For workers who have given the best decades of their career to a job with the promise of a pension as the end goal, headlines can certainly be scary. As I write, here's a sampling of just a few of those headlines from around the country:
"More than 100 Michigan municipalities to submit pension crisis plans to state"
"Don't rely on markets to plug pension shortfall, Prudential says"
"State wants Jackson to fix underfunded police pension program"
"Underfunded pensions force choice: Lay off workers or keep promises to retirees"
For workers in pension plans, one overriding concern looms over all else as retirement draws closer: Is my traditional pension plan safe? Nothing is more disturbing than imagining that all you've worked for might disappear just as you're nearing the time when you can finally reap the rewards of your labor.
It can be hard to find clear answers. For starters, pension plans are complex financial vehicles with a variety of funding sources, investments, and base assumptions. To make matters worse, the media often distorts the truth in the search for clicks, and political figures twist the facts when presenting their cases to constituents.
Let's attempt to cut through some of the noise and levels of opaqueness to give you a sense of what you can look at to determine if your pension is safe.
What is a pension?
A pension is a defined benefit retirement plan that promises a certain monthly payment to employees after they retire. This is different from retirement vehicles such as 401(k) plans, which are defined contribution plans. A defined contribution plan only promises how much an employer will match an employee's contribution to the plan, not how much is paid out to retired employees.
The amount employees receive usually depends on their average salary while working and how long they worked for their employer. Let's walk through a quick example: A typical police department's pension plan might offer officers 2.5% of their salary for each year of service, where the salary is defined as the average of their three highest-paid years. If a police officer retired under this plan making the median national salary for law enforcement officers of $53,109 their entire career, after 20 years of service they would be entitled to 50% (calculated by multiplying 2.5 * 20) of their salary, or $26,554.50, paid out as an annual benefit. If this same officer worked 25 years, he would be entitled to 62.5% of his salary (2.5 * 25), or about $33,193 each year in retirement.
A myriad of other factors can go into these calculations, such as whether overtime and bonuses should count toward employees' yearly salaries or just their base pay. Other considerations such as the maximum benefit that can be earned (typically benefits are capped at a certain percentage of salary), or whether a COLA (cost-of-living adjustment) should be included in retirees' packages also need to be considered when doing these calculations. A COLA is a small increase in benefits designed to keep retirees' buying power from being eroded by inflation over time.
These details are usually negotiated between employee representatives (e.g., union) and management (e.g., company or governmental representatives). When a collective bargaining agreement -- essentially a contract between management and employees -- is reached, pension and other benefits are clearly defined for a set period of time.
How pension payments are made
Pension distributions are paid at regular intervals throughout the year, much as retirees' annual salaries were paid while they were working and can be made via checks or direct deposit. Taxes on pension payments are a bit more complicated. When participants have not made any after-tax contributions to the pension plan, pension benefits are taxed as ordinary income. When after-tax contributions have been made by the employee, pension payments are partially taxed.
Participants in pension plans can also choose to receive their entire pension benefit in one lump-sum payment, immediately upon retirement. While every situation differs, this is usually not advisable. A Metlife survey found that 21% of retirees who took the lump-sum payment depleted all resources within just 5.5 years. The temptation to spend over their budget on luxurious vacations, new cars, or other nonessential purchases simply proved too great for many retirees. Other mistakes the survey highlighted was the complexity of managing such a large sum of money and retirees severely underestimating how long they would live.
How pension plans are managed
Pension assets are held in a trust fund, a type of fund consisting of assets for the benefit of an individual or group. These assets are physically held by the pension plan's custodian, which is typically a bank or brokerage. Custodians handle the buying and selling of assets, recordkeeping of deposit and withdrawal activity, and may also distribute payments to the plan's beneficiaries.
A pension plan's assets are managed by trustees. Every plan is unique as different states have varying requirements for trustees. In the state of Florida, where I am a trustee for my employer's plan, each plan must have equal representation from the employer and employees; neutral third parties, those who do not represent the city or pension plan participants, hold the tie-breaking vote. The board of trustees is responsible for managing the plan's assets, including determining asset allocation, hiring the plan's money manager, and ensuring all plan participants are making or receiving the proper amount.
The larger the plan, the more diverse asset classes one might find in the plan. This includes typical investments such as stocks -- usually in the form of a stock index or mutual fund -- and bonds, but may also include hard real estate and infrastructure assets.
A quick history of pension plans in the United States
In 1875, the American Express Company established the first pension fund for employees in the United States. Due to favorable tax laws, pension plans quickly became a staple of the American workforce. In 1940, approximately 4.1 million private sector workers, about 15% of all private sector workers, were covered by pension plans. This number quickly skyrocketed and, by 1980, had increased to 35.9 million workers, or 46% of all private sector workers .
