Everybody wants to cut costs nowadays, but some do it at the expense of others. In this article, The Economist explains how cost-cutting is often achieved in pension benefits, at the disadvantage of retirees, of course.
TO THOSE on fixed incomes, including many retirees, inflation is the enemy. Workers can generally expect their wages to rise with inflation (if not in one-for-one lockstep). But after retirement income is set, and erodes in real terms as prices increase. Some retirees are protected; their pension benefits increase with inflation each year. That protection may now be vulnerable. A smaller cost-of-living increase is a sneaky, and sometimes only barely legal, way to cut benefits when a pension is under-funded.
Indexing benefits to inflation is expensive, but it’s not always appreciated. The value of inflation indexation is less apparent early in retirement, particularly when inflation is dormant, as has been the case since the mid-1980s. That may help explain a new enthusiasm for fiddling with indexation as a means to address funding shortfalls in a financially-strapped post-crisis world. Dutch defined-benefit plans only offer conditional indexation; benefits will in some cases go up by 100%, 50% or even 0% of inflation, depending on the health of the particular pension fund. State defined-benefit pension plans in America are increasingly considering tinkering with their indexation rates. The hope is this will provide a loophole for states to cut benefits. That’s because pension benefits, at least in nominal terms, are often guaranteed by state constitution.
Lowering inflation indexation is also in vogue for national pensions. Pension benefits are still fully indexed, but Britain recently moved to a different measure of inflation which increases at a lower rate. A similar move was recently under consideration in America: indexing Social Security to chained-CPI, which would also lead to smaller cost-of-living adjustments. That would mean smaller real benefits in turn for retirees whose spending is often weighted toward health care, for which prices typically rise faster than normal inflation. No surprise: chained-CPI isn’t a popular idea and has been tabled for now.
Benefit cuts are unfortunate but inevitable. Moving to a chained-CPI is not adequate to put Social Security on firm financial footing. It only delays trust fund exhaustion by a few years. A reduction in nominal benefits would be better than smaller cost-of-living increases. It’s more transparent and easier to plan around. Lowering indexation not only lowers real benefits but also introduces another source of risk to retirees. Unfortunately, it seems that straightforward benefit cuts aren’t politically viable; smaller cost-of-living increases, though bad for retirees, may be the only realistic option for bringing spending closer in line with available funds.
What more inflation risk will mean for future retirees is uncertain. Perhaps there will be more demand for inflation-indexed annuities or other inflation-linked assets. I expect retirees will be more aware of inflation, and perhaps more vocally opposed to expansionary monetary policy. Future policymakers may be tempted to increase inflation to erode their nominal debt. When that happens retirees, who have lots of political clout, will feel the pinch. In that case there may not be much space for a high-inflation future.