PENSIONS, PLAN TYPES AND POLICY APPROACHES

The U.S. retirement income system is analagous to a three-legged stool. The first leg is the public Social Security system, which covers virtually all workers and provides benefits based on lifetime earnings at sixty-five, and reduced benefits at sixty-two. The second leg consists of employer-provided supplementary pensions, which cover roughly half the workforce. These tax-subsidized plans are sponsored by private employers, by the federal government for its employees, and by state and local governments for their workers. The third leg consists of individual saving, which occurs in tax-subsidized Individual Retirement Accounts or directly in nonsubsidized forms. Those sixty-five and older currently receive roughly half of their non-earned income from Social Security, one quarter from employer-provided pensions, and one quarter from private saving. Social Security accounts for virtually all retirement income at the low-end of the income scale; employer-sponsored pensions are important for middle- and high-income individuals.

Private pension plans in the United States date from 1875, but the early plans were financially vulnerable and most were bankrupted in the 1930s by the Great Depression. Contemporary U.S. pension plans, both private and public, are rooted in the desire for financial security that became part of the national psychology after the onset of the Depression. Although World War II initially consumed much of the nation's resources that might have been directed toward improved provisions for old age, wartime wage controls greatly stimulated the expansion of private plans. Since legal limitations on cash wages impeded the ability of employers to attract and hold workers in the tight civilian labor markets, the War Labor Board attempted to relieve the pressure on management and labor by permitting employers to bid for workers by offering attractive fringe benefits. Pension benefits cost firms little in view of the wartime excess profits tax and the ability to deduct contributions. The growth of new pension plans fell off markedly in the postwar period as employees focused on cash wages to recover ground lost during the period of wage stabilization, but by 1949 pension benefits again became a major issue of labor negotiation.

Coverage under private pension plans

The main expansion of today's pension system, in both union plans and nonunionized industries, began in the 1950s. The Korean War further stimulated the pension movement as employers once again competed for workers in the face of wage and salary controls and excess profits taxes. The growth in pensions continued in the 1960s. But much of the growth during that decade was due to expansion of employment in firms that already had pension plans as opposed to establishment of new plans. The percentage of the private workforce covered by any type of employer-sponsored retirement plan continued to increase until the late 1970s, but since then coverage has stagnated. In both 1979 and 1999, only 50 percent of nonagricultural wage and salary workers in the private sector between the ages of twenty-five and sixty-four were covered by a pension plan of any sort, even though 1979 was the end of a decade of stagnation and 1999 was the height of the longest expansion in the postwar period.

Pension coverage in the United States varies sharply by size of firm. In companies with one hundred or more employees, 70 to 80 percent of the full-time workforce is covered by a pension. The figure drops to 37 percent for firms with less than one hundred employees. Small employers frequently cite uncertainty about future earnings and the expense of employer contributions as important reasons for not providing pension coverage. Small employers also mention high employee turnover, the preference of their employees for cash wages, and administrative burden. The low levels of pension coverage in small firms is an important policy concern since almost 40 percent of full-time workers are employed in firms with fewer than one hundred workers. In an effort to make it easier for firms to establish and maintain plans for their employees, the federal government has passed several pieces of legislation over the years to ease financial and reporting requirements. Despite this legislation, the discrepancy in coverage between large and small firms remains.

A shift to defined contribution plans

Although the percentage of the workforce covered by a pension plan has remained virtually unchanged since the late 1970s, the nature of pension coverage has changed sharply from defined benefit plans to defined contribution plans. Defined benefit plans provide retirement benefits—in the form of a lifetime annuity—generally calculated as a percentage of final salary for each year of service. For example, a worker with a final salary of $40,000 might receive 1.5 percent a year for thirty years of service, producing an annual pension of $18,000. This form of pension made it easy for employers at the time that they established their plans in the 1950s to grant retroactive credits for older workers for whom they had made little or no contributions. In contrast to defined benefit plans, defined contribution plans are like savings accounts. The employer, and sometimes the employee, contributes a specified dollar amount or percentage of earnings into the account. These contributions are usually invested in stocks and bonds. When the worker retires, the balance in the account determines the retirement benefit.

