Where Have All the Pensions Gone?

By Richard Ippolito and Thomas A. Firey
This article was first published in National Review Online, March 28, 2002.

Beginning in the late 1980s, and in increasing numbers in the 1990s, employers have been converting their traditional pension plans into cash-balance or other tax-advantaged investment plans. Though some employees may like the change, many others lament it because of the loss of guaranteed retirement income. That lament was underscored earlier this year by the tales of Enron employees who watched the value of their 401 (k) plans dwindle.

Where have the traditional pension plans gone? Conventional wisdom holds that corporate greed killed pensions in exchange for 401 (k) plans. But that does not jibe with reality; a company that blindly pursues profit to the detriment of employees would neither offer a 401 (k) nor a traditional pension. What is more, such a company would not be very successful in attracting quality employees in a competitive labor market.

So, what did cause the disappearance of traditional pensions? To answer that, we must first understand how the plans worked and what benefit they offered to employers.

Under a traditional pension, an employee’s retirement benefit is determined by some multiplication of his final year’s earnings and the number of years he worked for the company. For instance, a 40-year-old employee with 20 years of service would already be assured of a certain level of retirement income given his current pay level and tenure. That income would increase in coming years as he adds to his tenure and his pay rises.

But what would happen if the company experienced financial difficulty and had to terminate the plan? Our 40-year old worker would, upon retirement, still receive income from the old plan, based on his years of service and wage at the time of the termination. But the old plan would not give him additional income for more years of work and pay increases after termination.

Under the old plans, employers would regularly fund the pension plan at least enough to cover the retirement income that employees had earned up to that time. Most employers contributed additional money in anticipation of pay raises that would increase employees’ eventual benefits. That ensured that there would be sufficient funds to support the promises to workers.

What happens to the additional assets if the fund is terminated? Until 1986, the law said that any money left over, once workers’ earned benefits were covered, would revert to the employer (subject to corporate tax). Thus, firms and workers struck a kind of bargain: As long as the firm was successful, workers received a higher pension; but if the firm experienced trouble and terminated the plan, workers received a lower pension and the firm used the after-tax reversion proceeds to improve its financial condition.

In the 1980s, a small number of firms that did not appear to be in severe financial trouble nonetheless terminated their plans. Employees protested, and Congress responded by passing a 1986 law that placed an additional 10-percent tax on reverted assets. That “reversion tax” was increased to 50 percent in 1990, meaning that any excess assets would be taxed at about 85 percent (corporate tax plus reversion tax). The tax essentially dissolved the downside of the deal between workers and the firm. Now, if a firm experiences financial difficulty and decides to terminate its plan, the majority of excess assets go to the government.

Employer response to that change was as dramatic as it was predictable: About one in five plans (weighted by covered workers) converted to cash-balance plans, while other employers reduced their contribution rates to the traditional plans, which ultimately reduced excess pension assets by upwards of 60 percent.

The disappearance of the traditional pension plan was not predestined, but was the result of well-intended government action gone awry. That leaves us with a quandary: Are we willing to end the reversion tax and accept that some employers will still terminate their plans in order to attain the excess assets? Or will we keep the tax and encourage firms to not have traditional pension plans to begin with, or convert their plans to cash-balance plans?

Richard A. Ippolito is an economist and professor of law at George Mason University School of Law. Thomas A. Firey is managing editor of Regulation magazine, a publication of the Cato Institute. An in-depth study of this topic appears in the spring issue of Regulation.