INFLATION PROTECTION

Inflation has been a persistent feature of the U.S. economy, at least since World War II. Although the rate of inflation has gone up and down during that period, many economists believe that some degree of inflation is a permanent structural feature of our economy. A qualified plan, particularly a defined-benefit pension plan, is a theoretically long-range program; benefit levels are often determined for a 25-year-old employee's benefits that will not be paid until 40 years later. Thus, inflation is a serious problem in the design of pension plans.

Although no really satisfactory solution to the problem of inflation in private pension plans has yet been devised, there are some planning approaches that can help with this problem. A distinction can be made between approaches that are applied in the preretirement period while the employee is still at work and in the postretirement period, when the employee is least able to protect against inflation.

Preretirement Inflation
Some types of benefit design are inherently better able to cope with preretirement inflation than others. If the plan benefit depends on employee compensation, the final-average definition of compensation usually does a better job protecting the employee against inflation than the career-average definition because the final-average definition bases benefits on the employee's highest compensation level. Much of the increase in an employee's compensation level over a working career merely reflects inflation. Other reasons for compensation increases are increases in general employee productivity and increases in the individual employee's merit, and both are also appropriately reflected in the retirement benefit. If the plan does not use a final-average formula, the employer should consider periodically reviewing the plan's benefit level in light of inflation and amending the plan to increase benefits as appropriate. It is also possible to include an automatic mechanism in the plan under which future benefit levels for current employees are increased in accordance with some kind of formula based on the inflation rate; however, this is rarely done.

Defined-contribution plans provide some inflation protection not available under defined-benefit plans because the benefit in the defined-contribution plan depends on the value of the investments in each participant's account. In the long run, a reasonably diversified investment portfolio tends to increase in value to keep pace with inflation. This is not necessarily true for short periods; in the 1970s, for example, common stocks often declined even as inflation reached new heights. However, most economists believe that the long-range linkage between asset values and inflation will continue, so defined-contribution plans can be useful in dealing with inflation. Naturally, for this to occur the investment portfolio has to be chosen to emphasize the types of assets—common stocks, for example—that typically show inflation-related growth.

A defined-contribution plan, however, has a disadvantage similar to that of a career-average benefit formula: contributions to the participant's account in the early years are based on then-current compensation, which typically is at a low level compared with later years. This disadvantage tends to reduce the advantage of possible investment-related growth.

Postretirement Inflation
In the postretirement period, one approach to inflation protection in defined benefit plans is indexing of retirement benefits. With an indexed formula, the plan provides that the benefit is to be increased after retirement in accordance with some formula contained in the plan. The design problem here is the choice of a formula that is affordable by the employer and that accurately reflects the impact of inflation on retirees.

One approach is to use the consumer price index (CPI), a price index provided by the government. The CPI is a measure of the relative rise from month to month of a "market basket" of consumer products purchased by a hypothetical average consumer. There is some debate as to whether the CPI accurately reflects the impact of inflation, particularly on retirees, because it may emphasize rising prices of items not normally purchased by retirees or, conversely, may understate the impact of rising prices for items particularly important to retirees. At one time, for example, the CPI had a large component reflecting the cost of new housing, which typically is not a significant item in retirees' budgets.

The government also provides various types of wage indexes indicating the increase in wages in specific portions of the work force. Theoretically, it is possible to index retirement benefits in accordance with a wage index. Based on past experience, this would produce a larger increase in retirement benefits than a price index because wage indexes reflect increases in productivity that have historically outdistanced inflationary price increases. However, in short-term periods, wage indexes can fall behind cost indexes such as the CPI. A theoretical advantage of wage indexing is that retirees will obtain the same protection against inflation as people currently in the work force (but no better). Whatever the merits of this argument, however, wage indexes are rarely used.

A third approach to indexing is to use a formula for increasing benefits that is included in the plan itself and is not dependent on external price or wage indexes. Such a formula makes it easier for the employer to anticipate the cost of the benefit increases. The risk of possibly running ahead of the CPI can be minimized by providing that the formula increase will not exceed an amount determined by reference to the CPI or other chosen economic indexes.

Indexed pension benefits are obviously attractive to participants, but currently they are not extensively used in the private pension system. This is because even a small annual or periodic percentage increase in pension benefits can result in a very large increase in the ultimate cost of the benefit. Private employers, therefore, often avoid indexing because of the possibility of incurring an uncontrollable future liability. However, indexing is quite common in pension programs of federal, state, and local government units. Elected officials often grant indexed pensions to government employees with the implicit expectation that taxpayers in the future (after current officials' terms have expired) will accept tax increases to fund the increased pension costs.

In the private sector, probably the most common mechanism for dealing with postretirement inflation is to increase pension benefits through ad hoc "supplemental payments" to retirees. At one time, there was some concern that a program of supplemental payments might be deemed a separate pension plan involving various federal regulatory complexities. However, to encourage employers to make such supplemental payments, the Labor Department has issued relatively permissive regulations concerning these payments. Under these regulations [Labor Regulations Section 2510.32(g)], a supplemental payment plan will not be treated as a separate pension plan but rather as a welfare plan, which is subject to much simpler regulatory requirements if the amount paid is limited by a formula that effectively restricts it to the cost-of-living increases that have occurred since the retirees' pension payments commenced. The supplemental payments can be made out of the employer's general assets or from a separate trust fund established for them. In addition, there are special provisions [Code Section 415(k)(2)] allowing employees to contribute additional amounts to a defined-benefit plan to provide cost-of-living adjustments to benefits.