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Why You Won't Be Able To Retire - Part One

Befuddled pre-retirees are wondering why they won’t be able to retire. While there are many culprits to blame (collapsing 401(k) plans, Bernie Madoff), this article will address two of the culprits.

Defined-Benefit Plans
A Defined-Benefit Plan is an employer-sponsored plan in which the retirement benefit is determined by a set formula (salary history and employment duration) rather than by investment returns. In a Defined-Benefit Plan (DB Plan) the employer assumes all control of portfolio management and responsibility for investment risks and returns.
DB Plans are governed by the Employees Retirement Income Security Act (ERISA). ERISA mandates that DB PLans receive actuarially-calculated annual contributions every year to make sure they are properly funded. If somehow the DB PLan gets out of whack and becomes under funded, the employer is required to make appropriate and catch-up contributions to make the DB Plan properly funded. Under funded liability is the difference between the current value of the assets currently in the plan and the present value of future benefits. 
The Games That CFO’s Play
By fiddling with assumptions on future interest rates, investment results, and employee turnover. Companies and governments do not like to make contributions since it cuts into current earnings and reduces this years profits. Thus, every pension scheme from social security to, well, everything is unfunded. 
Companies are not allowed to let underfunded liabilities grow and are supposed to bring them to zero by making contributions to the plan.
The high cost of Defined-Benefit Plans makes it harder for American companies to compete with foreign firms. To calculate the yearly contributions, DB Plans must predict the future return of the investments in their plan. Depending on the assumptions used, a CFO can predict a high, average or low future rate of return. Chief Financial Officers invariably chose the most wildly optimistic assumptions with the highest rate of expected return. By doing so, they minimize the amount of contributions required to lower the costs. This raises profits and gives the CFO juicier bonuses. While Corporate Management benefits from this scandalous behavior, their self-serving actions threaten the solvency of the retirement plan and the solvency of the company itself. Over time, the pension fund becomes under funded, because of overly optimistic assumptions. Self-serving corporate officers put their own interests ahead of the company and retirees.
Because of the games that CFO’s play, many Defined-Benefit Plans have gone bankrupt or are severely under funded. If the chosen investment performs poorly, the corporation will need to dip into it’s earnings to keep the plan properly funded. According to the Pension Benefit Guaranty Corporation, there are about 38,000 Defined-Benefit Plans today compared to a high of about 114,000 in 1985. Scores of older American firms have been nearly bankrupted or completely bankrupted partially due to legacy pension plans.
The shortcomings of the Defined-Benefit have been exposed, and the DB Plan has become a thing of the past. They have been supplanted by the 401(k) plan, which, paradoxically, is a far worse way to fund a worker’s retirement. The future retiree has been thrown out of the frying pan and into the fire.
Social Security, Another Defined-Benefit Plan
The Old-Age, Survivors, and Disability Insurance program (Social Security) is similar to a Defined-Benefit Plan, in that retirement benefits are determined by a set formula (salary history and duration of employment), and not on investment returns. Just like DB Plans, when Social Security was created, it made overly optimistic assumptions about the future. Because corporate DB plans, have far more assets as a proportion of future liabilities, they are superior to Social Security. Unlike a DB Plan which relies on yearly cash investments that compound over time, Social Security mainly relies on current contributions from workers to support current retirees.
What Does This Have To Do With Bernie Madoff?
Charles Ponzi began defrauding investors in 1916, promising stellar returns. Ponzi never made any real investments. The funds from newer investors were used to pay “profits” to earlier investors. To keep paying “profits” to investors, Ponzi had to recruit more and more investors. Eventually, unable to find enough of them, his system collapsed and Ponzi went to jail, leaving his investors penniless. The Ponzi Scam was most recently used by Bernie Madoff to defraud investors of 50 Billion dollars.
What Social Security’s Supporters Say
Even Paul Samuelson, an ardent supporter of Social Security admits that it’s a Ponzi scheme, as he wrote in Newsweek (1967):
The beauty of social insurance is that it is actuarially unsound. Everyone who reaches retirement age is given benefit privileges that far exceed anything he has paid in…. How is this possible? … Always there are more youths than old folks in a growing population…. A growing nation is the greatest Ponzi game ever contrived.
Samuelson made an incorrect actuarial assumption when he assumed that the US would continue to grow at the same rate adding more workers every year.
When the Social Security program was initiated in 1937, the average life expectancy in the U.S. was under 65. Eligibility for benefits was set at age 65 in the expectation that less than half of the workers would live long enough to collect Social Security.

In 1945, the ratio of workers-to-retirees was 40+ to 1; in 1950, 16+ to 1; and in 1960, the ratio was 5 to 1, in 2005 the ratio was 3.4 to 1, and by 2035, it will be only 2 to 1. For a better look at the future; the following chart from the Bush Administration, shows the ratio since 1980.

As the worker-to-retiree ratio fell, the SSA was forced raise the tax rate from 2% in 1937-1949 to today’s 12.4% rate. Unless it drastically raises payroll taxes (a politically unpopular step) the Social Security Trust Fund will eventually be unable to recruit sufficient contributors to its Ponzi Scheme, in order pay out promised benefits.
What’s Good About Social Security?
To be fair, Social Security is run slightly better than a Ponzi scheme because it has built up a surplus. Every dime of this surplus has been loaned to the Federal Government in exchange for IOUs. Currently the Social Security Trust Fund has 3.5 Trillion Dollars saved for the future. According to the May 12 2009 Report by the fund’s trustees, starting in 2016, Social Security will begin to spend more money than it takes in through tax revenue and by 2037 the fund will run not be able to pay promised benefits, because it has run out of money.
Because of under funding due to overly optimistic assumptions and frequent failures due to insolvency, the DB Plan has been phased-out. Social Security, the world’s largest Defined-Benefit Plan is far more actuarially unsound than any corporate plan. So why hasn't Social Security been replaced by something more sound?
This is Part One of the Series: "Why You Won't Be Able To Retire"
DISCLOSURE: No positions. Running a Ponzi scheme is illegal except when it is legally permitted by law, as in the case of the Social Security program.