Understanding the Pension Problem
Despite how often we hear about them, pensions remain a mystery to many. Without getting overly technical, I thought it would be helpful to illustrate the basics of pension math using a simple example. First, let me define a few terms and summarize some of the problems people are worried about.
What is a pension?
The vast majority of pensions are defined benefit retirement plans. This means that when a worker retires, he or she will receive a pre-determined amount of money each year. That money is paid by his/her former employer and some of the cost is often shared by the employee throughout their years of service. This differs from defined contribution plans such as 401(k)s where the employee is ultimately responsible for investing their nest egg and distributing retirement income.
Why are people worried about pensions?
Until recently, many employers chose not to put money aside for the future payments owed to retirees. For decades, employers paid retirees out of their current budgets. This “pay as you go” method worked for a while, but as more and more workers with pensions began to retire, the required payouts were becoming unsustainable. The debt a system (employer) carries that is not covered by the value of assets, savings or investments that have been allocated to pay the debt, is known as an “unfunded liability”.
By the mid-80s and early 1990s, to address the oncoming budgetary issues and begin to pay down large unfunded liabilities, many pensions began adopting “funding schedules”. These schedules required systems to appropriate (set aside) dollars each year for future pension obligations. The ultimate goal of these appropriations was to “fully fund” systems by a certain date in the future. A fully funded system is one that has sufficient assets needed to provide for all accrued future benefits.
Why do unfunded liabilities matter?
Unfunded liabilities matter because they represent guaranteed payments that retirement systems are required to make but have not yet saved for. As the liabilities grow, more money from current budgets must be appropriated to reduce the debt. In the public sector, funds appropriated to pension liabilities eat into dollars that would be otherwise spent providing other services. Additionally, as unfunded liabilities grow, the financial position of states, towns, and cities deteriorate. Carrying high debt can negatively affect municipal bond ratings which would make it more difficult to raise funds for future growth.
The Landscaping Fund
Now that you understand basic pension lingo, here’s a simple analogy that hopefully helps illustrate how pension funding works.
Let’s pretend you want to hire a professional landscaper. After shopping around, you decide to sign a 5-year contract with a landscaper who will mow your lawn and maintain your property. For his services, you agree to pay him $1,000 at the end of each year. Before committing to the work, the landscaper asks you to provide evidence that you have the financial means to honor the contract.
Knowing that over the next five years you are obligated to pay your landscaper $5,000, you’d like to put money aside for the known future expense. This is your Landscaping Fund. Your Landscaping Fund has features similar to a pension. Pensions have known future payouts and they need to set money aside today that will help pay for that obligation.
There are several ways to fund your Landscaping Fund…
Scenario 1 – Cash on Hand
If you happen to have $5,000 available when you sign the contract, you could show it to your landscaper, lock it in a safe and pay him from it each year. Assuming your landscaper trusts that you won’t spend that money, this is the simplest solution.
Scenario 2 – Fully Funded Investment
If you’ve taken Finance 101, you might recognize the funding issue as a “time value of money” problem. The general concept of TVM is that money available today is worth more than that same amount of money in the future. This is due to the money’s earning capacity (i.e. you can invest the money and earn a return).
After identifying a few variables (payments, interest rate, number of payments), you can use a financial calculator or the Present Value formula in Excel (=PV) to calculate the amount of money you would need to set aside today in order to pay your landscaper in the coming five years. Assuming an 8% investment return, setting aside $3,993 in your Landscaping Fund today will allow you to pay your landscaper annually. In this scenario, the fund will always be “fully funded” (100% Funded Ratio).
Scenario 3 – Partially Funded + Contributions
What if you can’t fully fund the Landscape Fund immediately? Maybe you only have $3,400 available to invest. With a lower starting value, at the end of Year 5, you’d be left owing your landscaper $871. He won’t be happy!
One way to address this shortfall is by contributing extra money to the fund each year. By adding $150 to the fund annually, you’ll be able to fully pay your landscaper at the end of Year 5 with $9 to spare.
This situation is not unlike most retirement systems. Very few, if any, have the means to immediately fully fund their pension obligations. The extra contributions towns/states/employers make to their pension fund are known as “appropriations.” Easy enough, right? If you can’t fully fund immediately, set aside money each year.
Scenario 4 – Partially Funded + Contributions + Assumption Adjustments
Consider the possibility where you cannot fully fund immediately and you do not have the means to set aside the necessary extra $150 each year. You can only afford a $3,400 initial investment and an extra $50 contribution each year. Your landscaper surely won’t sign a contract with this information in front of him…
As it relates to pensions, the money towns and states are required to set aside for pensions each year has a big impact on their budgets. If budgets are tight, the difficult decision of laying off workers and cutting back services has to be made. For this reason, simply paying more money towards the pension is rarely the preferred method of reducing the size of unfunded liabilities.
What alternative is left? How can you make your landscaper believe in the financial stability of the Landscaping Fund given your tight budget? Well, what if instead of expecting a return of 8% a year on your investments, you now say you expect to return 12.5% per year on your investments? Like magic, the numbers look good again and your landscaper signs on the dotted line!
As you can see, adjusting return assumptions works wonders for calculating future liabilities. By increasing expected rates of return, a bad financial situation can look pretty darn good.
When we are only looking at returns over a 5-year period, the accounting sleight of hand may look obvious. With pensions, however, funding schedules are much longer than 5 years. Most operate on a 15-30 year timeframe and just a 1% decrease in the return assumption can result in a 25% increase in unfunded liabilities!
Facing Economic Reality
In recent years, the return assumptions used by public pension plans have come under attack. Unlike private pensions which are required to use fairly conservative growth rates for calculating liabilities, public funds are allowed to discount liabilities based on “expected investment returns”. Many funds simply use a historical average for this number, (i.e. if a fund has returned 8.0% annually over the past 30 years, it expects that rate to continue).
Many argue that such a simplistic method of calculating expected returns is ill-advised. Does the 30-year average return of a fund tell you anything about the future? Between 1985 and 2000, the S&P 500 returned nearly 19% annually and 10-Year U.S. Treasury Bonds were yielding greater than 7%. During this time, many public funds saw annual returns north of 12%. In the last 15 years, however, returns have been much more muted, closer to 6.0%. Is it reasonable to expect 7-8% forward returns in the current economic environment of historically low interest rates and elevated equity valuations? Probably not…
If public pensions are using a return assumption that is too lofty, they could be massively understating their actual unfunded liabilities. Convincing retirement boards to lower their return expectation isn’t easy. Higher unfunded liabilities would mean higher payments for municipalities, states, and workers. Although lowering expectations and requiring additional saving is likely the most responsible course of action, the politics of such a decision is difficult to overcome.
The Landscaping Fund certainly isn’t an apples to apples comparison to real public pensions but I hope now you have a little better understanding of what pensions are and why people are worried. If your landscaper is financially savvy, he can look at an overly optimistic return assumption and decide not to risk doing business with you. On the other hand, taxpayers and retired public employees have little choice but to live with assumptions retirement boards make…no matter how disconnected from economic reality those assumptions may be. The consequences of such decisions may not be obvious, but under the surface the stability of the public pension system is starting to buckle.