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 pensions Trends 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

COVERAGE RATES  Coverage rates vary considerably by –level of earnings –firm size –industry

Pension Participation Rates for Workers

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 DB Employee contributes Rarely Generally Rarely DB Participation Automatic EE choice Automatic DB Contribution level Automatic EE choice Automatic DB PBGC insurance Always No need Always DB Early departure penalty Yes No No DC Benefits easily portable No Yes Yes DC Annual communication Benefit at Current Current retirement balance balance DC Retirement incentives Generally Neutral Most neutral DC Accrual of benefits Back loaded Level Varies Mixed Financial market risks Employer Employee Shared Mixedbears Longevity 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

Large Plan Per Capita Administration Cost

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

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 Advisory Council ( l/report/findings.htm#overview)  Option proposed by President Clinton  Options proposed by Bush Commission on Social security (

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