Within the defined contribution world, the fastest growing type of plan is the 401(k). The defining characteristics of 401(k) plans are that participation in the plan is voluntary and that the employee as well as the employer can make pretax contributions to the plan. These characteristics shift a substantial portion of the burden of providing for retirement to the employee; the employee decides whether or not to participate, how much to contribute, and how to invest the assets. Despite the fact that employees bear much of the risk in 401(k) plans, these plans have grown enormously for a number of reasons. They are less costly to operate than defined benefit plans. They do not require employer contributions. They are fully funded by definition, eliminating the work associated with funding requirements and pension insurance. They are easily portable so employees can take benefits with them, eliminating the need for employers to keep track of pensions for departed employees.

Given their popularity and growth, one would have thought that the introduction of 401(k) plans should have boosted pension plan coverage in the United States. But, as noted above, overall pension coverage has remained virtually unchanged. This means that the enormous expansion of defined contribution plans, especially 401(k)-type plans, has produced a sharp decline in coverage under traditional defined benefit plans. Between 1978 and 1997, active participants in defined benefit plans declined from 65 percent to 32 percent of total participants. This shift is reflected in the financial statistics for the two types of plans. Between 1978 and 1997, assets in defined benefit plans declined from 72 percent to about 49 percent of total pension assets; benefits paid by defined benefit plans declined from 67 percent to 42 percent of total benefits; and contributions to defined benefit plans declined from 67 percent to 17 percent of total contributions.

In the late 1990s, some employers converted their pensions to hybrid plans that have both defined benefit and defined contribution characteristics. The most popular of the hybrids are the so-called cash balance plans. Cash balance plans are defined benefit plans that express each participant's accrued benefit as a balance that is available for distribution as a lump sum. Unlike a defined contribution plan, however, the accrued benefit accumulates at a specified and guaranteed rate of interest, and benefits tend to accrue as a constant percentage of compensation. The plans are attractive because they provide visible and portable benefits like a defined contribution plan, and secure accrual and government insurance like defined benefit plans.

Federal regulation

The federal government has played a major role in the development of employer-sponsored plans through both the provision of favorable tax treatment and direct regulation.

The Internal Revenue Code. The approach of federal pension policy as far back as the 1940s has been to provide tax incentives that will encourage highly paid employees to support the establishment of employer-provided pension plans that provide retirement benefits to the rank and file. The tax incentives arise because under the Internal Revenue Code employer contributions to a pension plan are deductible as a business expense when made, but the employee is not taxed until receipt of pension benefits. In addition, the pension fund is not taxed on its earnings. These two provisions, which permit tax deferral on both employer contributions and the earnings on those contributions, are equivalent to exempting from taxation the earnings on the money that would have been invested after tax, assuming the employee remains in the same tax bracket. This tax provision reduces personal income tax revenues by roughly 10 percent each year.

Because pensions are tax-favored, the tax code limits the amount that can be saved through employer-sponsored plans. In the case of defined benefit plans, the maximum benefit cannot exceed 100 percent of final pay averaged over three years or an indexed amount that is $140,000 for 2001. In the case of defined contribution plans, contributions are limited to the lesser of 25 percent of compensation or a fixed ceiling that rises with inflation (the ceiling is $35,000 in 2001). For the purpose of this calculation, compensation cannot exceed a specified limit, $170,000 in 2001. In addition, employee contributions to 401(k) plans cannot exceed an indexed amount of $10,500 in 2001, and as with defined contribution plans generally, total employee and employer contributions are limited to the lower of $35,000 in 2001 or 25 percent of the participant's compensation.

Because of the favorable tax treatment, the tax code also restricts access to funds contributed to defined contribution plans generally, and to 401(k) plans in particular. Before age fifty-nine and a half, the employee can generally withdraw money without penalty only upon disability or death; otherwise, the employee must pay a 10 percent penalty in addition to income taxes. After fifty-nine and a half, the employee may withdraw funds without penalty. Participants do have limited access to their 401(k) funds without penalty through borrowing provisions that allow individuals to borrow the lesser of 50 percent of their holdings or $50,000.

In addition to contribution and access limits, pension regulations include nondiscrimination provisions stipulating that benefits for highlycompensated employees be given favorable tax treatment only if a high proportion of rank-and-file employees are also covered by the plan. The technical and complex regulations allow considerable leeway, however. They only require that the classification for participation be reasonable and that the level of participation from the highly compensated group be not too much greater than the level of participation from the remainder of the workforce. Employers can exclude from participation those with less than one year of service and those under twenty-one. Employers can also exclude specific groups of workers provided that excluded workers do not exceed 30 percent of the non-highly compensated workforce. In addition, benefits may be forfeited for failure to complete five years of service. Thus, the nondiscrimination requirements do not fully achieve the goal of including all rank-and-file workers.

