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Interaction of defined benefit pension plans and social security

Bibliographic reference Pestieau, Pierre ; Possen, Uri M.. Interaction of defined benefit pension plans and social security. In: Pensions : an international journal, Vol. 13, p. 101-117 (2008)
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  1. Poterba James M., Venti Steven F., Wise David A., The Transition to Personal Accounts and Increasing Retirement Wealth : Macro- and Microevidence, Perspectives on the Economics of Aging ISBN:9780226903057 p.17-80, 10.7208/chicago/9780226903286.003.0002
  2. ‘The transition from employer managed defined benefit pensions to retirement saving plans that are largely managed and controlled by employees has been the most striking change in retirement saving over the last two decades. Individual managed and controlled retirement accounts, particularly 401(k) plans but also 403(b) plans for nonprofit organisations, 457 plans for state and local employees, the Thrift Savings Plan for federal employees, Keogh plans for self-employed workers, and Individual Retirement Accounts (IRAs), have grown enormously. Employer-provided defined benefit pensions have declined in importance. In 1980, 92 per cent of private retirement saving contributions were to employer-based plans; 64 per cent of these contributions were to DB plans. In 1999, about 85 per cent of private contributions were to accounts in which individuals controlled how much to contribute to the plan, how to invest plan assets and how and when to withdraw money from the plans’ (Poterba et al.,1 pp. 17–18).
  3. Fore, D. (2001) ‘Going private in the public sector: The transition from defined benefit to defined contribution pension plans’, in Mitchell, O. S. and Hustead, E. C. (eds.)‘Pensions in the Public Sector’, University of Pennsylvania Press, Philadelphia, pp.267–287.
  4. ‘There is evidence that the public sector pension environment is beginning to evolve. A small but growing number of state and local governments have switched or are contemplating switching from a defined benefit to a defined contribution plan. If these pioneers prove successful, in terms of employee and employer satisfaction, the public sector may follow the transition trend experienced in the private sector over the last quarter century’ (Fore,3 p. 267).
  5. Bodie et al.6 discuss some of the trade-offs when comparing defined benefit and defined contribution plans.
  6. Bodie Zvi, Shoven John B., Wise David A., Pensions in the U.S. Economy, ISBN:9780226062853, 10.7208/chicago/9780226062914.001.0001
  7. Feldstein Martin, Structural Reform of Social Security, 10.1257/0895330054048731
  8. For defined benefit plans ‘employees are guaranteed a pension of a given amount per year upon retirement. The benefit level is often a function of one or more factors, such as an employee's years of service and earnings profile over his or her tenure with the firm’ (Barnow and Ehrenberg,9 p. 524.) However, the earnings profile used in defined benefit plans is usually much shorter than that used for social security.
  9. Barnow Burt S., Ehrenberg Ronald G., The Costs of Defined Benefit Pension Plans and Firm Adjustments, 10.2307/1884468
  10. In the past, many private defined benefit plans were integrated with social security. For a discussion, see Bodie et al.11 However, as we move away from defined benefit plans this integration is becoming less prevalent.
  11. Bodie Zvi, Shoven John B., Wise David A., Issues in Pension Economics, ISBN:9780226062846, 10.7208/chicago/9780226062907.001.0001
  12. In looking at the trade-off between defined benefit plans and social security, one of the disadvantages of social security from the point of view of higher paid workers is that it is redistributive, but one of the advantages is that the benefits are indexed for inflation whereas most defined benefit plans provide a constant retirement benefit fixed in nominal terms. For a discussion of the inflation factor associated with defined benefit plans see Bodie.13
  13. Bodie, Z. (1990) ‘Pensions as retirement insurance’, Journal of Economics Literature, Vol.28, pp.28–49.
  14. Apps and Rees argue that ‘an ageing population is associated with an increasing ADR (aged dependency ratio), but it will also be associated with a declining child dependency ratio (CDR), when the root cause of population ageing is declining fertility. It does not then necessarily follow that the net effect of the fertility decline must be a reduction in the share of aggregate output consumed by the working population’ (Apps and Rees,15 p. 573).
  15. Apps, P. and Rees, R. (2002) ‘Fertility, dependency and social security’, Australian Journal of Labour Economics, Vol.5, pp.569–585.
  16. In terms of funding there is a big difference between defined contribution and defined benefit plans. ‘In defined contribution plans, by definition the value of the benefits equal that of the assets, so the plan is always exactly fully funded. But in defined benefit plans, there is a continuum of possibilities. There may be no separate fund, in which case the plan is said to be unfunded. When there is a separate fund with assets worth less than the present value of the promised benefits, the plan is underfunded. And if the plan's assets have a market value that exceeds the present value of the plan's liabilities, it is overfunded’ (Bodie and Papke,17 p. 152).
  17. Bodie, Z. and Papke, L. E. (1992) ‘Pension fund finance’, in Bodie, Z. and Munnell, A. H. (eds.)‘Pensions and the Economy, Pension Research Council Publications’, Pension Research Council and University of Pennsylvania Press, Philadelphia, pp.149–172.
  18. ‘The pegging of benefits in DB plans to final average wage would appear to provide employees with a type of income-maintenance insurance not available in DC plans. This observation has been used to support the selection of these plans over DC plans. This conclusion, however, is not robust. If wage paths are unpredictable at the start of a career, then individuals may view it as very risky to have their retirement benefits depend so heavily on final salary’ (Bodie et al.,6 p.147).
  19. For a discussion of the implications of having a trust fund one can look at Pestieau and Possen.20
  20. Pestieau Pierre, Possen Uri M., Investing Social Security in the Equity Market. Does it Make a Difference?, 10.17310/ntj.2000.1.03
  21. In this paper, we are not attempting to do a general equilibrium analysis of defined benefit plans. Ebrahim22 argues that if one wanted to do a general equilibrium analysis one would need to define them in terms of ‘not only the income but also expected portfolio payoffs. This is radically different from that observed in the ‘real world’, where it is defined strictly in terms of pensionable salary, which is derived only using the average of that in pre-retirement years (after incorporating the number of years of service)’ (see Ebrahim,22 p. 15).
  22. Ebrahim, M. S. (2006) ‘Pension fund design and corporate structure: A general equilibrium exposition’, unpublished.
  23. Given our specification, if there were only type 1's in our model and no redistribution, defined benefits and social security would be perfect substitutes. In general, however, one would not expect such an outcome since social security and defined benefit plans use different earnings profiles to determine benefits and unlike social security most defined benefit plans do not index benefits for inflation after retirement.