Old Age on the Balance Sheet

I

INDUSTRIAL concerns throughout the United States are giving increasing attention to the subject of pensions for employees who have grown old in their service.

A number of theories have been advanced as justification for the employer’s granting a retirement annuity. One theory is that a pension is a deferred wage, and that money expended for pensions comes out of funds available for compensation of labor and is, in effect, merely a part of the wages which might have been paid the worker during his productive years. This theory does not hold, for the simple reason that an employer does not have to pay pensions in order to procure and hold a labor force. Neither is the theory sound that a pension is a gratuity or reward for long service. The theory which is being advanced now by most students of the subject, and which seems to be sound, is that a pension plan is a direct aid to the management in keeping up efficiency and in lowering costs, and that it is therefore a legitimate business expense.

That a pension plan is needed is indicated by the fact that a large number of companies that have been in business for twenty or twenty-five years have introduced pension plans. In a recent study made by the Industrial Relations Counselors, Incorporated, record was obtained of 355 companies, exclusive of railroads, which had inaugurated some kind of pension plan.

The principal reason why organizations have adopted pension plans is that many employees reach retirement age without an appreciable amount of independent reliable income. While the proportion of persons reaching old age in poverty has been exaggerated in many statements and advertisements, it is true that many reach retirement age without sufficient income to support themselves. The most reliable statistics available on the subject are the results of an investigation recently made by the National Civic Federation of approximately 14,000 persons sixty-five years of age and older, living in certain industrial cities of New York, New Jersey, Pennsylvania, and Connecticut, and of a similar study made of 17,350 persons of like age by the Pension Commission of Massachusetts.

An analysis of the combined results of the t wo investigations — based upon interviews with approximately 31,000 persons sixty-five years of age and older — showed that 42 per cent of these persons owned property to the value of $5000 or more, 13 per cent owned property worth between $5000 and $2000, 15 per cent owned property worth less than $2000, and 30 per cent owned no property at all. They indicated that 56 per cent either possessed property to the value of $5000 or more or had an annual income of at least $1000. Some of the conclusions of the report of the National Civic Federation are given: —

This country has furnished the opportunity to persons with individual initiative to care for themselves, and the majority of our aged have succeeded either in accumulating enough or in being able to earn enough not to be dependent.

Labor is not so mobile but that a general adoption of a standard pension system in industry and commerce would produce substantial benefits to a high percentage of employees.

Nearly 40 per cent stated that they had been with the same employer twenty-five years or more. There is hardly a table in the report which does not contribute some point in the argument that a large proportion of those workers who are in danger of becoming dependent could be cared for in the future if industry generally should adopt a definite policy for retirement annuities and for providing light employment for the workers of failing strength.

This report indicates that, although there has been distinct progress toward the elimination of dependency of workers reaching old age, nevertheless industry should adopt some plan to provide for those who would otherwise be dependent in whole or in part upon others for support.

II

Without provision for the retirement of employees, an employer confronted with the discharge of an employee who has given long service and who does not have sufficient means for sustenance does not discharge the employee, but keeps him on the force. As a result, there is a pension cost which is not recognized as such. Large companies are, therefore, considering it better policy to retire such a man and replace him by an abler employee. Removing the older man who is no longer able to produce makes way for younger people and has a stimulating effect upon the whole organization. Employers all feel that, up to the age of declining strength, long-time service on the part of many employees is a business asset. An organization which takes adequate care of its superannuated people appeals to the workers. A well-established pension plan undoubtedly serves to attract employees, even at younger ages, who are of a more stable nature, and to that extent affects turnover and the general character of the working force. The reputation of an employer in a community is enhanced by the fair treatment of the older employees, and this is a definite business advantage.

Many students feel that state pensions are bound to come, while others think that if a pension plan is adopted by industry generally the state-pension plan can be avoided. Six states — Montana, Nevada, Wisconsin, Kentucky, Colorado, and Maryland — have already adopted straight old-age pension laws. There is agitation in a number of states for the passage of a ‘Standard Bill’ which is advocated by the American Association for Labor Legislation. This bill is a very modest proposal that a citizen of seventy years or upward who has resided continuously for fifteen years in the state shall, if the value of the applicant’s property does not exceed $3000, be entitled to a pension which, when added to other income, shall not exceed a total of one dollar a day. This bill offers a small pension; but, once such pension laws are enacted, the rates will probably increase.

Such a pension by the state, with poverty as a qualification, is really only a substitute for the poorhouses, and would not solve the pension problem of industrial concerns. On the other hand, a compulsory contributory system, such as has been tried in some South American countries, might easily become burdensome to industry. Almost all government schemes are more costly than others because of the inefficiency of operation.

