Bloomberg View: Traditional Pension Plans Can Still Work. Really.

Some hedge-fund managers recently came under pressure from the American Federation of Teachers to quit the boards of certain organizations, such as Students First and the Manhattan Institute for Policy Research, that favor the elimination of public-sector defined-benefit pension plans.

Those organizations should reconsider their view. Defined-benefit plans aren’t to blame for the crushing costs of pension liabilities in the U.S.

Defined-benefit plans are a type of pension in which an employer promises its employees a specified monthly benefit on retirement. With these plans, workers can count on future income and needn’t worry about investment risk.

These traditional retirement benefits have been disappearing in the private sector, generally replaced by 401(k)-type plans that provide investment capital to employees but don’t guarantee specified future benefits. Yet defined-benefit plans remain the dominant form of pension for state- and local-government employees, including public-school teachers.

As exploding pension costs divert money from classrooms and other public services, some free-market and school-reform organizations have argued that education funding would be better protected if governments moved to 401(k) plans. That would be throwing the baby out with the bath water. Properly managed, defined-benefit plans can work just fine.

The key is setting aside enough money when the promise is made so that, with reasonably expected investment earnings on those set-asides, there’s enough money when the promise has to be met. The level of those set-asides, or contributions, is based on investment-return assumptions.

Protecting Returns

Let’s say your employer makes a promise to pay you $100 in 20 years. To meet the obligation, it contributes money to a company pension fund that invests that money with the goal of having $100 on hand when payment to you is due. If your employer assumes the pension fund will earn 8 percent per annum, the amount it must contribute upfront is $21.45.

Everything works out fine if the actual return equals the expected return. But if the pension fund earns less than that, a deficiency is created. Because of compounding, the deficiencies are multiples of the upfront contributions. For example, if your employer assumed 8 percent but earned 6.6 percent per annum, then there will be only $77.03 in the fund when payment is due. The employer must dig into its pocket for $22.97 to make up the difference. In total, your employer will have spent $44.42 ($21.45 plus $22.97) to generate a $100 benefit for you.

If your employer had assumed 6.6 percent at the outset, however, it would have contributed $27.85 upfront — and nothing more. In other words, had your employer contributed an additional 6.4 percent from the start, its total costs would have been 37.30 percent less.

Public plans get into trouble when politicians manipulate investment-return assumptions to minimize upfront contributions at the expense of creating large deficiencies down the road. This allows elected officials to make promises without consequences until they are long gone.

There are models of well-managed defined-benefit plans. For example, several subsidiaries of Berkshire Hathaway Inc. (BRK/A) offer their employees benefits funded through assets held in pension-plan trusts. According to Berkshire’s annual report, these assets are “generally invested with the long-term objective of earning amounts sufficient to cover expected benefit obligations, while assuming a prudent level of risk.” Consistent with that objective, Berkshire assumes a 6.6 percent rate of return — a fraction of that assumed by most public-sector defined-benefit systems.

Unlike most politicians, evidently Berkshire’s management is willing to suffer pain now to avoid more pain later, even though those longer-term consequences would probably take place after today’s managers have departed.

Retirement security is a huge issue in the U.S. People need more, not fewer, options for supporting themselves after they stop working. But self-serving management of public-pension plans by short-term elected officials is threatening to remove defined-benefit plans from the mix. For that to change, citizens need to see that these politicians are little better than thieves, stealing from future generations.

(David Crane, a former financial-services executive, is a lecturer at Stanford University and president of Govern for California, a nonpartisan government-reform group. He was an economic adviser to California Governor Arnold Schwarzenegger from 2004 to 2011.)

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