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 .
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:
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.
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:
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.
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.
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.
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.
What can they do?
Certainly not with bonds as they used to do. The stock market is okay, but not good enough after costs to invest.
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?
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