Employee Retirement Income Security Act (ERISA). The federal government has also sought to protect pension benefits through the direct regulation of these plans, most notably through the Employee Retirement Income Security Act of 1974 (ERISA). ERISA's principle objective was to secure the rights of plan participants so that a greater number of covered workers would receive their promised benefits. It was a response to failings and abuses in defined benefit pension plans, which covered the majority of workers at the time. Before the legislation, some employers imposed such stringent vesting and participation standards that many of their workers reached retirement age only to discover that because of some layoff or merger they were not eligible for a pension. Even workers who satisfied their plans' requirements had no assurance that accumulated pension assets would be adequate to finance benefits. And a few pension plans were administered in a dishonest, incompetent, or irresponsible way. Others engaged in forms of financial manipulation such as concentrating investments in the stock of the plan-sponsoring company, which, while not illegal, also jeopardized the welfare of plan participants. The net effect of these problems was that in the pre-ERISA era plan participants were at the mercy of plan sponsors. ERISA was designed to change the balance of power.

Most observers agree that ERISA has been successful in meeting its stated objective of strengthening workers' claims on benefits. Participation and vesting standards enable workers to establish a legal right to benefits. The implementation of funding and fiduciary standards and the establishment of the Pension Benefit Guaranty Corporation, a mandatory pension insurance program for defined benefit pension plans, ensure that money will be available to pay these benefits. As a result, more workers covered by private sector–defined benefit programs received benefits, and many got larger benefits than they would have in the absence of ERISA.

Although the legislation was successful, its focus was limited. Questions of portability, inflation protection, and coverage were discussed during the deliberations, but they were either not addressed at all or addressed in a very limited fashion in the final legislation. Other issues such as cashing out of lump-sum benefits received almost no attention.

Major issues facing the pension system

The major issues facing the pension system today can be divided into those that affect the benefits of workers covered by a pension plan and those that affect the ability of workers to gain access to pension coverage.

Retirement protection for covered workers. Retirement protection for employees covered by pension plans depends on the extent to which accrued pension benefits are preserved. The preservation of benefits requires that the termination benefits of mobile employees be adequate, that job changers not spend their lump-sum payments, and that the value of pension benefits not be eroded by inflation after retirement.

Erosion of termination benefits. For workers who remain with one employer throughout their work lives, defined benefit plans have the advantage of offering a predictable benefit, usually expressed as a percent of final pay for each year of service. A problem arises, however, in the case of mobile employees, and this would arise even if all firms had identical plans and immediate vesting; mobile employees receive significantly lower benefits as a result of changing jobs than they would have received from continuous coverage under a single plan. This difference arises because final earnings levels usually determine pension benefits in defined benefit plans. The worker who remains with a plan receives benefits related to earnings just before retirement, but the benefits for mobile employees are based on earnings at the time they terminate employment. A simple example indicates that, if wages increased 4 percent annually, the pension of a worker who held four jobs would equal 61 percent of the pension of a worker who remained continuously employed by one firm. The more wages rise with productivity and inflation, the relatively lower the benefits received by the mobile employee.

This problem cannot be solved simply by improving portability. Literally, portability means nothing more than the ability of an employee to transfer the present monetary value of vested pension credits to a succeeding plan or central clearinghouse upon termination of employment. The key issue is the amount of money transferred. Employers are willing to keep their benefits up-to-date with wages, by basing benefits on final salary, for people who remain covered by their plan until retirement, but they resist doing so for terminated employees. Increasing benefits for terminated employees will increase employer cost and mean either lower benefits for remaining employees or lower wages for all employees. On the other hand, the erosion in the value of benefits for mobile employees under defined benefit plans is one factor behind the shift to defined contribution plans.

Cashing out lump-sum distributions. One issue not covered in the ERISA debates was the threat to retirement income security created by cashing out money received in a lump sum when an employee terminates employment. The availability of lump-sum distributions in both defined benefit and defined contribution plans has increased substantially over time. Less than half (47.8 percent) of pension plan participants had the option of a lump-sum distribution in 1983, compared with 71.5 percent ten years later (Scott and Shoven).

