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Pension Plan Discrimination Against the Short-Lived
Many pension plans pay out benefits over a worker's remaining life. Perhaps
inadvertently, they then discriminate against groups with shorter life expectancies.
Losers include those with poorer health, less education, and more physically demanding
jobs. Racial groups with higher mortality rates, like blacks, also lose. This
discrimination, however, can largely be overcome with compensating mechanisms.
Retirement plans are of two types. One type revolves around deposits to such accounts
as 401(k) plans and individual retirement accounts (IRAs). Typically, when employers pay
compensation to this type of retirement plan, the benefits are proportional to cash wages
and of equal benefit to all workers at the same wage level. The more classic pension plan,
on the other hand, has a formula for "replacing" wages over a worker's remaining life.
For instance, a firm might pay workers with 30 years of service an annual benefit equal
to 20 percent of pay earned during their highest earning years.
At first the classic pension plan might appear to treat equally those workers with the
same jobs, wages, and time with the firm. But it does not. Why the discrimination?
Converting benefits to annuities gives those with shorter lives fewer benefits than
those with longer lives.
Generally speaking, we want to encourage annuities. They do a lot of good things. As
death is a random event, most pensioners are happy to get the extra protection in
case they live long lives. Annuities help prevent our living standards from falling as
we age. Social Security, for these reasons, pays out benefits as an annuity to meet its
social policy objective of "insuring" for those with long lives.
Still, consider the extreme case of George, who is in poor health throughout his life,
works for a firm for 30 years, gets no survivor benefits, and dies at eligibility age.
The firm would pay George zero pension benefits. Meanwhile, Paul, who is in very good
health and can expect to live a long life, receives substantial pension benefits. The
discrimination isn't just among individuals, like George and Paul, but also among
groups. Blue-collar workers might do worse than white-collar workers and blacks worse
than whites.
Social Security shows us that it is possible to deal with this type of discrimination
through offsetting mechanisms. For instance, Social Security has a progressive benefit
formula that provides higher benefits relative to past lifetime earnings (higher
"replacement wages") to those with lower-than-average lifetime earnings. Because lower
earnings are correlated with lower life expectancy, people from educational, racial,
and other groups with lower life expectancy are more likely to get equal returns on their
Social Security contributions or taxes
Unlike Social Security, classic pension plans don't have access to lifetime earnings
records, so they can't use the same offsetting formula. To provide equal pension pay
for equal work, other offsetting mechanisms must be tapped. A simple example is life
insurance, which tends to favor those with lower life expectancies. An adequate amount
of life insurance provided in addition to the classic pension plan could compensate some
of those who lose out because of the annuity feature of the plan. However, such life
insurance would need to carry forward beyond employment years since people with shorter
life expectancies often do make it to retirement age.
Another simple compensating device would be to require that annuities contain a certain
minimum number of years of payments to heirs if the worker dies. Such "life certain"
policies can insure, for instance, that even if a worker dies at retirement age, at least
15 years of payments would be made. These rules could also be used to insure more equal
treatment of those with lower-than-average life expectancies who convert their 401(k)
and similar balances into annuities. Firms sometimes increase the probability that
benefits will be paid for at least some years by providing survivor benefits, but those
benefits often don't help single workers.
While classic pension plans have been on the wane in the private sector, millions of
government workers participate in such plans. Federal, state, and local governments
could examine and amend these pension plans to reduce discrimination among their own
workers. Similarly, protections should be put in place for those purchasing annuities
with their 401(k) and similar accounts. Future retirement and pension plan reform must
start to address this discrimination. Short lived shouldn't mean short changed.
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