In 1978, however, the U.S. Congress passed the Revenue Act of 1978, which established that employees did not have to pay taxes on income they elected to receive as deferred compensation. A few years later, Ted Benna, a benefits consultant with a private company, used his own interpretation of this law to establish the first 401(k) plan that enabled employees who deposited money into their own accounts to receive matching contributions from their employer.
Because defined benefit plans are more expensive than defined contribution plans for employers, 401(k) plans exploded in popularity as employers dramatically cut back on pension plans over the last few decades. By 1990, the percentage of private sector workers participating in pension plans had stopped its dramatic climb and actually decreased a little to 43%. Today, that number has fallen to 18% of domestic workers in the private sector, according to the Bureau of Labor Statistics. When public sector workers are included, too, this number jumps to 23%. As these statistics show, most workers can now only contribute to their retirement through investment vehicles like an IRA or 401(k) plan; few employees, outside of a select number of large companies and government entities, currently have access to a pension plan.
Who pays for all those benefits?
Pension assets consist of a combination of employee and sponsor (employer) contributions and investment gains. Because the power of compounding is so cool, the vast majority of all pension payments consist of investment gains. In public sector pension plans, for instance, investment earnings make up about 62% of pension assets, employer contributions 26%, and employee contributions 12%, according to the National Association of State Retirement Administrators.
Is my pension insured?
As a general rule, public sector pensions are considered safer than pension plans offered by private companies. After all, companies can -- and do -- go out of business all the time. Cities and states do not run that same risk. However, government entities can still default on their loans. For instance, the city of Prichard, Alabama, stopped paying its retirees their pension payments in 2010, despite a state law saying it was illegal for a municipality to do so. While this is an extreme case, it does show that public funds under great pressure can stop paying pension benefits too.
Private pension plans are at least partially insured by the Pension Benefit Guaranty Corporation (PBGC), a government agency established in 1974 by the Employee Retirement Income Security Act (ERISA). The goal of PBGC was to provide a retiree with uninterrupted pension payment's if their employer's pension fund went bankrupt. In 2015, the same year 69 employer-sponsored pension funds went bankrupt, it paid out $5.6 billion in benefits to retirees. It also distributed a bit more than $100 billion to financially stressed private pension funds. The PBGC can only pay a maximum benefit of about $60,000 per year and does not guarantee it will pay the full benefits promised to a retiree by their employer. In 2015, the agency's deficit was $76 billion and it had about twice as many liabilities as it did assets.
How can I tell if my pension is safe?
The quickest way to judge your pension plan's sustainability is by looking at its funding ratio, also known as a funded ratio. The funded ratio is found by dividing a plan's assets by the benefits it must pay. When expressed as a percentage, a 100% funded ratio means the pension plan has enough assets to pay all future benefit obligations. Anything under 100% means the plan does not have enough assets to pay out future obligations. Sometimes the board of trustees makes this information, like the funded ratio, available through a newsletter or fund website. If not, a good place to find this information is by asking one of the plan's trustees.
All else being equal, the higher the pension plan's funded ratio, the better. A good rule of thumb, but by no means foolproof, is that a plan with a funded ratio of 80% or higher is considered to be in sound shape. However, as we shall see, this statement requires so many caveats it's almost not worth repeating. Nevertheless, when you first start examining a plan, a good place to start is discovering what its funded ratio is.
An imperfect measurement
Unfortunately, the funded ratio is far from a perfect form of measurement. For starters, it only takes into account the assets the plan has on hand. For active plans, where employers and employees are still making contributions, it is silly to not take this into account. Many of the plan's liabilities are not due to be paid for a long time and, unless there is another red flag, there is no reason to believe the plan's sponsoring employer will stop making payments.
An apt comparison would be to liken it to a new homeowner who just took out a 30-year mortgage to pay for a house. The homeowner might not have enough in his savings and investment accounts at the moment but that doesn't mean his home is in danger of foreclosure. The bill for the house comes in doable increments over the course of 30 years. In the same way, it is not like the plan's sponsor must make up the difference between the plan's liabilities and assets in a short amount of time. The employer usually has decades to make up the difference. Besides, there are numerous variable inputs that considerably impact the funded ratio. The two most significant variables are probably the mortality rate and the assumed rate of return.
