Social Security is in trouble. While the system is currently generating tax revenue that is approximately equal to the benefit payouts, this will not be the case in the near future. Many state and local pension funds are in a similar situation.
Retirement plans in the U.S. can be classified into two broad categories: defined benefit programs and defined contribution programs. The former include traditional pension funds where retirees receive a fixed monthly benefit upon retirement; this is often a fixed percentage of the salary they earned in the year just before they retired. The latter include familiar 401(k) plans that many private employers offer. Under these plans, a defined percentage of the worker's salary is deposited in an investment fund earmarked specifically for that worker and the worker receives the market value of that personal fund upon retirement.
Defined benefit programs place plan riskiness on the employer or the pension fund manager with whom the employer has contracted. Since benefits are fixed according to a predefined formula, extraordinary losses or gains in the value of the pension fund's assets accrue to the fund itself and do not affect the worker's retirement benefits. Defined contribution plans, on the other hand, place all of the risk on the employee. As many of us discovered a few years ago, losses in the value of investments have big effects on a worker's expected retirement income.
Richard W. Evans, a colleague of mine at BYU, and I have been working over the past few years on a series of papers dealing with the financial viability of the U.S. Social Security system, Social Security in general and (most recently) state and local pension stability. One recurring theme in our research is the fundamental instability of defined benefit programs.
Social Security and government pensions are defined benefit programs where the system's income is determined by a set contribution (or tax) rate; i.e. the percentage of each worker's salary that must be paid into the pension system with each paycheck. Sometimes this is paid by the employer, as with most state and local pensions. And sometimes this is paid directly by the worker, as with Social Security taxes. At the same time, the benefits paid out are also set according to a well-defined set of rules.
To see how this generates instability, consider the case where the system has been perfectly calibrated so that the contribution inflow exactly matched the benefit outflow. If the pension fund starts off with no assets, then the amount of assets over time will remain zero as long as contributions exactly match benefits. However, if the pension fund starts off with a positive asset balance, it will accrue interest over time that sends the pension fund balance off to infinity in the long-run due to compounding of interest. If the fund starts off in debt, the same compounding drives it off to negative infinity over time.
Of course in the real world, inflows and outflows rarely match up exactly. Unexpected fluctuations in either of these can tip the fund from an unstable upward path to an unstable downward path or vice versa. Pension fund managers are constantly monitoring the balance of their fund's assets along with actuarial projections of future contributions and benefits to ascertain as accurately as possible on which path the fund is headed in the long run.
In a pension fund, the managers have the ability, and indeed the obligation, to adjust the contribution rate as needed to ensure the fund is fully funded in the long run. With apologies to LDS apostle Dieter F. Uchtdorf, an appropriate analogy might be an airplane. An airplane left to cruise without any pilot control will eventually crash. Its flight path is unstable in exactly the same way as the path of a pension fund balance. The altitude of the airplane corresponds to the value of the pension fund.
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