October 11, 2015

Solving the Retirement Benefits Problem

There is a relatively easy pair of solutions to the unemployment crisis. The biggest issue for private sector employers which have provided retirement benefits for their employees is the burden of providing for future benefits for current and future retirees. (Government accounting is different. Government employers only have to provide for what they out in the current year.) What many people do not understand is that when a private employer provides such benefits, it not only covers what it pays in the current year, but a share of what it will pay out in future years. The exact allocation between current and future year benefit expenses varies from employer to employer, but there is no question that portion of current-year benefit expense allocable to future years is huge and it gets in the way of employers hiring new workers.

So how do we solve this problem? It’s very simple, but the answer varies between pension and retiree medical expenses.

Pension Benefits

The future pension obligation for an employer is determined with the following factors taken into account:

  • The pay taken into account and against which the formula will be applied;
  • The assumed level of pay increases for current employees;
  • The percentage of pay that will be provided;
  • The life expectancy at retirement age;
  • The investment return on monies in the pension trust;
  • The discount factor applied to future year obligations; and
  • The cost of living increases applied to pension payments.

Many employers also provide for a lump-sum pension payment right from their plans.

I want to zero in one of these factors: life expectancy. The fundamental assumption under the laws governing pensions is that individuals “retire” and draw a pension when they are no longer working. The end result is that employers are paying retirement benefits to individuals no longer delivering any services to them. This is also true of other post-employment benefits, but, other than retiree medical coverage, these benefits tend to be temporary.

When the Social Security system and private pension plans were created in the 1930’s, the life expectancy for a benefit recipient retiring at age 65 was around 5-7 years. Today, many organizations have agreed to retirement benefits at age 55, and the life expectancy is around 27 additional years. In effect, pensions are paid over a much longer period of time than they were decades ago, both because of earlier retirement and longer life span.

Moreover, in the early days of Social Security and private pension plans, people truly stop working when they retire. Today, many retirees from one employer, especially at age 55, go to another employer and work full-time. This is sometimes called “double-dipping.” We want to provide income for the elderly who cannot work, but many pensions go to people who are working or are able to work.

Many solutions have been proposed to reduce the pension obligation burden, among them:

  • Changing the pay calculation formula to reduce the wage or salary base subject to the pension formula;
  • Reducing cost-of-living adjustments;
  • Requiring an individual to work longer to begin collecting retirement benefits; and
  • Reducing the percentage payout.

The common element of all these solutions is that they require employees or retirees to give something up. Inevitably, these solutions get resisted by employees or their union representatives. But what if there were a solution that actually increased someone’s take-home income and cost the employer less? There is such a solution.

The solution requires the tax law to be changed to allow someone to keep working, although at a reduced pay rate, but get enough of his or her pension benefit to take home more money in the current year. Current law allows someone to work part time for the employer and collect a pension, but limits that work to 750 hours a year. We need a solution that allows an employee to collect a portion of his or her pension and work full time, although at a reduced pay rate.

How would this work?

Today, if someone makes $100,000 a year and has a pension that equals 75% of his or her pay, and gets the right to retire with a full pension at age 55. In effect, the employer pays $75,000 per year for 27 years, plus cost-of-living adjustments. Without adjusting for pay increases for an active employee or cost-of-living adjustments for a retiree, the employer is responsible for $1,725,000 if the employee lives to age 82.

However, imagine a law that allows the employer to start to pay down the pension immediately, but only if the employee takes a pay reduction. For example, let’s assume the law allows the employer to pay $30,000 a year for the employee from the pension and $75,000 in base pay. The employee would get 5% more. The employee decides to work 10 additional years. The first ten years cost the employer $300,000 instead of $750,000, and the employer can take an immediate reduction in its pension costs.

Why has this not been seriously pushed before?

  • Historically, companies wanted older workers to retire so that they could replace them with younger workers. The reduced pension cost of keeping an older worker was more than offset by the reduced cost of replacing the older worker with a younger work. However, in my proposed solution, the employer can effectively replace a $100,000 worker in place with a $75,000 worker, without losing that older worker’s skills and experience.
  • In many cases, the older workers were not as productive as those who replaced them. Today, there is ample data to show that older workers are more productive, more loyal, and do higher quality work than those who replace them.
  • Moreover, in many industries, it is extremely difficult to replace older workers, because there are fewer younger people with the same skills. Such positions as mechanical and aeronautic engineers are particularly hard to replace.
  • People always thought of pensions as a very small post-employment benefit that did not burden the employer. Because of a combination of lower investment returns, higher percentage payouts, much lower discount rates on future benefits (which makes them higher), and longer life expectancy, the per-year cost of future benefits has grown dramatically. This was not as attractive a solution under earlier conditions, but the math makes it much more attractive now.
  • The math might be more complicated if the average employee can retire at age 55, but actually retires at age 62. In that case, the program can be implemented at the average retirement age, rather than the initial retirement age. There is still a savings, but it might be smaller, although still significant.

This is not a solution for every organization, because many employers simply need to shrink their workforce or to replace older workers with people who have very different skills. However, it should be available to employers who can make it work.

There needs to be another change in the law: employers need to be able to offer this kind of program to some workers, perhaps those over a certain age or a certain level of experience, but not other workers. Right now, tax and labor laws severely limit discrimination within a workforce. This is a great transitional strategy to help employers move away from defined benefit pension plans that no longer work for them..

Retiree Medical

I have talked about the easy solution to the retiree medical problem: helping people stay healthier longer, so that they do not have the long, slow decline with multiple chronic diseases that adds $200-300 thousand dollars to lifetime medical costs, relative to healthier retirees. Taking the medical inflation rate down by 1-2% per year would significantly reduce what employers have to set aside for retiree medical coverage. Moreover, healthier employees are more productive and do better quality work. Employers just need the will and the skill to fix the problem by focusing on a culture of health for both employees and retirees.

The challenge for managing retiree health is more complicated, because retirees are more geographically scattered, but there are many opportunities for retiree outreach, especially if “corporate practice of medicine” laws can be modified to give employers an opportunity to provide primary care clinical services to retirees who do not have their own primary care physician.

These are win-win solutions, as opposed to solutions that involve cutting back benefits, and creating resentment by employees or retirees or their families.