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pensions: OVERVIEW OF DYNAMICS AND RISKS

Introduction:

We will be focusing on defined benefit (DB) pensions.
Defined benefit pensions are a guaranteed source of periodic income vested to employees based in part on length of service and salary history.

Offered widely in the past, defined benefit pensions are becoming rare in the private sector due to their sometimes large and unpredictable costs.
In private industry, defined benefit plans are offered to just 20% of all workers1 . This is down from 38% in 19802. Just 10% of all private industry ESTABLISHMENTS (businesses) offer defined benefit pensions 3.

The public sector presents a different story.
For government jobs, defined benefit plans are offered to 84% of all workers4.

Why the difference between public and private sector?
The generally accepted explanation is: public sector jobs generally pay less than the private sector. To compensate for this difference the public sector offered more generous benefits. This may have been true at one time. Today the mean hourly earnings for private sector workers is $20.47 vs. $26.08 for state and local government workers5. On average, public sector workers actually make MORE than private sector workers! . One thing to note: 36.2% of the public sector are union members while 6.9% of the private sector is unionized6. Another thing to note is that the public sector unions have a political infrastructure to influence state legislators.

A defined benefit (DB) pension is very valuable.
For example, assume a person wants to duplicate the benefit with an annuity. A 55 year old male in Florida desiring an annual income of $62,996 (no beneficiary payments) would have to pay $1,004,631 for a single life annuity7. To add inflation protection reduces the payout by about 30%8. Someone retiring with this pension is an immediate millionaire (not counting their personal savings)! CONCLUSION: we are dealing with an expensive benefit.

SUMMARY TABLE: DEFINED BENEFIT AVAILABILITY AND SALARY COMPARISONS

  PRIVATE SECTOR PUBLIC SECTOR
  TOTAL NON UNION UNION TOTAL NON UNION UNION
DEFINED BENEFIT PENSION AVAILABILITY 20% 15% 69% 84% 74% 96%
HOURLY EARNINGS $20.47 $20.19 $23.13 $26.08 $23.12 $29.72
UNION MEMBERSHIP 6.9%     36.2%    


 

DEFINED BENEFIT FUNDING DYNAMICS:

A DB pension trust is set up by the employer for its employees. The fund actuary determines how much money is required for the trust to generate the projected benefits. This estimate is based on many factors that can change over time. Each year the fund trustee reviews the fund performance and makes the appropriate funding adjustments.

What factors determine the funding level? There are at least 8. Some of the key factors are:
  • investment return - projected rate of growth of invested pension assets
  • salary increases - raises and other factors increase the value of the workers pension benefit
  • cost of living adjustment -a yearly increase in the monthly retirement benefit

In addition to the above, any change in the way the employees pension benefit is calculated or when an employee can retire will have an immediate impact on the required size of the trust fund.

How do these factors impact the required funding level of the pension and the total pension liability?

impact of an INCREASE in: ... on total pension liability ... on required funding impact on required funding of a 1% change in assumption is...
investment return none lowers 10% of payroll
salary raises raises 0.5% of payroll
cost of living adj. raises (1% change has a 9-11% impact9) raises  

 

RISKS

Let's look at one parameter in detail- investment return.
Investment return is the amount of increase the pension plan investments will average on a yearly basis.
If the actual investment return comes in ABOVE projection, the pension trust generates MORE money internally that year and thus the need for funding goes DOWN.
If the actual investment return comes in BELOW projection, the trust generates LESS money internally that year and thus MORE funding is required to make up the difference.
Changes in the investment return assumption do not impact the total pension liability, just the contribution amount required to fund that liability.

For most Florida public pensions an 8% investment return is assumed.
Taking the Florida Retirement System (FRS) as an example, the return for the year ending 1Q11 was 13.7%10. However, looking at the 3 ,5,10 and 15yr returns shows a different picture (3.2%, 4.4%, 5.8%, 7.5% respectively). Only over a 15-year time frame does the return approach the target. While results are not available to date, the Dow dropped 9% from 4/1 to 9/2/11. Thus, the full year performance will be reduced for 2011.

Whatever the markets do in the future, it seems prudent to plan for the possibility of a lower rate of return on investments11.
The impact is large.

EXAMPLE:
payroll: $4.215M
total pension contributions: $1.1M
current assumed investment rate of return: 8%

impact of lowering rate of return assumption from 8% to 7% (13% change):
1) a 1% reduction in assumed rate of return results in increase of funding level requirement by 10% of payroll
2) 10% * $4.215M = $421,500
3) new funding level = $1,100,000 + $421,500 = $1,521,500
4) new funding level is 38% higher

In the above (realistic) example, a 13% change in the assumed rate of return (8% to 7%) impacts the required yearly funding requirement of the pension by 38%. That is a 3:1 impact.
We are in no way stating that this WILL happen, only that it is POSSIBLE. Some contingency planning is in order.

NEXT STEPS

From the above information one can conclude that DB pensions may entail unpredictable and material risks.
Organizations, especially ones with limited resources, should consider steps to mitigate and/or off load these risks.
Some excellent suggestions on how to do that can be found in "Protecting Florida's Cities through Pension Reform". To quote from that document:

"The problem can be addressed by encouraging local governments to place all new employees in 401k-style "defined contribution" pension plans rather than "defined benefit" plans, and to encourage current employees to convert to defined contribution plans as well. This would help ensure that that the present costs of government would be funded in present budgets. Municipalities that wanted to offer defined benefit plans should be encouraged to offer them through the state government's Florida Retirement System; this can be encouraged by removing the disincentives that currently discourage municipalities from entering — or re-entering — the FRS."


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