It is easier to promise than deliver
We must be alert for the effects of politically motivated decisions that are poorly costed. Politicians make promises that mature far in the future. They know they will never deliver or be held accountable. They have little interest in getting them financially right .
Pensions are a case in point
Pension plans are a promise to deliver money some day in the future. How much depends on whether the plan is a “defined benefit plan” or a “defined contribution plan.”
Both employer and employee contribute part of their current income.
The difference is this:
- In a defined benefit plan, the pension payable, some day in the distant future, is calculated by a formula. Some look like 2% of the average of your best five years times the number of years of service to a maximum of 35. Under that plan your pension would by 70% of the average of your best five years income. Some are tied to inflation and continue health benefits.
In this kind of plan, the employer is responsible for making sure the funds in the pension plan are enough to pay the promised amounts. These plans have a blank check aspect to them. No one knows what is required to make the capital work out right.
- In a defined contribution plan, the employer and employee contribute money each year, usually a percentage of salary, and whatever capital is in the plan at retirement creates the pension payable.
Most businesses have decided they cannot afford the risk of defined benefit plans and so have wound them up and replaced them with defined contribution plans.
Your spendable pension depends on capital accumulated
The nature of pension plans is to turn small amounts of capital saved at frequent intervals in into a large accumulation and then dissipate the large accumulation by paying out small amounts at frequent intervals, usually until death.
How much you need depends on many things:
- What is pension formula to create the payout amount?
- How long will the person live after retirement?
- Are there survivor benefits?
- Is the pension tied to inflation?
- Are there other benefits?
- How long until retirement?
- What is the investment yield earned throughout?
- What is the contribution formula?
- How does vesting work?
Actuaries come up with a required capital at any point for an employer by blending all of the above. They could give you the liability at any year and could compare to the fund’s asset to determine if their is a shortfall or a surplus. The amount is a best guess.
An example of just one employee aged 30.
Current earnings are $60,000 annually and are expected to increase 10% per year for 10 years, then by 5% per year for 10 more, and finally 3% to retirement at age 65. Pension formula is 2% per year based on best five years. Contribution formula is 8% of income. We expect the person and surviving spouse to collect for 25 years from retirement.
How much capital is needed?
The answer, of course, is “it depends.”
If yield is 7% throughout the fund value would need to be about $3,000,000 and the employees contributions would make up about 2/3 of that. So, the employer is on the hook only for about $1,000,000. Half as much as the employee. They often throw in indexing and medical benefits to about match the employees contribution.
Now the fund requirement is $4,000,000.
Remember in a defined benefit plan, the employer is responsible for any shortfall.
- Earnings are only 5% instead of 7%. Employer side is about $1,000,000 short.
- People live longer, maybe only 5 years longer, add another half million.
What about government pensions?
Almost all are defined benefit plans. Salary increases become an issue. People live longer. Bond yields tend to be tamer than they were 20 years ago.
Many of the plans have distressing shortfalls in the assets.
What can they do?
- They could cut the pension promise, but at considerable political cost.
- They could reduce the rate of salary increase. Again not very palatable.
- They could terminate people earlier than 65
- They could invest for a higher yield.
Increase the investment yield looks good, but how?
Certainly not with bonds as they used to do. The stock market is okay, but not good enough after costs to invest.
Private equity! There’s the solution.
That might not work, either. Bloomberg published on this point a few months ago. Pension Plans’ Risky Flirtation With Private Equity
The unfunded liability of state and municipal pensions has increased to about $1.8 trillion. Some of it from the 2007-2009 investment debacle, but the recovery in a bull market is weak or non-existent.
Private equity is a high risk proposition even for people who know what they are doing. It gets more risky as less well informed people get into the marketplace. There are only so many acceptable deals and the latecomers tend to bid up prices, or the funds increase their fees as more customers appear. Demand matters.
What if the yield falls even further as they make nothing or less on ill-considered investments?
The politically unpalatable options will be necessity. And won’t that be fun?
- Promising is cheap and easy.
- Delivering is hard
- Pension investment managers and politicians are not much affected by their decisions
- If you think your house is your biggest purchase you are wrong. Pension are worth millions. Maybe!
- If your own retirement savings are too low, don’t risk them hoping for a big win. Some are better than none.
Be vigilant, up to the edge of paranoia.
Don Shaughnessy arranges life insurance for people who understand the value of a life insured estate. He can be reached at The Protectors Group, a large insurance, employee benefits, and investment agency in Peterborough, Ontario. In previous careers, he has been a partner in a large international public accounting firm, CEO of a software start-up, a partner in an energy management system importer, and briefly in the restaurant business.
Please be in touch if I can help you. firstname.lastname@example.org 866-285-7772