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Promoting Work at Older Ages

The Role of Hybrid Pension Plans in an Aging Population

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Document date: December 31, 2003
Released online: December 31, 2003

The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.

Note: This report is available in its entirety in the Portable Document Format (PDF).


Introduction

The world of retirement plans has changed dramatically since the early 1970s. Defined contribution (DC) plans have now supplanted the defined benefit (DB) format as the most common type of retirement plan, in terms of number of participants and value of assets, while hybrid pension plans, including cash balance and pension equity plans, have transformed the DB universe. Although these changes partly represent reactions to tax laws and new conventions among employers perhaps looking to save money, broader economic forces are also clearly at play. Demographic shifts, reflected in the aging of the population, stand out.

During the 1970s and 1980s, when the nation's labor force was growing rapidly, many employers used their pension plans to encourage workers to retire early. Traditional DB plans typically provide lifetime annuities paid in monthly installments that depend on years of service and salary earned near the end of the career. The size of the monthly benefit increases with years of service, but plan participants lose a year of payments for each additional year of work beyond the age at which they can first collect benefits. Because the increase in benefits paid in each installment is often insufficient to offset the reduction in the number of installments, many workers in DB plans lose pension wealth by delaying retirement. DB plans also often include early retirement provisions, which further discourage work at older ages by subsidizing benefits for those who retire early, often as young as age 55.

Although many workers remain productive at older ages but retire with many years of life expectancy remaining, employers still used to argue that the retirement incentives in traditional DB plans enabled them to make room for the large numbers of young workers entering the labor force each year without resorting to layoffs or wage cuts for older workers, which can destroy employee morale. In addition, seniority pay systems often ended up compensating some older workers more than they were worth in productive output, making the retirement incentives in DB plans even more appealing to employers.

Employers were able to let productive workers go because the influx of women and young baby boomers into the workforce created an ample supply of labor. Today, however, as the relative size of the younger population falls, employers confront potential worker shortages and are reluctant to lose their skilled workers to retirement. Meanwhile, pension costs for traditional DB plans have risen over the past few decades, after adjusting for stock market gyrations, because retirees are now living and collecting benefits longer than they did in the past.

The growing popularity of hybrid pension plans represents one response to the changing demographics of the labor market. As in DC plans, which are typically tax-deferred retirement accounts into which both employers and employees contribute, hybrid plans express future retirement benefits as account balances. In cash balance plans, employers set aside a percentage of each employee's salary each period, which earns interest at a set rate. Balances in pension equity plans equal a given percentage of final average earnings for each year of service. Because these account balances continue to grow at about the same rate after the retirement age as they did beforehand, DC and hybrid plans generally do not discourage workers from remaining on the job at older ages. By shifting from traditional plans to hybrid plans (or never adopting DB plans, which is standard practice for new firms), employers may be better able to retain their older workers and hire new workers of any age.

These shifts are not without controversy. Employers may change plans to reduce pension costs, especially when they drop early retirement incentives. Whether this saving accrues primarily to workers or owners of the company depends greatly upon whether the shift raises compensation costs or profits, and whether workers are able to demand that their total compensation, regardless of pension plan design, reflects their overall productivity. Even if pension costs do not fall, some workers will lose out when changes in pension format spread benefits more evenly among all age groups. In many traditional DB plans, 50-year-olds receive large increases in lifetime pension benefits in return for an additional year of work, but 65-yearolds receive next to nothing. Converting to a different format, such as a cash balance plan, that increases pension wealth by a moderate amount for both groups could generate opposition from those planning to retire early.

This private transformation of retirement policy may indirectly support national retirement policy objectives. With the aging of the population, there is increasing concern about the ability of workers to pay enough taxes to support future retirees and other government functions. Moreover, the vast majority of today's retirees depend more on Social Security and Medicare than their own saving (Gustman et al., 1999), yet they spend close to one-third of their adult lives in retirement. By instead working and saving for a few more years, they can do much to reduce this level of dependency.

More importantly, if current employment patterns persist, fewer workers producing fewer goods and services can threaten standards of living for Americans of all ages—or at least the rate at which those standards rise. By promoting work at older ages, conversion to hybrid pension plans and other initiatives may increase the labor pool and relieve some of the demographic pressures on public programs caused by population aging. Put another way, people who work an extra year produce goods and services that can support their own current consumption and help cover the costs of both retirement programs and other government efforts (such as defense) while at the same time reducing tax pressures on younger workers to support them in retirement.

This paper examines the growth in hybrid pension plans within the context of the changing labor market. The next section documents how population aging is transforming the labor market and how the labor force will likely change in the near future if current participation rates persist. The paper then considers how improvements over time in health status and declines in the physical demands of work increase work capacity at older ages. Section IV examines how retirement incentives differ between hybrid plans and traditional DB plans, and section V offers conclusions.

Note: This report is available in its entirety in the Portable Document Format (PDF).



Topics/Tags: | Economy/Taxes | Employment | Retirement and Older Americans


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