PENSIONS IN TRANSITION: United States and Japan Robert L. Clark Professor of Economics North Carolina State University 19 September, 2002.

PENSIONS IN TRANSITION:United States and Japan

Robert L. Clark

Professor of Economics

North Carolina State University

19 September, 2002

NATIONAL RETIREMENT PLANS

NATIONAL RETIREMENT PLANS CONSIST OF

employer pensions

social security

national retirement policies

PARALLELS AND CONTRASTS

Employer pensions in U.S.,

DC plans are dominant

Emergence of cash balance plans

In Japan,

new regulations allow DCs

underfunding plagues DBs

PARALLELS AND CONTRASTS

Both countries face significant Social Security funding problems due to population aging– In U.S., debate rages over use of

individual accounts– In Japan, five year modifications lower

benefits and raise costs

U.S. AND JAPAN RETIREMENT SYSTEMS

Similar pressures Similar options Different choices? Can we learn from each other?

OUTLINE OF PRESENTATION

Employer pensionsTrends in U.S.

New options in Japan Social Security

Need for action now

Options for both countries

CHOICE OF PENSION PLAN

Pensions are an important component of labor compensation.

The generosity and style of pension depends on worker preferences and employer preferences.

PENSION COVERAGE Approximately half of the labor force

covered by pension in the US

Total coverage rates have been relatively stable over the past three decades

Trends in Pension COVERAGE

30%

35%

40%

45%

50%

55%

60%

65%

Sponsorship RateParticipation Rate

COVERAGE RATES Coverage rates vary considerably by

– level of earnings – firm size – industry

Pension Participation Rates for Workers

0%

15%

30%

45%

60%

75%

90%

1979 1983 1987 1991 1995 1999

Year

Pe

rce

nt

of

wo

rek

rs

pa

rtic

ipa

tin

g

LT $15,000

$15 - $24 K

$25 -$49 K

$50,000 +

TYPES OF PENSION PLANS

Overall coverage has remained stable in the United States

However, there have been significant changes in plan type and plan design

TYPES OF PENSIONS traditional defined benefit defined contribution hybrid

Features of Alternative Plan Types

Plan feature DB Plan DC Plan Hybrid Tendency

Employer contributes Always Sometimes Always DBEmployee contributes Rarely Generally Rarely DBParticipation Automatic EE choice Automatic DBContribution level Automatic EE choice Automatic DBPBGC insurance Always No need Always DBEarly departure penalty Yes No No DCBenefits easily portable No Yes Yes DCAnnual communication Benefit at Current Current

retirement balance balance DCRetirement incentives Generally Neutral Most neutral DCAccrual of benefits Back loaded Level Varies MixedFinancial market risks Employer Employee Shared Mixed

bears bearsLongevity insurance Generally Generally no Not often taken Mixed

WORKER PREFERENCES Workers want the pension plan that

gives them the most value of each dollar of reduction in salary

Portability is important

WORKER PREFERENCES Understanding the value of the

pension

Workers express preferences for individual accounts and lump sums

EMPLOYER PREFERENCES Employer preferences are to develop

compensation policies that attract and retain quality workers

Plans that provide appropriate retirement incentives

PENSION PREFERENCES Desired pension policies can change

with economic conditions

Workers and firms want to provide the most value in retirement benefits for the lowest cost

ADMINISTRATIVE COSTS Administrative costs are affected by

government regulations

Higher administrative cost make some firms less likely to offer a pension

Changes in administrative costs can affect the most desirable plan type

Small Plan Per Capita Administration Costs

0

100

200

300

400

500

600

700

1981 1983 1985 1987 1989 1991 1993 1995

DB

DC

Dollars per year

Large Plan Per Capita Administration Cost

0

10

20

30

40

50

60

70

80

1981 1983 1985 1987 1989 1991 1993 1995

DB

DC

Dollars per year

PLAN CHOICE If establishing a new plan, which plan type

should the firm adopt?

Increasingly firms starting first time pension plans are selecting DC plans.

Cash balance plans have typically come from converting traditional DB plans into the new hybrid plan.

