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Properly funding a defined benefit plan requires solid average returns and some luck

by Adam Millsap on February 2, 2016

in Debt, Pensions, Public Finance, Taxes

Saving for retirement is something most workers do – either on their own or through an employer – and most are aware that the rate of return on their retirement investment matters. For example, if I save $100 today and it earns 10% per year in interest for the next 20 years I will have $672.75 at the end of 20 years. If the money earns 6% instead I will only have $320.71 at the end of 20 years.

Moreover, if I wanted to have $672 at the end of 20 years and the interest rate was only 6% I would have to save $209.54 today rather than $100. This demonstrates that the higher the interest rate is, the less money I will have to save today in order to have a specific amount of money in the future. This simple truth has important implications for pension funding.

For many years state pension plans assumed average returns of around 8% per year when calculating pension liabilities. Assuming this relatively high rate of return meant that pension plans required less contributions today in order to meet their future goals. But this also came with significant risk – if the average rate of return fell short of 8% then the pensions would not be able to pay out the benefits that were promised. This is demonstrated in the previous example; if a person wanted $672 after 20 years and assumed a 10% rate of return they would have only saved $100. However, if the rate of return turned out to be 6% per year instead of 10%, they would have ended up over $300 short of their goal ($672 – $320 = $352).

It turns out that an expected rate of return of 8% was unachievable and many pension plans are lowering their expected returns. This can generate large pension shortfalls, since a lower rate of return means that more money needed to be saved all along. In many states the budget is tight and it’s not clear where the additional money will come from, but there’s a good chance that taxpayers are going to have make up the difference.

Assuming too high of a return is an obvious problem. But there is a more subtle issue that doesn’t get as much attention yet generates similar results; even if a pension plan gets an 8% return on average, the plan may still fall short of its goal. This is because different returns have different effects on the actual amount of money over time. The chart below provides a simple example, where the goal is to accumulate $100,000 in 10 years.

Based on the $100,000 goal and an 8% yearly return one can calculate that (approximately) $6,400 must be contributed to the plan at the beginning of each year, which is the contribution amount I used. In each scenario in the table the average annual return is 8%, but not every plan returns 8% each year.

pension-avg-return-table2

Scenario 1 is the most straightforward; the plan actually earns 8% each year and the $100,000 goal is reached by year 10. But while this is the simplest scenario, it’s also the most unrealistic. Anyone who follows the stock market knows that it’s volatile – some years it’s up, some years it’s down. Standard pension accounting, however, assumes scenario 1 will occur even though that’s incredibly unlikely.

In scenario 2, the plan earns 8% in each of the first two years, then loses 15% the third year. After that returns are above average and plan actually exceeds its goal of $100,000 at the end of 10 years. In scenario 3 the plan earns 8% for the first 6 years, then 14%, before losing 15% in year 8. In this scenario, even the exceptional gains in years 9 and 10 are not enough to reach the $100,000 goal. And finally, in scenario 4 the gains fluctuate more often – there are some high return years in the beginning and the loss year is relatively late (year 7). In this scenario the plan ends up over $6,500 short of its $100,000 goal.

There are infinite ways a plan could get an 8% return on average, but these 4 examples demonstrate the different dollar amounts that can result even if the average return goal is met. In two of the scenarios (3 and 4) the plan falls short of its actual dollar goal and is underfunded even though it met its return goal. This exemplifies the inherent risk in any pension plan that promises a specific amount of money in some future period, as defined benefit plans do. As the previous example shows, even if the required contributions are made each year AND the plan’s average return goal is met, there is still a chance the plan will be underfunded.

The risks associated with the variability in returns is another reason why many pension reform advocates recommend defined contribution plans rather than defined benefits plans. Defined contribution plans don’t promise a specific amount of benefits, which means they are not subject to the same underfunding risks as defined benefit plans. Switching from defined benefit plans to defined contribution plans needs to be a part of the solution to public sector pension problems. Otherwise there’s a good chance that taxpayers will be required to pick up the tab when plans inevitably miss their funding goals.

 

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