Why Pension Plans Are Still Relevant In Today’s Economy
Pension plans offer a guaranteed regular retirement income, preventing financial shortfalls during post-retirement. However, several factors can affect the amount you receive. Unlike a 401(k), pensions are not invested with money from an employee’s paycheck. The employer instead funds them.
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Pensions Are A Form Of Social Security
In many private-sector workplaces, for example, Boeing pension plans guarantee a fixed income during retirement, often based on an employee’s average salary over their career with the company. Employees typically make contributions to the plan, which are tax-deductible for employers. Pensions are a long-term commitment that can strain budgets, especially in bad economic times. To reduce the risk of short-term budget problems, some states and localities reduced their contributions to pension funds during good economic times when those programs appeared fully funded or investment returns exceeded expectations. However, those reductions will lead to future budget problems. Instead, states should increase and stabilize the money flowing into pension plans and avoid reducing those benefits. They should also consider removing or restructuring legally imposed contribution caps. This will allow for more accurate budget trade-offs. It will also help prevent “double-dipping,” a practice that occurs when an employee draws a pension while still working for the same employer, which can result in a lower income than would otherwise be received.
Many state and local employees have pensions that pay a fixed income after they retire, often based on the number of years worked. This type of retirement plan is more like insurance than a savings account. But a pension can be less predictable than a savings account because it relies on the long-term investment performance of its underlying investments. States must move slowly and cautiously to bring their underfunded pension plans back to fiscal health, but they must also be careful not to push costs onto future generations. This means avoiding deep cuts to benefits for new workers and making modest changes in current benefit rules that can reduce costs over time without jeopardizing economic recovery. One crucial step is to change the method used to calculate funding needs. Currently, most public pension funds use an actuarial discount rate that reflects the average historical return on their assets, about 8 percent. Instead, these funds should use a riskless discount rate, such as that on Treasury bonds, which would better reflect the expected returns of their underlying investments.
Pensions provide a source of retirement income that can last a lifetime. They also offer a tax advantage, as contributions are made with pre-tax dollars, and investment earnings are only taxed once they are distributed to employees. However, many pensions have issues. The most common problem is needing more assets to pay their current liabilities. To address this, some states have put in place legal restrictions that cap the amount of annual employer contributions to pension plans. These caps reduce state contributions when stock market returns have boosted the value of pension funds, and they increase contribution rates in bad economic times. However, such limits would require significant additional pressure on state budgets when state revenues are depressed. Rather than this, states should gradually transition to more accurate methods for determining required contributions. These methods can include “asset smoothing,” which phases in the effect of significant stock market changes.
While pension funds are investments, their assets must cover the benefits promised to retirees. The actuaries who determine the annual contributions needed to meet these obligations periodically conduct valuations of the plan’s assets and liabilities to ensure they will be sufficient to meet future payments. Because pensions are invested long-term, a few years of lower-than-expected investment returns are offset by a more extended period of higher returns. For example, while stock market declines have hurt some pension fund investments, many states use “asset smoothing” to adjust for these changes. This technique phases the effect of significant stock market changes over five years. State and local governments can also reduce required pension contributions in economic distress. This can help them free up resources for other purposes like minimizing layoffs and keeping essential services operational. Some state officials have argued that basing required contributions on actual rates of return will lead pension managers to invest funds in riskier investments, but this concern is overblown.