Workers who thought pensions would fund their retirements are getting an unwelcome surprise as Uncle Sam looks the other way.
Having a pension used to be the retirement gold standard. A defined benefit plan meant workers could count on payments for as long as they lived, without ever worrying the money would run out. But all that’s changed, and the government says it’s OK.
The number of workplace pensions has gone down in recent years as companies opt for defined contribution, rather than defined benefit, plans. However, pensions are still a significant factor in retirement budgets. A 2017 Bureau of Labor Statistics survey found that 23 percent of private-industry, state and local government workers were participating in a pension plan. When state and local government workers are separated out, the number participating in a pension plan shoots up to a whopping 74 percent.
Recently, the U.S. Department of the Treasury declared that it’s acceptable for companies to replace a worker’s pension with a lump-sum payment worth less than the expected pension. The U.S. Department of Labor kept mum on the issue. And this isn’t the first time that Treasury and Labor, the government entities responsible for shaping the retirements of millions of Americans, have let companies off the hook for pensions they committed to.
Employer-backed pensions used to be the default retirement plan for American workers. In 1974, Congress enacted the Employee Retirement Income Security Act (ERISA) to support the pension system, but it had the opposite effect. ERISA outlined strict fiduciary responsibilities for private corporations, which started looking for alternatives. Companies figured out that instead of having to commit to lifetime specified benefits, they could instead offer a 401(k) that requires employee funding. At most the company would only be responsible for a limited amount of matching funds during a worker’s employment. With that, companies wanted out of previous pension commitments, and Treasury complied by granting the option to pay those employees receiving a pension a single upfront payment.
The lump-sum payment is tempting for anyone. Depositing a fat check gives brains a shot of dopamine and eases worries over credit card payments, hospital bills, education for children and a plethora of financial ills. The problem is, that money has to last for the rest of that person’s life. It’s impossible to know how long you’ll live, and miscalculations are ugly.
Union Pensions Reduced
The 2008 recession pulled the floor out from under many a pension plan. Returns on investments shrank drastically in the years following due to a severe reduction in core funds. Congress reacted in 2014. The Kline-Miller Multiemployer Pension Reform Act is a bipartisan law that allows certain underfunded pension plans to temporarily or permanently reduce benefits owed to participants. Multiemployer pension plans are those arrived at through collective bargaining agreements between labor unions and at least two unrelated employers. Under the law, trustees may reduce retirees’ benefits more than those of workers.
Since Kline-Miller was enacted, the number of participants in plans that have applied to cut benefits is a whopping 520,247, or more than half a million workers, according to data from the Pension Rights Center. That number could soar higher as more and more trustees apply to the Department of the Treasury. While receiving a reduced pension is certainly better than no pension at all, how could companies have so grossly miscalculated pension fund needs?
The prudence standard, or the level of care a fiduciary must demonstrate when managing a pension fund, is an important aspect applied to trustees. Most states use the “prudent person” standard, while others have adopted the “prudent investor” standard. Generally, the former demands the prudence exercised by an ordinary citizen putting money into his own account, and the latter requires that of an investment professional.
The Pew Charitable Trusts recently looked at how many states complied with the fiduciary provisions in the Uniform Law Commission’s Uniform Management of Public Employee Retirement Systems (UMPERSA), a model law seeking to improve and bring uniformity to existing fiduciary provisions for pension trustees. Here’s what they found:
Although all states have a prudence requirement, there is a failure to adopt basic rules of investing, such as diversification and with the goal of producing income for beneficiaries, in almost half of the states. Furthermore, less than half require “reasonable administrative expenses” that won’t eat up fund profits. Even if pensions stay solvent, many states are not running them in the best interests of the people they’re meant to benefit.
Public pensions are in no better shape, yet the average retired public servant is not living like a king. Census data analyzed by the National Institute on Retirement Security found that the average annual benefit was $27,415 for state and local pensioners in 2016. Compensation varied widely among states, with a low of $16,441 in West Virginia to a high of $37,934 in Connecticut. Most state and local employees are not eligible for Social Security.
Furthermore, most of that income is not supplied by taxpayers, instead coming from investment earnings. And these have been paltry. In an era when market returns have been bountiful, the median public pension plan’s investments returned about 1 percent in 2016, contrasted with assumptions of 7.5 percent. For comparison, the S&P index (based on 500 large companies that trade on American exchanges) returned 9.84 percent in 2016, or 12.25 percent including dividends. Even the 10-year U.S. government bond, which hit all-time lows in July 2016, had better results than the median pension fund with a 1.36 percent yield, according to Factset.
“Using a fair market valuation,” according to the American Legislative Exchange Council (ALEC) Tax and Fiscal Policy Task Force, “State Budget Solutions, (a project of the ALEC Foundation) estimates that America’s state pensions are in a collective $4.7 trillion hole — far deeper than official government accounting standards would suggest.”
Not every state is struggling. New York, Wisconsin, Tennessee and South Dakota have enough assets to pay greater than 90 percent of liabilities. But states with problems have only to look at lawmakers to find the root of the problem.
Overestimating and Underfunding
“States that have funding problems most often can blame it on lawmakers failing to make the required contributions and then they fall way behind,” says Kelly Kenneally, spokeswoman for the National Institute on Retirement Security. According to a 2017 report, only 32 states in fiscal year 2015 sufficiently contributed to the pension fund to diminish accrued unfunded liabilities.
But the issue runs much deeper than a lack of contributions. Public pension plans were never subject to the strict fiduciary duties laid out in ERISA. Instead, for fiduciary requirements, states look to multiple sources, including constitutions, judicial opinions, statures and pension board bylaws. Further, state requirements are often much less rigorous than private requirements.
Ideas to solve the pension crisis abound. Alaska, Michigan, Oklahoma, Rhode Island and Utah are states that have enacted reforms to combat pension shortfalls. Many more municipalities are turning off the pension spigot, or slowing it to a trickle. Often, health care benefits are the first thing to go.
A bipartisan bill that passed the U.S. House of Representatives on May 23, 2019 echoes the call for more defined contribution plans. The Secure Act simplifies the process for small businesses to offer 401(k) plans and removes the maximum age limit of 70 1/2 to make individual retirement account (IRA) contributions. It would also mandate retirement account offerings for part-time workers who have been with a company long-term.
Retirement plans such as 401(k)s are sometimes limited in investment offerings and can carry hefty expense ratios. Like IRAs, they do have the benefit of tax-deferred compounding. And IRAs can be invested in a wide range of stocks, bonds, real estate and other vehicles, including exchange-traded funds (ETFs), which many advisors favor. However, the individual worker must still choose the investment, make withdrawals and hope it lasts.
Hybrid pension plans combine elements of traditional defined benefit plans with a retirement savings account. By bringing together a smaller pension element with a defined contribution plan, systems can be more financially stable over time. Burdens are shared between employer and employee in these “side-by-side” plans.
What does seem clear is that the age of company pensions may be drawing to a close. Retirement funds have taken a decided swing toward defined contribution plans, shifting the burden to workers. Individuals will likely rely more heavily on the finance industry, including robot-advisors, to guide retirement investing decisions.
Click below for the other articles in the July 2019 Senior Spirit
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