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September 13,1974 Historic Lalbcir Day President Ford signed an "historic" pension-reform bill on Labor Day— "historic in the sense that this legis lation will probably give more benefits and rights and success in the area of labor management than almost anything in the history of this country." Some analysts take a less exuberant view, noting in particular that although the new law solves many problems that have afflicted past retirees, it doesn't really address itself to the problems created for pension plans by rapid inflation. some 32,000 different plans. Legis lation in 1958 corrected many of the most blatant abuses of the sys tem, but other problems persisted. Many workers have lost their bene fits, even after relatively long ser vice, because their pension rights automatically ended when they were forced to leave their jobs. Others have sustained hardships because their employers went out of business, leaving insufficient funds behind to pay promised pensions. With the 1974 legislation, these problems should be corrected. The private pension system, the subject of this legislation, has sig nificance far beyond the 6 million retirees now receiving $10 billion a year in pension benefits. The sys tem is important also to the more than 30 million Americans covered by pension plans, and to an economy which must deal with trust funds wielding $200 billion annually in assets. Retirement benefits have in creased 30-fold over the past quar ter century to $10 billion dollars in 1972, and continued rapid growth seems assured. After all, about onehalf of the nonfarm workforce is still not covered by any retirement system, while the average retiree's pension amounts only to about 25 percent of his terminal or maximum salary, compared to a 50 to 70-per cent average in most European plans. The act makes employees generally eligible to participate in pension plans at age 25 after one year's ser vice, with full vesting— guaranteed benefit rights— achieved after 15 years' service. Government-spon sored termination insurance is available to qualified plans, to en sure that employees get their vested benefits if their employers are forced out of existence. Also, past service must be funded over 30 years for single-employer plans and 40 years for multi-employer plans, to ensure that sufficient funds are available when employees reach retirement age. New legislation Over the years a number of prob lems have arisen in the pension field, as could be expected in a voluntary system encompassing 1 Despite these advances, the new legislation has not really focused on the problems of most immediate concern to pension planners. The pension structure is simply not com patible with the pattern of rapid wage-price increases that has emerged in recent years, for if the existing situation of inflation were to persist, the cost of the most prevalent type of plan— final aver(continued on page 2) Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco, nor of the Board of Governors of the Federal Reserve System. age pay—would rise to unsupport able heights. Robert D. Paul, a leading pension consultant, ex amines these problems in the current issue of the Harvard Business Review. Pensions and inflation To most pension experts, the opti mum form of pension is the finalaverage-pay plan, in which retire ment benefits are based on the average earnings in the years (gen erally five years) immediately before retirement. Most private plans are of this type or of the equivalent flatbenefit type— plans that pay fixed benefits of (say) $300 a month to everybody who meets eligibility re quirements. Plans of this type worked well dur ing periods of low inflation, but they can't be considered economically sound during periods of prolonged high inflation. An actuary, when determining the annual contribu tion rate needed to support a given plan, generally makes no explicit assumptions about investment yield to accommodate modest price in creases. For example, if the actual yield on investments is 2 to 3 per cent higher than the typical 5-per cent yield assumption, the differ ence can offset the cost impact of moderate 2- to 3-percent inflation. But if the rate of inflation were to persist in a 5- to 10-percent range for an extended period, the typical pension plan would require an investment return in the 10- to 15percent range to maintain costs at a level percentage of payroll. Paul 2 asks, "Are there such investments— sound, secure investments— that will meet the 'prudent man rule' written into the new pension legis lation?" Other cost problems Spiraling prices tend to create de mands for wage and salary increases sufficient to offset rising living costs, but they also lead to demands for pension increases high enough to maintain purchasing power after re tirement. A considerable number of public and private plans have al ready added post-retirement costof-living increases to pensions— witness this year's pathbreaking set tlements in the aluminum and steel industries. With pensions increasing (say) 0.5 percent for each 1.0-point increase in the consumer price in dex, at present rates of inflation the amount of the average pension would double well before the pen sioner reaches the end of his normal life expectancy. Actuaries fear to tread into