Commentary | Retirement

Beware allowing employers to reduce benefits and break promises about future payments

Opinion pieces and speeches by EPI staff and associates.


Beware allowing employers to reduce benefits and break promises about future payments

By  Christian E. Weller

Peel away the technical words and numbers and a pension is, at bottom, a simple, straightforward promise. Work today and in return, your employer pays you two different ways: wages or salary now and the promise of deferred compensation from a pension fund after you retire. So ingrained is this promise that workers will often agree to lower wages today in exchange for the promise of a decent pension in the future.

Unfortunately, in Washington at least, that a promise is no longer really a promise. Under cover of “reform,” the Bush administration and employers are now crossing their fingers behind their backs when they talk about pensions.

One administration plan would undermine employees’ promised benefits by changing Internal Revenue Service rules. If enacted, these new rules would make it easier for employers to set the level of employees’ benefits according to something called a cash balance formula. Many employers have used this technical sleight of hand in the past to conceal that they are reducing the benefits they promised their employees.

Another administration proposal would change the way pension funds are regulated and ultimately would make more employers likely to break their pension promises. It would offer employers some short-term relief for the next two years (not a bad idea in a downturn), but would also make pension funding more complex and volatile thereafter. This complexity and uncertainty will give employers new incentive to renege on the pension promises to their employees.

It’s true that pension funds are having financial troubles, putting pressures on employers who offer them. Like every other investor, pension plans lost a lot of money in the stock market. In addition, the plans’ liabilities — the sum of promised benefits — rose when the long-term interest rates used to calculate them fell to the lowest levels in decades. Consequently, employers were required to contribute more to their pension plans at a time when their earnings are not stellar. This triple whammy of poor stock market performance, falling interest rates and low earnings tends to recur in almost every recession.

Encouraging employers to keep their pension promise takes two ingredients: immediate relief to keep employers from cutting benefits and pension funding rules that stabilize the level of contributions required over the long haul. The Bush administration’s proposal would address the first need by letting employers use a higher interest rate for two years to calculate how much they will have to pay out, reducing their liability. But the funding relief would be short-lived.

After two years, employers would have to switch to a patchwork of interest rates to calculate their liabilities. For a pension benefit payable in five years, they would have to use a 5-year bond rate, for one payable in 20 years, a 20-year bond rate, and so on. Because short-term interest rates are typically lower than long-term rates, it would make short-term liabilities, such as benefits to older workers, more expensive.

For employers with a high percentage of workers nearing retirement — such as manufacturers — pension costs will likely rise faster than for other, younger businesses. Employers may opt to abandon their pension promise.

Fortunately, there are better alternatives. By basing contribution requirements on a formula that averages interest rates over time, we could smooth out the peaks and valleys in interest rates and make pension funding less volatile for employers and pension benefits more secure for employees. Some members of Congress have shown some interest in these “smoothing” techniques.

The Bush administration’s proposal should be scrapped. It offers employers only short-term relief. And it offers millions of workers nothing more than a chance to cross their fingers that their employers will keep their pension promise.

Christian E. Weller is a macroeconomist with the Economic Policy Institute in Washington, D.C.

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