There is little doubt that 2016 will go down in history as a year of revolutionary change. Within the past twelve months:
- Voter dissatisfaction with business as usual surprisingly trumped all other issues in the US presidential election.
- UK voters opted to Brexit from the European Union (which very few brexperts brexpected.)
- The Chicago Cubs won the World Series for the first time since 1908 (which may have torn a hole in the space-time continuum, contributing to the other two.)
Regardless of your political affiliations, world view, or baseball allegiance, you have to agree that these three revolutionary events have a common characteristic: That which was long thought to be impossible suddenly occurred.
Obsolete status quo?
If ever anything was ripe for a revolution, it would be the regulation of single employer defined benefit (DB) plans. For over four decades, DB plans have been ruled rather tyrannically by the Employee Retirement Income Security Act of 1974 (ERISA) and its voluminous subsequent regulations.
At the time ERISA was drafted, the chief concern of lawmakers was ensuring that pension promises made by employers to employees were 100 percent guaranteed. This seemed an appropriate goal for the era considering the cutbacks participants had recently sustained from underfunded plan failures. (Remember that 401(k) plans had yet to be invented, so DB was the only meaningful employer provided retirement benefit option available.)
We now know that those full guarantees are incredibly expensive disincentives to employers. Skyrocketing Pension Benefit Guaranty Corporation (PBGC) premiums and the threat of forced funding of full guarantees during times of business hardship are serious impediments to DB sponsorship.
Medical insurers, recognizing the rapidly increasing incremental cost of coverage as levels approach 100 percent, have long used lower co-insurance levels (such as 80 percent) to strike a reasonable balance between protection and cost. Perhaps ERISA drafters should have taken a similar approach with DB pensions.
A new problem: lifetime income
But they didn’t, which has contributed to defined contribution (DC) becoming firmly established as the primary retirement benefit structure in the US. An entire generation of Americans has now passed through full careers with 401(k) as their primary source of retirement benefits. Many have only frozen DB pensions, or possibly none at all. The risk of some loss is now universally accepted as part of the retirement benefit contract.
As such, the key need of employees today is no longer the full guarantee of their pensions. (Those with no DB benefits may not even be familiar with the concept.) Rather, it is the availability of affordable and predictable lifetime income options to complement the pool of assets they have accumulated in their 401(k)s, at an acceptable level of risk.
A number of DC-based solutions have come to market touting lifetime income. Many, however, are not widely utilized. This is because they generally require people to voluntarily hand over substantial sums they have spent careers accumulating to purchase potentially complex annuities at prices perceived to be unattractive. (Principal recently rolled out an in-plan DC option with this problem in mind.)
Lack of DB choices
In its natural state, DB is better suited for providing lifetime income to rank and file employees. It delivers the advantages of longevity risk pooling and professional investment management without asking retirees to make stressful annuity purchase decisions. Unfortunately, the types of DB plans that employers would voluntarily implement, ones with design flexibility and risk sharing options to fit their needs, aren’t permitted under law as it exists today.
Henry Ford allegedly said that any customer can have a car painted any color they want so long as it’s black. ERISA essentially takes a similar position: you can have any kind of DB plan you want as long as the pension is 100 percent guaranteed…and normal retirement age is no later than 65…and benefits accruals aren’t back-loaded…and eligibility begins at age 21…
An entire room full of ideas exists to improve US pensions, but ERISA only allows the use of the ones you can see through their keyhole.
Toiling under the ERISA yoke for so long has made employers and retirement providers incapable of even considering new DB plans. Designs that would make DB plan sponsorship more attractive are immediately discounted as impossible under the law. So promising ideas are quickly dropped, and the world tries valiantly to reconstruct DB lifetime retirement income solutions using only DC components.
You say you want a revolution?
With revolutionary change in the air and current regulations struggling to address today’s lifetime income needs, it seems that the beginnings of a grass roots movement may be in place. All interested parties have something to gain from loosening restrictions on DB plans, so they should be on the same side of this issue.
- Employers want design flexibility to attract and retain talent, to facilitate dignified retirement of their employees, and to effectively share cost and risk. They are willing to make reasonable contributions but don’t want to take on irreversible or existential risk.
- Employees want lifetime income to complement their pool of retirement savings, but they are hesitant to part with their accumulated wealth to get it. They have enough experience with risk that they are now willing to accept a pension with a partial guarantee over a non-existent fully guaranteed one. They are also willing to make tax deferred contributions toward their retirements, but are prohibited from doing so inside DB plans.
- The government doesn’t want to take on more private pension risk, but needs help delivering lifetime income to retirees as the finances of social security get squeezed. Insuring a lower percentage (like 80) and allowing employers and employees to share the remaining risk would significantly reduce PBGC exposure while still encouraging lifetime income solutions in the private sector.
(Note: I am assuming these changes apply only to future benefit accruals; past DB benefits would continue to operate under current full guarantee rules.)
Join the movement
Identification and articulation are always easier than execution, but common ground apparently exists to open a dialogue on this important issue. Emboldened by the seismic changes of the past year, I will open the discussion by calling for the emancipation of pension design from obsolete and overly restrictive limitations. (“Mr. ERISA, tear down this wall!”)
If 2016 has taught us anything, it is that the needs of stakeholders can’t be ignored indefinitely. Tone-deaf institutions can quickly be discarded, and the status quo isn’t as much of a sure thing as everyone thought.
If you agree, I encourage you to accept my invitation to join the defined benefit revolution. Demand plan design options outside the narrow constraints of current ERISA rules. The future of American lifetime income security may depend on it.
Mike Clark is a fellow of the Society of Actuaries (SOA) a member of the American Academy of Actuaries (AAA), and a lifetime fan of the Pittsburgh Pirates who allowed the Cubs to blow right past them in the standings last year! Read more on this topic in his 2013 article in Contingencies magazine: http://www.contingenciesonline.com/contingenciesonline/20130910?pg=45#pg45
This document is intended to be educational in nature and is not intended to be taken as a recommendation.
The subject matter in this communication is educational only and provided with the understanding that Principal® is not rendering legal, accounting, or tax advice. You should consult with appropriate counsel or other advisors on all matters pertaining to legal, tax, or accounting obligations and requirements.
Insurance products and plan administrative services are provided by Principal Life Insurance Company, a member of the Principal Financial Group® (Principal®), Des Moines, IA 50392.