Many companies have started to retire employees without any definite pension plan, handling each individual case on its merits. The experience in such cases has been that, when the number of people retired increased as the company grew in size, a definite pension plan was developed. There is little argument as to the advantages to a company of having a definite plan, from the point of view of both employee and employer. The employee knows what he may expect, and the employer can use the pension plan to retire those employees who have become disabled through age or ill health.

Most pension plans in this country are dealt with as supplementary pay roll, and the pension expenses are charged to operating costs as they are paid. Annual pension expenditures have increased steadily, — in some cases in a startling manner, — and so heavy have these payments become that some nonfunded plans have been either reduced or abandoned. The following table showing the pension expenditures made by the United States Steel Corporation since 1911 illustrates the tendency of pension expenditures to increase: —

The Pennsylvania Railroad pension payments increased from $300,000 in 1900 to $0,083,000 in 1928. Wage increases and increases in the force account for part of this rapid growth; but the principal cause of the increased payments is inherent in the pension system itself.

The cause of rapid increase can be easily understood by considering an organization which has shown no growth in number of employees for a long period of years. In such an organization a fairly uniform number of employees might be expected to reach retirement age year by year. It is evident that the payments of pensions granted each year must be added to the amount paid on pensions granted in previous years. Not until the annual amount of pensions discontinued on account of death among the pensioners equals the annual amount of new pensions granted will a maximum annual cost be reached. This will probably take twenty-five years after payment has begun on the first pensions. If, however, the organization is one that has been growing over a long period of years, the number of persons reaching pension age increases more or less steadily, with the result that the annual cost rises more rapidly and the time of maximum cost recedes into the future probably forty or fifty years. In fact, the day may come when the annual pension expenditures represent a very large percentage of the annual pay roll.

III

Many companies which established pension plans years ago are now facing the problem of how to meet the increasing pension payments. Funds which were set aside to provide for pensions and were originally sufficient are now found to be inadequate. Very few of the pension plans in existence among industrial companies to-day are on a sound actuarial basis, and the companies must begin setting aside an additional amount each year to take care of the accrued liabilities or they will soon face an almost prohibitive increase in the pension costs. The following is quoted from an article appearing in the Monthly Labor Review of the Department of Labor: —

It is evident that the majority of plans dealt with in this discussion (all private industrial pensions) are on a thoroughly unsound basis. They are meeting present liabilities, but making no attempt to provide for the heavy expenses which must eventually be faced.

Most of the employers undoubtedly have every intention of meeting pension claims honorably and fully, but in this matter intentions are a poor substitute for investments. ‘As far as the employees are concerned, and from any sound financial and actuarial point of view, these plans are hopelessly insolvent.’

Many of the larger companies have begun to realize the probable increase in their pension payments and have taken steps to put their plans on a funded basis.

There are several ways in which a plan can be funded. A fund may be set up, the income from which will be expected to bo sufficient to pay pensions. Instead of setting up a large reserve at once, a definite percentage of the pay roll may be added to the fund each year to accumulate an amount sufficient to carry the pensions over the ‘peak’ to be reached in the future.

The more scientific method is to take care each year of the pension liabilities accruing during the year on account of employees on the active pay roll. This method is called the ‘group annuity plan.’ While this plan is of comparatively recent origin, a number of companies have adopted it. Some of those companies arc the Western Clock Company, Cleveland Railway Company, Metropolitan Life Insurance Company, New York Stock Exchange, St. Joseph Lead Company. The most recent adherent of the group annuity plan is the Eastman Kodak Company, which had an accrued liability of $6,500,000.

Under the annuity plan the employer puts up during each year of the employee’s term of service an amount of money sufficient to provide him with a certain annuity payable at retirement age. This sum is either set aside in a fund administered by trustees appointed by the company or turned over to an insurance company. The company has no recourse to this fund, and a man is entitled to the stated annuity when he reaches retirement age. The next year, and each year following, the employer puts up an additional amount. Although the employer intends to put money into the fund or make payments to the insurance company each year to add to the annuities, he is not legally bound to do so, and he can omit payments in any year. If payments arc omitted, he can make them good in later years. Furthermore, he can cither increase or decrease the amount which he puts up to provide for the annuities. In any case, despite possible changes in payments, pension-earning employees are assured of the benefits of all sums that have been paid into the fund.