TRANSITIONS When converting a traditional defined

benefit plan, companies must consider the impact on current and future workers.

Impact of plan change varies by type of worker.

IMPACT OF PLAN CONVERSIONS

Workers who leave before reaching the age of early retirement will tend to be better off under a cash balance or DC plans compared to DB plans

Workers leaving between the early and normal retirement ages will tend to have higher benefits in a DB plan

EARLY RETIREMENT SUBSIDIES

Virtually all traditional defined benefit plans have subsidized early retirement plans.

These plan provisions create substantial jumps in the value of lifetime pension benefits.

Neither defined contribution or cash balance plans have these provisions.

Decline of Defined Benefit Plans in U. S.

Coverage by traditional defined benefit plans has been declining for the past quarter century

Since the mid-1970s, coverage by defined contribution plans has increased sharply.

This trend has been primarily among smaller firms.

PRIMARY PENSION COVERAGE

0102030405060708090

1979 1996

DBDC401(k)

DECLINE OF DEFINED BENEFIT PLANS

This trend has been driven by:– increased administrative cost of DB plans

relative to DC plans.– change in composition of labor force and

preference for portable pensions.– change in industrial mix with employment

decreasing in companies with traditional DB plans.

DECLINE OF DEFINED BENEFIT PLANS

Many large firms have converted their traditional DB plans to cash balance plans.

First cash balance plan in 1985.

REASONS FOR PLAN CONVERSIONS

– Restructure compensation to appeal to a changing labor force.

– Value of plans is easier to explain to workers.

– Reducing the level and uncertainty of pension costs.

– Ending early retirement subsidies.

COMPANY POLICIES Companies must consider impact on

current and future workers New policies must be explained Rationale for pension changes should

be explained

TRANSITION BENEFITS Many workers who are near retirement

will accumulate lower retirement benefits.

To moderate the loss of expected pension benefits for senior workers, many companies have provided transitional benefits.

COMMUNICATION Full disclosure and effective

communications with workers is a key to plan transitions

Workers should know the reasons for the change

Computer software should be developed to all workers to estimate the impact of the plan change on them

PENSIONS IN THE 21ST CENTURY: U.S.

Pensions in the 21st century will be increasingly based on individual accounts

Workers will have greater responsibility for their own retirement income

Government regulation of pensions will affect the outcome

PENSIONS IN THE 21ST CENTURY: Japan

New regulations – permit DC plans– eliminate TQPPs– allow conversion of EPFs

PENSIONS IN THE 21ST CENTURY: Japan

Conversion made more difficult by– underfunding of existing DB plans– relatively low limits on DC contributions– not allowing both employer and employee

contributions– available rates of return on future

individual accounts

FINANCIAL EDUCATION Defined contribution plans place

greater responsibility on workers Employees must decide when to start

contributing and how much to contribute

Employees must decide how to invest account balances

FINANCIAL EDUCATION Do workers have sufficient financial literacy

and know to make appropriate choices? Do firms with DC plans have an obligation to

provide financial education? Does the government have an obligation to

provide increased financial education to workers?

SOCIAL SECURITY IN TRANSITION

Population aging placing increasing stress on social security systems in U.S. and Japan

In U.S., great debate but no action as yet

In Japan, periodic changes do not solve funding problem

SOCIAL SECURITY IN TRANSITION

Will there be individual accounts?

How will existing program be restructured?

COMMISSION REPORTS IN U.S.

Options presented by 1994-1996 Advisory Council (www.ssa.gov/history/reports/adcouncil/report/findings.htm#overview)

Option proposed by President Clinton Options proposed by Bush

Commission on Social security (www.csss.gov)

FIVE YEAR REVIEWS IN JAPAN

Since 1985, regular 5 year reviews have Lowered benefits

Increased retirement ages

Increased tax rates

Increased government contributions

CONTINUED POPULATION AGING

Continued population aging raises projections of future costs – especially true in Japan

Need for action is immediate

RETIREMENT POLICIES Important to recognize the linkage

between – Employer pensions– Social security– National retirement policies