The rate of inflation over the past 20 years has seemed somewhat benign, particularly to those who were trying to make ends meet in the 1970s. However, at just 2.6% per year, a dollar loses 40% of its value in 20 years. So from 1991 to 2011, the consumer price index averaged an annualized 2.6%, resulting in 60 cents in remaining purchasing power of $1 at the end of the period.
Using an 80-year long-term annualized average CPI of 3.4%, the loss over 20 years is half of the value.
Those who believe in reversion to the mean are expecting something in excess of 3% inflation prospectively.
Consider the person who retired in 1965 with no COLA — at the end of 20 years, a fixed dollar benefit had lost 70% of its value. From 1965 to 1985, the consumer price index averaged an annualized 6.3%, resulting in 30 cents in remaining purchasing power of $1 at the end of the period. (All periods are ended March 31.).
The decision regarding whether defined benefit pension plans should include a COLA provision in the plan design is, indeed, a policy decision. However, there is a serious question regarding whether plan sponsors with no COLA provision should have the latitude to ignore that fact in describing the benefits provided by their plans. By federal law, private-sector plans must provide participants with summary plan descriptions that are calculated to be understood by the average plan participant. By practice, public-sector plans commonly do the same thing. Ostensibly, the purpose of these documents is to permit plan participants to make informed decisions regarding their financial futures.
As long as they are working, employees typically have an awareness of inflation, but they are probably not giving it serious consideration for long-term planning purposes since wages will eventually be adjusted for at least some portion of inflation. Accordingly, they do not have experience in planning for a protracted period during which inflation will be affecting their expenses but not their income. This brings to mind two of the current industry buzzwords that come up in one way or another on almost a daily basis — sustainability and transparency.
In order to have a sustainable standard of living during retirement, active employees need to begin planning as early as possible. Because inflation is not an everyday consideration while working, efforts should be made to elevate active employee awareness of its potential impact on lifestyle sustainability during retirement if their pension has no COLA. This leads directly to transparency with respect to the obligation of a plan sponsor with no COLA to notify active employees that, by design, their pension plan will, over time, probably be paying them off at pennies on the dollar. (This has particular relevance in the common case where the plan sponsor is consciously funding the benefit with the expectation of receiving inflation-generated investment return.)
Consequently, participants in plans with no COLAs need to be planning to somehow make up for the shortfall due to the eroding purchasing power of their retirement benefit dollars if they hope to sustain their standard of living. In fact, it is a little surprising that the Department of Labor's Employee Benefit Security Administration has not mandated such disclosures.
This all takes us back to the initial question: Is it the public sector or the private sector that is getting it right with respect to COLAs?
Gary Findlay is executive director of the Missouri State Employees' Retirement System, Jefferson City.