Lies, Damned Lies, and Defined-Benefit Plans

I posted last week, contrasting blogs on Detroit by libertarian Louis Woodhill and Keynesian Paul Krugman.  My point was not so much to pick sides as to make an observation about the different perspectives on cause-and-effect.

I’d like to focus on two of Woodhill’s brasher statements, and unpack some of my own thoughts on the intersection of different economic and political approaches.  Here are Woodhill’s two statements:

From the very beginning, Detroit’s benefit plans were based upon a lie.  This is because Detroit’s plans are defined benefit plans, and all defined benefit plans are based upon a lie. The lie at the heart of every defined benefit plan is that you can guarantee the future.  You cannot.  No one can even guarantee that they will be alive five minutes from now.

Ultimately, however, the big lie that drove Detroit into bankruptcy is liberalism itself. The great strength of liberalism is that it attempts to address the real problems of ordinary people.  The great weakness of liberalism is that its “solutions” are based upon lies, double standards, and wishful thinking.

My first observation is that, in a complex economy, we make all kinds of decisions based on assumptions, hopes and intentions about the future.  Indeed, you can make a persuasive argument that planning for the future, or being able to do a thought experiment about what might happen next, constitutes the central evolutionary advantage conferred by the larger brains that humans carried out of the African savanna.  Woodhill thinks this general advantage must be a disadvantage when applied to income security in retirement.

I’m not convinced.  Defined-benefit plans fail when the assumptions are unrealistic, the contributions are insufficient, or the investment policy is unwise.  All of those possible pitfalls are exacerbated by any policy order where interest rates vary dramatically, or where the value of money is unstable.  (Two very much related issues.)

Private-sector defined benefit plans have a better history than public-sector plans, for two reasons.  First, private plans are regulated by the Department of Labor, and guaranteed by the Pension Benefit Guarantee Corporation, a quasi-public entity.  (Though the PBGC does not cover union plans, and is currently under-funded.)  Second, with private plans there is at least one party at the negotiation table with an interest in paying only affordable benefits, and fully funding them as incurred.  With public-sector plans, especially in cities like Detroit, the public-sector unions are often among the key supporters, poll workers and funding sources for the elected leaders who in theory sit on the opposite side of the table when it comes time to negotiate benefits packages.  Politicians of both parties have for years substituted high pensions payable in the out years for wages paid during their terms, and have under-funded those pensions by making over-optimistic forecasts about investment returns.  (Like countless other elected officials from Stockton to Detroit, New Jersey Republican Governor Christie Todd Whitman “balanced the budget” back in the 1990s using the latter strategy.)

As an aside — Woodhill argues that Social Security, while under-funded, is easily fixed by simply cutting benefits to match tax receipts.  (This would be about a one-third haircut.)  It is hard for me to imagine a more unrealistic assessment, in a democracy, at the intersection of public policy with the interests of specific constituencies.

In the private sector, defined contribution plans like 401ks have largely supplanted defined benefit plans, starting in the early 1980s.  One of the forgotten reasons for this switch was a policy backed by unions in the mid-80s.  Back then, companies had to adequately fund their defined benefit plans under Department of Labor regulation.  When the markets exploded to the upside starting in 1982, many such plans quickly became over-funded — they had more dollars than were needed to fund future benefits.  Leveraged-buyout firms were able to pursue hostile takeovers against public companies, funded in part by Michael Milken’s junk bonds, but also in part by the target company’s own pension plan.  Once acquired, loans could be retired by withdrawing excess money from the pension plan. Thus the company paid for its own dissolution.

Unions objected that this was a raid on worker’s income security, and succeeded in having Congress pass a law making any such withdrawals subject to confiscatory taxation.  Over-funded pensions would no longer provide ammunition for hostile takeovers.

But the law of unintended effects exacted a toll.  Companies now faced a deeply asymmetric risk landscape when funding defined-benefit plans.  If investment returns were low, the companies were on the hook for larger contributions.  Yet if returns were high, companies could not recover the excess.  Heads you lose, tails you…break even.  This accelerated the move to defined-contribution plans, where the investment strategy and the consequences of investment results were entirely the responsibility of the employee-participant.

And that had an effect Woodhill does not acknowledge. Good data demonstrates that the typical 401k participant made lousy decisions with his assets, and earned only a fraction of available market returns, much lower returns that a more bureaucratic, policy-driven pension fund manager would have earned.  Greater choice and greater individual responsibility persuasively resulted in poorer outcomes for most.  (Not for all.  My wife contributed to a 401k for four years in the early 1990s.  Her assets have grown more than ten-fold, and are now in the mid-six figures.)  We saw similar outcomes during the financial crisis — it turns out the concept of homo economicus, the rational, self-interested actor, accessing price information in a free-market and making decisions to maximize his own advantage, and thus optimizing the allocation of economic resources, is deeply flawed.  Individuals and corporations are way less rational than free-market absolutists wish to believe, and are capable of horrendous errors, especially when acting in groups.

I’ve always found the defined-benefit vs. defined-contribution issue fascinating.  Policies supported by liberals had the unintended effect of damaging the long-term retirement security of workers.  Greater individual choice and empowerment had the effect of damaging the financial independence of those same worker-investors.  To me, both liberals and conservatives want the best for ordinary workers, and both are guilty of “wishful thinking.”

4 thoughts on “Lies, Damned Lies, and Defined-Benefit Plans

  1. Jim
    FYI:
    The PBGC does cover multi-employer union defined benefit pension plans. As indicated in the sites FAQ’s “Another PBGC program insures multiemployer plans covering unionized workers of non-related employers in the same industry, such as trucking or construction.”
    As to the underfunding statement, most defined benefit plans are in that predicament!!! Such is the life of the retiree, ever cautious about the rug being pulled out from under you.

    A Votre Sante,

    John

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  2. Jim, would or should corporations that started defined benefit plans have provided some form of professional advice for employees knowing that employees would most likely make bad investment decisions when left on their own? One thought would be an in-house CFP who would make periodic recommendations for employees to make plan adjustments based on market conditions

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    • This is an interesting and difficult issue. Briefly, my response would be that CFPs or other financial advisers tend to make the same mistakes made by individual investors. They tend to follow trends, to panic near market bottoms, and to chase performance near market highs. The degree to which individuals make bad investment decisions in practice, especially in volatile markets, is entirely in conflict with what until recently has been the dominant economic policy viewpoint, the efficient markets theory.

      As a conservative, one of my big changes in viewpoint in recent years has been to recognize the number of contexts in which unconstrained individual decision-making does not yield optimal results. I guess I’d say I’m no longer a free-market absolutist.

      The data suggest 401k investment decision-making is improving, as more participants transition to target-date retirement funds and other less-active strategies.

      The difficulties with retirement plans funded by and run by individuals spotlight the potential value of public-sector retirement solutions like Social Security, if they can be adjusted sensibly to accommodate changing demographics. So far that has not happened.

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