long after turning 65. Now we do. Medicare didn’t provide a prescription drug benefit because prescription drugs weren’t a big deal in 1965. It took 38 years before a prescription drug benefit was added in 2003.
Defined benefit pensions are now mostly a thing of the past, replaced by defined contribution pensions, which place some risk directly on individuals rather than promise them full protection, which turns out to be highly risky when big entities out of their control fail.
We need to adjust defined benefit public policies to shift some short-term risk to individuals while reducing toward zero the huge systemic risk that exists now.
Barack Obama seems to believe we can shore up these policies by taxing high earners more. But there’s not enough money there to keep things going as they are, and a big tax increase on high and middle earners would increase the risk that our current sluggish economy becomes the norm. That’s not a risk worth taking.
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