The principle underlying the group annuity plan is that a certain liability as to pensions accrues each year and that a charge should be made against that year’s operating costs to cover this liability. The liability can be set up on the books and payment made later, but the concern which makes its charge and pays for it at the same time is in a better position than the concern which merely makes a charge.

If a company started this plan when it was first organized, liberal retirement annuities could be provided for all employees without a very heavy cost to the employer, owing to the accretions on account of compound interest and savings from mortalities and withdrawals. But if a company has been in existence for some time prior to the initiation of a pension plan, there is an accrued liability, owing to the fact that employees are already reaching retirement age and no reserve has been set up for their past service. The annuity which would be provided for the older employees from year to year would not be enough to give them sufficient retirement benefit because of the short period of employment they have left in which to accumulate an annuity principal.

Hence, in a company which has been organized for some time, it is necessary to take care of the accrued liability. Otherwise, provision would not be made for the very people for whom the plan is inaugurated — the men who are now approaching retirement age. Where a company has been organized for a long time, the accrued liability is quite an appreciable item. This has been the real obstacle to the inauguration of a financially sound retirement plan by many companies; but it can be met by spreading the accrued liability over a period of years.

Many companies which have adopted the annuity plan set aside a sufficient amount each year to provide an annuity of 2 per cent of the annual salary. By the time an employee has reached retirement age, which is usually sixtyfive for men and sixty for women, there will have been accumulated for him an annuity equal to 2 per cent of his entire salary during his period of employment. For an employee of, say, thirtyfive years’ service this would represent an annuity of 70 per cent of his average annual salary. In setting up the accrued liability, it is customary to provide for an annuity equal to 1 per cent of an employee’s present annual salary multiplied by his years of past service. Because of the big increase in wages since the war, I per cent of the present pay might, in the case of a person of long service, equal 1½ per cent or 1¾ per cent of the average pay during the entire period of employment.

Many of the older pension plans which are in existence base the amount of the pension on a certain percentage of the final salary or the average salary during the last ten years of employment. This feature is not desirable for a pension plan on an actuarial basis, because it is impossible accurately to predict what the final salary or the salary during the last ten years of employment is going to be.

There are many advantages in the annuity plan. The employer knows that he is taking care of his pension problem, and he knows in advance what liability he is assuming. The employer provides each year for the liability accruing in that year. Each year is a closed book. If for any reason the plan should have to be discontinued, the employee would get the benefit from the amount which the employer had already set aside. Later the employer might decide to make up for the years in which payments were discontinued. Of course, an employer entering upon this plan should be reasonably sure that he will continue to make the payments each year; but it is always stated that the employer is under no legal obligation to continue these payments.

The only uncertain factor is the turnover of employees in the future. If the turnover is conservatively estimated, the employer is sure he has covered his pension liability, and, if the turnover should be higher than estimated, credits would be given on the current payments each year.

So far as the employee is concerned, he has defnite knowledge of the annuity which he can expect, and he knows that the amount which has already been paid for cannot be withdrawn. He knows that everyone is put on the same basis, the percentage and the length of service applying to each person in accordance with his salary. It is easy for the employee to calculate what his pension will be.

IV

Most of the plans which are now in existence are non-contributory, with the employer paying all the cost; but there is a distinct tendency now toward the contributory plan. This type of plan has two advantages. More adequate benefits are possible without making the cost too burdensome to the employer; and the participation of the employees ensures their cooperation and active interest.

It has been found in practice that, where an employer provides a certain pension and the option is given to the employees of taking an additional pension, very few of them will come in unless the employer offers some inducement. The older employees are willing to come in, but the amount of the annuity which they can buy with a certain deduction from their pay is much less than what the younger employees could buy. The younger employee is not particularly interested in pensions. In order to encourage contribution by employees, the employer generally gives a certain minimum annuity and will give an additional one if the employee will agree to a deduction from his salary toward the purchase of an annuity for himself. This means, of course, not a reduction in the wages the employer has to pay, but that the wage deduction is paid to the insurance company or the pension fund instead of to the employee.

Another way in which employees have been induced to contribute toward their pension cost is by tying the pension up with other features, such as life insurance, disability insurance, and health insurance, and having the employee contribute a certain percentage of his salary — say 3 or 5 per cent — toward the cost of all these benefits. This plan, called the ‘package plan,’ has succeeded well in a number of cases where it has been tried, because almost any employee is interested in some one feature. While the younger employees, and girls in particular, might not be interested in the retirement annuity, they would be interested in life insurance or sickness benefit.

