A couple of generations ago, the financial burden of providing for retired workers was much more manageable. American factories had little competition for high-end goods abroad, by and large, and American productivity was the envy of the world. Furthermore, in those days, industrial workers generally only lived a few years into retirement – dying, on average, at age 70 to 72. This is lower than the overall nationwide life expectancy, but many of these workers worked in hazardous industries, exposed to noxious fumes and chemicals, soot, carcinogens, debilitating injuries and other factors that contributed to a shorter life expectancy.

Eventually, though, the economy changed. A globalizing economy made offshoring significant production to cheaper workers and factories abroad became a viable strategy, even for high-end goods and technology. 

Meanwhile, health care advances were enabling retired workers to live well beyond their forefathers, and well into their 80s. A welcome development, yes – but one that put increasing strain on the actuarial soundness of pension plans, which must be very carefully calibrated to ensure that assets are available to fund pensions not just for today’s retirees, but for retirees many decades into the future. For instance, workers who join a plant out of high school can work 30 year careers and retire in their 50s, with full pensions. In these cases, workers can easily spend more years in retirement, collecting pension benefits, than they ever spent on the job.

Foresight

Alfred Sloan, the former CEO of General Motors, warned in the 1940s that long-term obligations such as pensions were dangerous to companies, and feared that these defined benefit pension plans would eventually grow “extravagant beyond reason.”

It turned out he was right: The combination of a relentlessly globalized economy and ever lengthening lifespans is making the traditional defined benefit pension plan a thing of the past. Companies structured under the 1940s and 1950s model, with large numbers of unproductive retirees living off the current production of today’s workers simply cannot compete in the same arena with younger companies that don’t have that burden. As a result, corporations are increasingly abandoning them in order to become more competitive in the global economy.

But workers still need some provision for their retirement, over and above the bare subsistence level wages of Social Security. That’s where the defined contribution plan comes in.

The most well-known defined contribution plan is the 401(k). Compared to traditional pension plans, 401(k)s are vastly more popular among today’s employers, for the following reasons:

  • No minimum contributions. Traditional pensions have to be funded come rain or shine – and are closely regulated by Congress. 401(k) plans, on the other hand, have no contribution minimums. Any underfunding is the workers’ problem, not the employer’s.
  • No huge liabilities on company balance sheets. Pension benefits have to be accounted for, and come right out of company assets. They are also an expected drain on future earnings. All else being equal, a company with a 401(k) instead of a generous defined benefit pension plan will likely have a higher stock price than companies that offer traditional pensions. 
  • No premiums payable to the Pension Guaranty Corporation – a quasi-federal agency that exists to guarantee pension benefits for workers in case a given company’s pension plan became insolvent.

The downside to defined contribution plans, of course, is that workers must take on a much larger responsibility for their own retirement plans – a responsibility many of them are ill-informed or equipped to take on. Although many employers do match contributions to some extent, the primary burden of funding these plans falls on the worker, not the company. The worker also bears the significant risk of running out of money before death. Think of it: If increasing longevity was an actuarial problem even for professional pension fund managers, simply transferring the burden of funding and managing those plans only diffused the problem to millions of individuals. It did nothing to make the problem disappear.

A Great Disappointment

The demise of the traditional pension plan – at least in the private sector – was a long time in coming. The 401(k) plan first came to the market in the early 1980s, at the very beginning of a long equity bull market that continued for almost 18 years. As companies shed their defined benefit pension plans, things looked like they were going to work out, as 401(k) balances grew relentlessly.

Amateur investors became increasingly overconfident in their own investment ability. Like the rooster taking credit for the sunrise, people thought their own fund-picking ability was responsible for the bull market. More and more, they invested in riskier funds – focusing on Internet and technology companies that weren’t earning a dime. They also demanded their 401(k) plan sponsors open brokerage windows within their 401(k)s so they could trade individual stocks – piling on still more risk. More investors also put much of their 401(k) contributions in company stock – the most famous example of which is Enron. And companies matched contributions in stock, because they didn’t have to use scarce cash to make those matching contributions. By the spring of 2000, they had bid up the S&P 500 to an unprecedented price/earnings ratio of 40 – and the Nasdaq p/e was up to 100.

Oops!

Then the Internet bubble burst. Enron collapsed, stocks fell by 50 percent – just as they had multiple times before, incidentally – and workers had their retirement plans put on hold. Those who were early in retirement and counting on being able to withdraw 4 percent of their portfolios to create retirement income now found themselves drawing down an unsustainable 6 or 8 percent just to maintain the same incomes they had before.

Workers in now bankrupt companies like Enron, who had entrusted their 401(k) balances to company executives, simultaneously lost their jobs and their retirement savings.

Congress intervened eventually, and placed restrictions on the role of company stock.

Americans, meanwhile, developed a healthier appreciation of the role of risk in the equity markets. And so placed their faith in home values – again, with disastrous results. The mortgage and real estate bubble popped in 2007 and 2008, and by 2009, banks were in crisis mode and stocks had been beaten down to levels even below where they were after the Internet debacle and the 9/11 attacks.

Both defined benefit and defined contribution plans took it on the chin. The poor stock market returns of the post 2000 era and the low interest rates on bonds combine to make it very tough to adequately fund a pension, whether it takes place in a traditional pension plan or 401(k) or other defined contribution retirement plan.

The economy has undergone a sea change. There is no longer any way for U.S. companies now in fierce competition with younger companies with lower cost structures and no army of unproductive retirees siphoning off profits to honor a promise of a lifetime comfortable income for a 30 year retirement. The increasingly global economy has changed that paradigm for good. If American manufacturers don’t like it, the emerging economies in Asia and Eastern Europe are now very capable of making cars themselves.

So that, in a nutshell, is what happened to pensions. The average employee is taking on more and more responsibility for their own retirement incomes – and bearing the risk of outliving their assets themselves.

Hoberman & Lesser’s NYC accountants serve a broad cross section of businesses, ranging from publicly held companies, to private sector businesses, to individual entrepreneurs throughout New York, New Jersey, and Connecticut, and across the United States. To schedule a complimentary and confidential consultation with a member of our team, please contact us.