A 1996 survey of lump-sum payments from large pension plans revealed that among job changers a full 60 percent of distributions were cashed out and only 40 percent of distributions to workers changing jobs were rolled over into other qualified retirement plans. Although the numbers are alarming, the trend is improving: the 40 percent rollover rate in 1996 can be compared with only 35 percent in 1993. Further, in 1996, 95 percent of distributions over $100,000 were rolled over compared to only 5 percent of distributions under $3,500. As a result, more than 75 percent of total dollars distributed were rolled over (Yakoboski).

Despite the improving trend, the numbers imply that roughly $20 billion per year leaks out of the private pension system. Moreover, small distributions currently being cashed out in large numbers could ultimately translate into a large loss of retirement income. Considering that the typical workforce entrant today will on average hold over eight jobs before reaching retirement, several small distributions over the working life could become the norm. Thus, the cashing out of lump-sum distributions is a serious problem.

Erosion of benefits after retirement. Private sector pension plans generally do not provide postretirement cost-of-living adjustments. Consequently, even moderate rates of inflation will erode the purchasing power of benefits fixed in nominal terms, noticeably lowering retirees' standards of living. When persistent inflation is combined with the trend toward earlier retirement, the value of nominal pension benefits declines significantly. Some employers have offered ad hoc increases, but these adjustments tend to offset no more than one-third of inflation's erosive impact. The lack of postretirement inflation adjustment has not received much attention lately because the inflation rate has been so low. But even at 3 percent inflation, the value of a $100 benefit declines to $64 after fifteen years, $55 after twenty years, and $48 after twenty-five years. Given that life expectancy at age sixty-five is about twenty years, this erosion remains an important problem.

While Congress discussed the issue of protecting the value of pensions against inflation during deliberations on ERISA, the legislation did not contain any guidelines about postretirement increases. The implicit decision was to continue to rely on ad hoc increases through unilateral employer action or the collective bargaining process. As a result, the erosion in the value of pension benefits remains a serious problem in defined benefit plans, particularly those in the private sector.

Coverage

As discussed above, only 50 percent of nonagricultural wage and salary employees in the private sector participate in a pension plan. Part of the coverage issue arises in firms where the employer offers a plan and employees are excluded or choose not to participate. The other part of the problem is that some firms—particularly small ones—do not offer pension plans. Surveys reveal that 29 percent of workers without pension coverage are employed by firms sponsoring pension plans, and 71 percent work for employers without plans.

The framers of ERISA recognized the lack of coverage as a serious problem, but shied away from mandating coverage in any way. Instead, they believed in encouraging the growth of employer-sponsored plans, and, for those workers whose employers did not provide a plan, authorized the individual retirement account (IRA). Historically, IRAs allowed individuals to accumulate $2,000 per year on a tax-preferred basis. The maximum rises to $3,000 in 2002 and will gradually increase to $5,000 in 2008, and thereafter increase inflation increments of $500. Recent data show that 28 percent of households have an IRA, but they are used primarily by upper-income households and appear to supplement conventional pension coverage, since nearly 50 percent of total households with IRAs also have pension coverage. This pattern means that only an additional 13 percent of households picked up coverage through IRAs, leaving a very large number of households with no pension provisions at all. It is not surprising that IRAs cannot solve the coverage problem. Low and moderate earners have too many pressing needs for current income to think about saving. Tax relief is also unlikely to affect their decisions since many low and moderate earners face low marginal tax rates.

The lack of pension coverage would not be a source of concern if Social Security provided enough income for workers to maintain their preretirement standard of living, but Social Security alone—even for lower paid workers—is inadequate when viewed either in terms of replacement rates or relative to poverty thresholds. The question is the extent to which the provision of pension income can be solved through the expansion of the existing employer-based system or whether some new program may be needed for those who cannot reduce their cash wages further in order to receive pension protection.

In any event, the lack of universal coverage for supplementary retirement benefits, like the erosion of termination benefits in defined benefit plans, the cashing out of lump-sum distributions, and lack of inflation protection, remains an unsolved problem.

Alicia H. Munnell

See also Consumer Price Index and COLAs; Employee Retirement Income Security Act; Individual Retirement Accounts; Retirement Planning; Social Security.

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