Fundamentally a contributory plan seems to be sounder than a noncontributory plan. The contributory plan also takes care of the very difficult problem of the employee who leaves before retirement age. Under this plan the employee will get back with or without interest the amount which he has contributed toward his individual annuity. He could take the refund either in the form of cash or in the form of a paid-up annuity.

In most plans which are not contributory the employee who leaves before reaching retirement age does not get anything, as the employer pays the entire cost and has instituted the pension plan only for the employees who reach retirement age with the company. Some companies, however, have adopted the policy of giving the pension outright to employees after they have served, say, twenty or twenty-five years, even should they later leave the employment of the company before reaching retirement age.

V

Assuming that a company decides to set up reserves to cover pension liabilities, the question immediately arises as to whether these reserves should be set up on the books of the corporation, placed in a separate trust fund, or given to an insurance company.

One of the principal purposes in setting up reserves for pensions is that the money set aside shall be used for pensions and nothing else. If the reserve is simply set aside on the books of the corporation, there will always be the danger of having the reserve used for other purposes by the management in the future. A pension plan for an average employee thirtyfive years of age who retires at sixtyfive and lives, say, twelve years on pension involves forty-two years, which is a very long time in business. During this time there will be many changes in business conditions, ownership, management, profits, and so forth. If a sound, safe pension plan is desired, it seems well established that this cannot be achieved by setting up a reserve on the books of the corporation.

The question resolves itself, therefore, into whether it would be better to turn the money over to trustees with the provision that it could be used for no other purpose than the pension, or whether the money should be turned over to an insurance company.

A pension fund would increase rather rapidly during the first few years while the reserves were being built up, and payments into the fund would greatly exceed the amount being paid out to pensioners. The fund would probably increase for fifteen or twenty years and would not become stabilized until the payments to pensioners equaled the liability incurred each year for future pensioners. While the management in the future could not divert any of the money set aside in this fund from the purpose for which it was intended, they could cease to make appropriations annually for it. If this were done, no difficulties would develop right away; but in future years the fund would be on an unsound basis, and it would become necessary either to curtail the pensions or to set aside additional appropriations.

The investment of the assets would require considerable work on the part of someone in close touch with the investment field. If an ultraconservative policy were adopted for the investment of the funds, as would probably be the case, the yield would be low as compared with the yield on the investments of an insurance company.

The arguments generally advanced in favor of a self-insured plan are that the employer would like to keep in touch with the pensioners direct instead of through an outside agency; that the cost of administration is less than that charged by the insurance company; and that the insurance company must make some money from the transaction or it would not be in the business, and this profit to the insurance company is a cost the employer can save.

It is a debatable question whether the cost of administering a self-insured plan is less than the overhead charged by insurance companies. The overhead expenses of some self-insured plans in England of which we have record are higher than the overhead charged by insurance companies. The insurance companies maintain that they are expert in this field and that, because of the large number of transactions which they handle and the large number of policies in force, they can do the administrative work at a lower cost per item than can an individual company dealing with a relatively small number.

There are other arguments advanced in favor of turning over the money to an insurance company. Only a very large industry would have enough pensioners to obtain the average life expectancy required for annuity rates. The insurance company guarantees the rates for the working lifetime of persons coming under the contract. It also guarantees the safety of the principal sum, a certain minimum return on the principal, and a certain maximum charge for overhead. The employer is further safeguarded by the supervision of the State Insurance Department exercised over the insurance companies. The insurance company, with its skilled investment men, can obtain a higher yield on investments than the average company handling its own pension plan can secure. A plan administered by a large insurance company would probably appeal more strongly to the employees than a selfinsured plan.

The cost of pensions consists of three elements under any plan, whether it be handled by an insurance company or a trust fund, or whether no reserve is set up: (1) the amount of benefits actually paid out to employees, plus (2) the cost of administration, and minus (3) the interest on invested funds.

The great majority of pension plans are still self-insured, but practically none of these are on a sound actuarial basis — that is, very few of these companies have actually set aside enough money in their pension funds to take care of their pension liabilities. As these companies already have a number of pensioners on their pay roll, they have to pay part of the pensions out of current income. In a number of companies the income from the fund is still more than sufficient to meet, the current payments to pensioners, but will soon be insufficient. The payments to pensioners in practically all these cases are increasing quite rapidly each year. If the companies are not prepared to pay these costs out of current income, the plans will either have to be drastically reduced or discontinued.

Good, humane management will not permit employees of long service to be discharged if they have not adequate means of sustenance. Yet good management cannot keep employees on the force when they are no longer productive. The solution is the inauguration of a sound and adequate pension plan. The longer the solution is delayed by business organizations, the more expensive it becomes.