U.S. pensions, will there be a problem?

At the end of last month, there was a “death spiral” in the pension fund of the British occupational DB scheme, and since the financial system of the UK and the US is relatively similar, many people want to know…

Is the U.S. pension system similar to the U.K., is there a DB plan for U.K. pensions, and is there a “death spiral risk” for U.S. DB plans?

After all, the current U.S. 10-year Treasury yield has risen to 4.25%, and the U.S. pension fund, if the asset side is also dominated by long-term Treasury bonds, there is bound to be a substantial shrinkage of the asset side.

The following article is a comprehensive study of U.S. pensions by the Society General Securities Institute, with the red-letter portion of the closing paragraph of each section added by me.

From 1935, the initial establishment of the U.S. pension security system, especially after the 1970s with the improvement of the law gradually formed a three-pillar pension system, indeed very similar to the United Kingdom.

The first pillar is the U.S. Social Security program, the Old Age, Survivors and Disability Insurance (OASDI) system, which is led by the federal government and is the earliest established and most widely covered public pension program.

The second pillar is the employer pension plan, which can be divided into Defined Benefit (DB) and Defined Contribution (DC) according to the payment method. In a DB plan, the employer guarantees a certain amount of benefits to the employee upon retirement, and the investment risk of the pension is borne by the employer. In a DC plan, the employer only assumes the responsibility of making contributions for the employee, and the benefits the employee will eventually receive depend on the performance of the investment, which is at the employee’s own risk. By sector of pension provision, it can be further divided into private sector and public sector. 401(k) belongs to the representative of DC plans in the private sector, while 403(b) is the representative of DC plans in the public sector.

Here, the British and American pension systems bifurcate, the U.S. occupational pensions, DC plans and DB plans currently occupy half of each, which is completely different from the dominance of the British DB plans, because the ultimate performance of DC plans, depending on the choice of individual investment varieties, mainly by individual employees to bear the investment risk, the risk is spread to each employee, so that the U.S. occupational pensions break out The possibility of a death spiral is very low.

The third pillar is individual savings pension plans, including Individual Retirement Accounts (IRAs) and pension insurance annuities, the most significant of which, are traditional IRA accounts, as well as Roth IRAs (Roth IRAs) and other forms of IRAs.

The U.S. government promotes the construction and improvement of the pension system by establishing laws and regulations. 1935 Roosevelt administration promulgated the Social Security Act, which established the Old Age, Survivors and Disability Insurance System (OASDI), marking the birth of the basic pay-as-you-go pension security system under the unified management of the U.S. federal government as the first pillar of the country’s pension system; and the treatment-determined (DB plan) employer pension plan as the second pillar of the U.S. pension system.

First pillar

Basic pension security with broad coverage

The first pillar is the basic pension system, which covers the vast majority of the working population. The basic pension insurance system is the most extensive and basic pension system in the United States, which is legislated and enforced by Congress. Since the 1980s, this mandatory government social security program has basically achieved full coverage of employed people. It is primarily funded by social security taxes, which are paid on a pay-as-you-go basis. The social security tax is a special tax, which is used only for pensions and survivors’ and disabled persons’ benefits for members of the pension system, and is completely separate from other government taxes. Also, because the program is mandatory for the government, the government treasury provides the ultimate guarantee for the system.

The U.S. basic pension insurance fund (OASDI) grew rapidly in the early years and has slowed down in recent years. The U.S. law has strict regulations on the asset allocation of the basic pension fund, which is mainly allocated to federal government bonds with high security. In the middle and early periods, the accumulation of funds was fast due to low dependency rate, increasing tax rate, and good investment returns; however, with the increasing number of recipients under the aging population and declining investment returns on long-term bonds, OASDI’s current year balance declined after 2008, and the growth of total assets slowed down. By the end of 2020, the total asset size of OASDI is $2.91 trillion, accounting for about 7.7% of the total pension assets of the three pillars in the U.S., and 98% of the allocated assets are long-term bonds. According to the 2021 annual report issued by the OASDI Board of Directors, the OASDI reserves are expected to be depleted in 2034 under neutral assumptions.

Obviously, the Social Security Trust Fund, which is the basic retirement protection provided by the U.S. federal government for Americans, the asset side of this pension protection trust, which is basically all long-term treasury bonds, is theoretically most affected by rising interest rates, but it is a federal government asset, and it does not matter what you lose or earn, unless the federal government is completely dissolved, there is basically no risk.

Second Pillar

Employer-sponsored pension plans, with the largest funds

The second pillar is the employer-based DB and DC plans, which are the core of the U.S. pension system and account for half of the funding size.

DB plans are defined benefit and DC plans are defined contribution, which together constitute the second pillar of U.S. pensions. As of the end of 2020, the combined pension assets of the second pillar DC plans and DB plans in the U.S. were about $20.13 trillion, accounting for about 53.4% of the total pension assets of the three pillars in the U.S., of which the asset size of DC plans and DB plans were $9.65 trillion and $10.45 trillion, accounting for 25.6% and 27.8% of the total pension assets, respectively.

The contribution rates of DB plans are negotiated between employers and employees. Upon retirement, employees can receive a fixed amount of pension at a certain rate as agreed with their employers. However, because it is a non-government mandatory plan, there is no national standard of treatment and there is no statutory maximum. The standard that each employee can enjoy depends on the result of negotiation and consultation between the employer and the employee.

Before the 1970s, DB plans were generally funded on a pay-as-you-go basis, which had the advantage of being easy to manage; however, the problem was that since it was an employer plan, once the company suffered a loss or even went bankrupt, the source of funding could not be guaranteed and disputes could easily arise. Based on this problem, the U.S. government introduced the Employee Retirement Security Act in 1974, which clearly stipulates that employers implementing DB plans must change the pay-as-you-go system to a fund system, i.e., to form an employee pension fund. The Act also requires that the pension fund must be separate from the employer’s assets and that the fund’s investments must be completely separate from the employer’s business.

A DB plan, either corporate or non-corporate, usually establishes a fund management organization to manage the funds, and the management organization delegates the investment of the funds to an investment organization. The management body usually consists of employer representatives, employee representatives, and investment and actuarial professionals. The investment of such pension funds is usually not directly implemented by the fund’s management body (trustee), but is entrusted by the fund management body (trustee) to a specialized investment institution, i.e., fund management and investment are separate, with a principal-agent relationship between the two, and individuals are not involved in the investment process.

The DB program has a wide range of fund asset allocation directions, including stocks and bonds, real estate and other forms of financial products. There are no specific government restrictions on the investment of their funds and the percentage of investment, but rather the fund management organization decides at its own discretion. Typically, fund managers have adopted a diversified portfolio investment approach to protect against risk and obtain the greatest possible benefit. As of the end of 2019, the U.S. individual sector DB plans had the largest asset allocations to corporate equity and bonds, at 35.0% and 34.5%, respectively.

Note here that while the U.S. DB plans are managed in a similar manner to the U.K., the fund composition is relatively more diversified and the proportion of long-term Treasuries in the assets invested is not as high as in the U.K. The proportion of mutual funds + equity + mortgages (64%) greatly exceeds that of bonds, which avoids the risk of concentrating the asset side of U.K. DB plans in medium- to long-term Treasuries.

DC plan contributions enjoy tax advantages. The U.S. exempts from personal income tax the funds contributed by employers and employees to individual accounts in DC plans, and then collects personal income tax under the tax code when the pension is eventually received (EET model). Since its creation in 1974, the DC plan has been larger than the DB plan in terms of the growth rate of assets and the expansion rate of the number of plans, and it is only a matter of time before the total assets of the DC plan exceed those of the DB plan.



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