Fully Funded Pensions
109 Pages Posted: 16 Nov 2019 Last revised: 16 Jul 2020
Date Written: November 8, 2019
At retirement, workers want to have enough income to support themselves throughout their retirement years. In that regard, financial planners often suggest that retiring workers should aim to replace 70 to 80 percent of their annual preretirement earnings. Social Security benefits typically replace around 35 percent of the typical worker’s preretirement earnings, and the purpose of this Article is to show how pensions could and should be designed to replace, say, 40 percent of the typical worker’s preretirement earnings throughout her retirement years. In particular, because so many public and private pension plans are underfunded, this Article is focused on how to fully fund those pensions.
At the outset, Part II provides an overview of Social Security, pensions, annuities, and other lifetime income mechanisms. In particular, Part II explains how Social Security works, how traditional pensions work, and how newer 401(k) plans and individual retirement accounts (IRAs) work.
Part III then focuses on funding issues for Social Security and pensions. In particular, Part III shows that the Social Security system is currently underfunded by at least $13.9 trillion, that State and local government pension plans are currently underfunded by at least $4.7 trillion, that the U.S. government’s civilian pensions are currently underfunded by at least $911 billion, and that the U.S. government’s military pensions are currently underfunded by at least $767 billion. Part III also shows that private-sector pensions are also severely underfunded. In that regard, traditional defined benefit pensions are currently underfunded by at least $553 billion. Moreover, Part III shows that most workers with 401(k) plans or individual retirement accounts (IRAs) are not saving anywhere near enough to have pensions that could replace 40 percent of their preretirement income; and many workers have no retirement savings of any kind.
Part IV then looks at some basic compound-interest and pension mathematics, and Part V explains pension benefit accrual and funding in traditional defined benefit plans. First, Part V.A develops a model, traditional defined benefit plan; and Part V.B then shows how that model defined benefit plan could provide a typical retiree with a pension that would replace 40 percent of her preretirement earnings. Part V.C then uses that model defined benefit plan to explain and compare the various mechanisms that are currently used to fund such traditional pensions, including everything from the pay-as-you-go method to the principal actuarial cost methods that are used to prefund those traditional pensions.
Part VI then looks at benefit accrual and funding in defined contribution plans (and IRAs). Part VI develops two alternative model plans that could replace 40 percent of a typical worker’s preretirement earnings. For these model plans, the idea is for the worker to save enough money in her individual account by age 65 so that she could then buy a lifetime annuity that would replace 40 percent of her preretirement earnings.
Part VII then expands the defined benefit and individual account models to address some of the most important problems of providing pensions in the real world, including, for example, the problem of postretirement inflation. Part VIII then offers some recommendations about how to redesign—and fully fund—real-world defined benefit plans, defined contribution plans, and IRAs; and, finally, Part IX offers some concluding remarks.
Keywords: pension funding, pension underfunding, adequate retirement income, Social Security, Pension Benefit Guaranty Corporation, pension reform, state and local pension funding, defined benefit, defined contribution, multiemployer pensions
JEL Classification: D91, G22, G23, H55, H62, H63, H68, H75, J14, J26, K31, K34
Suggested Citation: Suggested Citation