When Enron collapsed, thousands of people lost their jobs and many also lost their hope for a secure retirement. Such dramatic events have led millions to wonder, "Do I understand retirement plans?"
It has been said that whoever can solve the problems with pensions is capable of solving the problems of the world. Pensions seem simple in concept but are very complex and challenging.
A pension is simply an employer's agreement to provide income when an employee retires. An employee sells an employer labor. For this labor, the employee earns current compensation (a paycheck today) and deferred compensation (a paycheck after retiring). As an employee provides labor, ideally the employer sets aside money so the deferred compensation will be available when the employee retires.
The money set aside is invested, grows and is adequate to meet the employer's promise of retirement income. So how does this become complex?Since deferred compensation only comes into play in the future, certain questions arise:
1. When will the employee retire?
2. How long will the employee live?
3. How much will the employee receive during retirement?
4. Are there any special considerations for dependents, disability or other needs?
5. How much should the employer currently set aside (i.e., pay into a pension fund) to make sure there are sufficient funds for the employee's retirement?
Actuaries analyze past and projected trends to help answer these questions. In reality, however, there still are uncertainties and risks. This leads to the final question: Who bears the risk?
Our society has answered that last question by creating two types of pension plans - defined benefit plans and defined contribution plans. A defined benefit plan is one in which the employer bears the risk. The employer promises the employee that he will receive a stipulated income at retirement.
Here in Virginia, an example of a defined benefit plan is the state's Virginia Retirement System. A state employee who is eligible and participates in VRS (called vesting) is promised an income, for as long as he or she lives after retirement, based on a past earnings formula. It is the responsibility of the state to determine how much will be set aside each pay period and how these funds will be invested. The employee bears no risk; the state bears the risk.
If the state does not make adequate contributions or poorly invests the contributions, then the pension fund is under-funded and the state must make up the difference. If the state over-funds the pension plan, however, the excess funds revert back to the state.
An example of over-funding is when an employee dies prematurely and does not receive the retirement benefits to which he or she is entitled.
The U.S. Social Security system is a modified defined benefit plan. Employers and employees contribute agreed-upon amounts to the U.S. government. The U.S. government, not the employer, bears the risk of under-funding.
In a defined contribution plan, the employee bears the risk, not the employer. The employer pays a specified amount into a pension fund each pay period. This money is the property of the employee and is invested at the discretion of the employee. The employer is responsible only for making the agreed-upon contributions to the pension fund. Whether the funds are adequate to meet the employee's retirement needs is the employee's responsibility.
An example of a defined contribution plan is the Teachers Insurance and Annuity Association-College Retirement Equities Fund. Most University professors choose this vehicle to fund their retirement. Each pay period, the state of Virginia pays a specified amount to TIAA-CREF on behalf of each faculty member. The professor then directs TIAA-CREF to invest this money into different types of investments, such as stocks, bonds and government securities.
Another example of a modified defined contribution plan is 401K plans, in which employers make contributions based on employee contributions. With a defined contribution plan, the employee suffers if there are insufficient funds in the pension fund - if it is under-funded. Given that the employer has contributed the agreed-upon amounts, this insufficiency is caused by the employee agreeing to lower-than-needed contributions or by setting bad investment policy. If the pension fund is over-funded, however, the employee or his or her heirs receives this over-funding.
An example is the employee who dies prematurely. With a defined contribution plan, the unused money in the pension fund will go to employee's heirs, not the employer. Each type of pension plan - defined benefit or defined contribution - has strengths and weaknesses. Each has benefits, costs and risks. So where does the government come in the equation?
Given the complexity of pensions, the government tries to ensure that all parties understand and meet their obligations. Through the Employment Retirement Security Act of 1974 and related laws, the U.S. government tries to make sure employers make adequate contributions (defined benefit plans) or agreed-upon contributions (defined contribution plans). The government also tries to ensure that pension investments are safe, particularly in defined benefit plans.
So why are there so many challenges and how do we deal with these challenges? First, employers always will seek to minimize the cost of labor, in this case deferred compensation and pension costs. To ensure that the labor exchange is fair, the employee must be informed. The government must ensure adequate information between all parties.
Second, there can be no tolerance for failing to meet agreed-upon commitments. Employers must fund their pension obligations. The government must impose stiff penalties for inadequate funding.
Third, investing practices must protect the employee, particularly when the employee does not directly control the investment policy. The money set aside is there to take care of the employee. The government must ensure sound investing practices.
Last, but not least, is a simple fact: Employees must take their pension contract seriously from the start of their employment. That requires employees to be educated and active participants in pension activities.
(Robert S. Kemp is a Ramon W. Breeden Sr. Research Professor in the McIntire School of Commerce).
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