Plan Types Pensions and Policy Approaches

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.