such uncharted territory, so the aluminum agreement simply limits the pension adjustment to the life of the contract. This eliminates the need for funding consumerprice increases, but it also means that the companies have to pay extra pension amounts out of cur rent income. Aside from the serious impact of inflation, various other factors also tend to increase costs in one way or another. For example, in earlier pe riods large numbers of women passed through the work force without accruing sufficient years of service to qualify for retirement benefits, so that their forfeitures of benefits helped keep pension costs down. This is no longer the case; more and more women will earn vested benefit rights and costs will go up correspondingly. Another cost factor stems from the fact that women live longer than men; the average man retiring at 65 will re ceive 175 monthly checks before he dies, but the average woman at 65 can expect 210 monthly checks. Women workers may not be willing to accept actuarially reduced checks because of this fact of life. Managing funds Finally, the economy must deal with the fact that pension-fund assets could become an unwieldy factor in financial markets in future years. In the past decade, assets of private pension plans and state-local gov ernment plans increased at annual rates of 10.1 percent and 11.4 per cent, respectively, reaching $166 billion and $72 billion by the end of 1972. By the end of the century, total assets of this type could ap proach $4 trillion, so that pension plans seem certain to expand their already dominant position in the nation's financial markets. In this situation, fund managers will have to develop new standards of investment performance. Certainly they can no longer follow the sim ple objective of beating the market, primarily because they are the mar ket. Besides, their recent perfor mance indicates they can't even meet that basic standard. With almost 75 percent of all noninsured pension-fund assets invested in 3 stocks, the value of their holdings fell over 20 percent during 1973— even worse than the dismal 15-per cent decline in the total market, as measured by the Standard and Poor index. Further, with a 25-per cent drop in the S&P index to date this year, the situation continues to appear bleak for the funds. Inciden tally, many fund managers showed their expertise by staying out of the stock market during the expansive days of the 1960's, and then shifting aggressively into equities at the be ginning of the prolonged bear mar ket in 1969. They could have im proved their performance signif icantly over the past decade by sim ply rolling over Treasury bills every three months. Since the bear market has destroyed the ability of fund managers to rely on large investment returns, corpo rations have been forced to expand their own contributions to meet their fund requirements. This of course can be a costly procedure, especially coming on top of the already substantial rise in pension costs of past decades. Indeed, supplements to corporate wages and salaries— a category which in cludes employer contributions to both private pension funds and social-insurance funds—jumped from $4 billion to $66 billion be tween the late 1940's and early 1970's, or from 4.8 percent to 15.8 percent of total wages and salaries. A quarter-century ago, supple ments were only one-fifth as large as after-tax profits, but today they practically match the profits figure. William Burke u o jS u jL is e M • M <?in • u o S a J O • e p E A a |\j . o n e p i IjE M E H . E |U JO ^ J |E 3 • E U O Z U y • B > |S E |V BANKING DATA— TWELFTH FEDERAL RESERVE DISTRICT (Dollar amounts in millions) Selected Assets and Liabilities Large Commercial Banks Amount Outstanding Change from 8/21/74 8/14/74 - Change from year ago Percent Dollar Weekly Averages of Daily Figures Week ended 8/21/74 Week ended 8/14/74 Comparable year-ago period - 114 413 299 - 31 226 195 11 126 -115 + 739 + 1,277 0 + 528 + 530 + 142 + + + - — — — + + — + + + + 8,280 + 7,950 + 36 + 3,033 + 2,610 + 723 - 499 + 829 + 6,936 + 640 + 74 + 5,846 + 13 + 5,431 - 236 + 3,762 11.04 13.75 3.16 14.80 15,20 8.29 9.72 6.90 9.54 3.05 16.02 11.66 0.07 23.20 3.81 31.28 83,251 65,782 1,177 23,526 19,782 9,441 4,633 12,836 79,631 21,609 536 55,968 17,758 28,840 5,954 15,787 - 585 94 19 52 42 3 336 155 146 777 226 429 7 292 18 428 + + + + + + Loans (gross) adjusted and investments Loans gross adjusted— Securities loans Commercial and industrial Real estate Consumer instalment U.S. Treasury securities Other Securities Deposits (less cash items)— total* Demand deposits adjusted U.S. Government deposits Time deposits— total* Savings Other time I.P.C. State and political subdivisions (Large negotiable CD's) — + + + + + + + — + Member Bank Reserve Position Excess Reserves Borrowings Net free ( + ) / Net borrowed ( - ) Federal Funds— Seven Large Banks Interbank Federal fund transactions Net purchases (+) / Net sales ( - ) Transactions: U.S. securities dealers Net loans (+) / Net borrowings ( —) in clu d e s items not shown separately. Information on this and other publications can be obtained by calling or writing the Administrative Services Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco, California 94120. Phone (415) 397-1137.
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