For the past few decades, a big part of the American Dream was to go to college, get a great job with a big company, work there for forty years and then spend your days cruising around in your golf cart in some place like Boca Raton, Scottsdale or Palm Desert.
Of course this whole “fantasy” (that’s arguable in my opinion) was possible because almost all retirees were covered by a traditional pension plan.
Pensions were created to take care of workers who put in their time with a company, stayed around long enough to get the gold watch, and sail off in their Winnebago to some place where the average temperature is just shy of a hundred degrees.
These plans are known on the inside of the industry as defined benefit plans which ironically in this case accurately describes what they are.
The Inside Scoop
First, a little background information to help connect the dots.
Keep in mind, I’m giving you the 30,000 view for now. Most companies, government agencies (local, state, and federal), and/or private sector businesses offer their employees two basic types of retirement plans. The two categories are defined benefit plans (pension) and defined contribution plans (401k, SEP, etc.).
In a defined benefit plan, the employee is entitled to a set monthly benefit despite the underlying performance of the plan assets. These plans are outrageously expensive for the employer in question and consequently is the reason that by in large, the private sector has abandoned defined benefit plans.
A defined benefit plan could be structured in a few different ways, but the basic premise is that you work for a pre-determined length of time and receive a “defined benefit” based on a formula that was written by an actuary on behalf of your company when they first started the plan. Typically speaking it will be something like 75% of your highest two years of salary or something like that.
Honestly, these plans are pretty much non-existent in the private sector anymore. There are some older employees of companies who are still working that have grandfathered in to their company’s plan that was in place when they started working 30 years ago. But in most of the private sector, defined contribution type plans are an employee’s only option.
Why It Doesn't Work
Now, with that background out of the way, let’s look at why the old school pension is a great deal for the people covered under them and a fiscal nightmare for the companies, education systems, municipalities, state government that offer them.
Really it’s not that complicated. Basically, it’s a great deal for the employee because the plan takes on all the risk, the future retiree has no risk involved and in many cases is required to contribute very little if anything at all to the their plan.
So, you get a guaranteed monthly payment without any of your own money at risk. Sounds like a good deal to me?
The problem with these plans is pretty obvious…especially when you look at it through the lens of what’s gone on in the economic climate of the last few years. Not that the problems are new, just that since late 2008 the layers have been peeled back to reveal the rotten core.
Whenever we experience a period of declining interest rates like we have in recent years, define benefit plans come under assault. The pressure of prolonged low interest rates and extremely volatile stock markets has made a difficult situation almost impossible.
In doing research for this article I was astounded to find out that most pensions still use an 8 percent return on their investments to calculate the level of funding required to meet future obligations.
Uhhh…I’m not sure that I know what to say about that
I can’t imagine why these plans aren’t working out so well (insert sarcasm)
It seems that almost every pension out there has made huge promises that are too big to keep based on math that any decent math student in high school could tell you won’t work.
By the way, have any idea how many people are covered under these sorts of plans?
Over 25 million people across the U.S. for state pensions alone, this doesn’t even count federal employees, municipal employees, or the legacy plans for big business (think GM, Ford, IBM, Xerox, etc.)
The fact that most of these retirees are also covered by healthcare plans that are grossly under-funded. Look at the graphic I’m including for the State of Georgia just an example.
Sidenote: if you’d like to read through some solid research on the big problem with state pensions in particular, check out The Widening Gap.
Of course, in looking at the report I was curious to see how my home state of Georgia faired in the analysis. Here’s a screenshot of the information I found
Good to see that Georgia is actually not doing so bad when it comes to funding the pension obligations. Bad to see that the funding for meeting the promises made for healthcare are woefully inadequate—which is definitely a common them amongst all the states.
Why Am I Telling You All This?
Well, what I'm telling you is that the math doesn't work. The jig is up. The chickens have come home to roost.
If you're being promised a pension of some sort, I'm not suggesting that you won't get some benefits from it but I'm merely suggesting that you do a little digging of your own. Not surprisingly, the biggest obstacle for all pension funds/defined benefit plans is the future of healthcare obligations for retirees.
People living longer and taking more drugs in order to do it was never accounted for in these initial calculations made decades ago. And the benefits aren't sustainable for the long term, much like those benefits being promised with social security and medicare.
Make sure you do your own planning, consider creating a pension for yourself. If that's something you'd like to discuss, we'd be happy to help.