A morbid fascination
There are only two certain things in life, and any deep discussion about pensions needs to cover both. We've already covered taxes, so let's talk about another fun topic: death. One of the key variables that help determine how good a pension plan's funded ratio looks is its underlying mortality assumptions. For pension purposes, this is the projected death rate of members used by the pension plan's actuary, a person hired by the trustees to statistically analyze liabilities and benefit payments. In the state of Florida, publicly funded pensions must use the mortality assumptions used by the state's retirement system. This mortality assumption rate is dynamic, in that it assumes the life expectancy rate will continue to slowly climb in the years ahead, which forces a pension plan to take into account the demographics of its members.
While the IRS does regulate the minimum standards for mortality assumptions that can be used by a pension plan, it can be helpful to compare your plan's mortality rates to similar plans.
The assumed rate of return
Probably the most important input that goes into a pension plan's funded ratio calculation is the assumed rate of return. The assumed rate of return is what the trustees, in consultation with their money managers, believe it is safe to assume the assets in the fund will return -- on average -- over the long term. Even small differences in this input can make a huge difference in the plan's perceived safety and sustainability.
To illustrate this truth, calculate the compound interest of $1 million over 30 years using both a 6.5% assumed rate of return and an 8% rate of return. Using 8% as our rate of return, $1 million turns into $10.9 million. Using a more conservative 6.5% assumed rate of return, however, sees that $1 million turn into "only" about $7 million, nearly $4 million less. When multiplied by the hundreds of millions, if not billions, of dollars in pension funds, the difference is huge. In other words, pension plans can disguise the true state of their financial sustainability by using artificially inflated assumed rates of return.
There are lots of reasons why trustees might do this. For starters, the lower the rate of return means that the sponsor must pony up more in annual contributions. Therefore, the sponsor's representatives on the board of trustees might feel pressured to keep the assumed rate of return high. This was the case in California recently when a legislative representative asked the CalPERS Investment Committee (California Public Employee Retirement System) to not lower their assumed rate of return to 7% because the public municipalities would not be able to make the increased payments into the system. The representative called for the committee to "think outside the box" to seek higher returns on their investments.
This is incredibly short-term minded and irresponsible. The pension plan's trustees' fiduciary responsibility is to act in the best interest of the pension fund, and seeking riskier investments with higher returns just so the plan does not have to sport lower assumed rates of return is the height of recklessness. Assuming higher rates of return might mean less is paid out by the plan's sponsor in the immediate future but, in the long run, it means the pension fund will inevitably miss these targets, causing the employer to pay much more in the future.
Other times, groups with other motivations play with the assumed rate of return to make the pension crisis seem worse than it really is. For instance, one recent study highlighted what it said was a jaw-dropping $6 trillion in unfunded pension liabilities across the country. Naturally, this gigantic number succeeded in winning numerous headlines. However, when the study was examined, it was discovered a "risk-free rate of return assumption" of 2.142% was used to calculate the results.
A realistic assumed rate of return for any plan would take into account the asset allocation of the plan -- the percentage of the portfolio that is in domestic and international stocks, bonds, real estate, and so forth -- and the historic long-term gains of each. Since every plan is unique, this means there's no single, universal rate of return that makes sense for every plan.
That being said, most plans should probably not have assumed rates of return much over 7% and anything over 8% should be viewed with a healthy dose of skepticism. If your pension plan has a low funded ratio and a high assumed rate of return, it might be a cause for concern and warrant further digging. By the same token, if someone is trying to say your plan's funded ratio is far too low, but they are using a ridiculously low rate of return, there is probably no need to panic just yet.
The most important thing
The big takeaway is that if you are fortunate enough to be covered by an employer-sponsored pension plan, congratulations! Fewer American workers are afforded this luxury every year and a pension plan is a wonderful financial vehicle to help you retire. No pension plan is bulletproof, though, despite the laws and regulations that federal and state governments have enacted to protect them. If a local government entity or private corporation falls on hard times, there is not necessarily a happy ending if you were placing all your hopes on your pension plan. It certainly appears that some of our country's largest municipality pension plans are currently showing signs of stress.
Instead, make sure you are not placing all your eggs in one basket. Many employers offer a hybrid pension and 401(k) plan. If this describes your employer's plan, make sure you are putting something away in the 401(k) plan. For instance, the Federal Employees Retirement System (FERS) consists of a Basic Benefit Plan and a Thrift Savings Plan (TSP). Government workers should at least contribute enough to their TSP to earn the government's matching contribution.
If your employer offers a pension but no other savings vehicle, strongly consider opening a traditional or Roth IRA. While having a pension plan is great, no one wants to have all of their eggs in one basket or have their retirement subject to the whim of possibly corrupt or incompetent local politicians. If you're not sure how safe your pension plan is, meet with some of your plan's trustees, your union representatives, or your company's management team and begin to ask some questions.