On the face of it, pensions are stupid.
You pay someone a little bit each month over your working life, and then they pay you a little bit each month until you die. The difference is, you know how long you’ll work, but they don’t know how long you’ll live. The risk of dying soon after retirement and having the other person keep all the money is offset by the possibility of living a really long time, where the other person must keep on paying.
But there is a mitigating factor — the law of large numbers.
Any group offering a pension can’t know (without employing a hit man) exactly when any one person will die, but they can be uncannily accurate in knowing when the average person will die. As long as such entities offer pensions to enough people, then the numbers work out, matching up contributions charged with benefits paid.
With this one simple twist, societies suddenly have a way for the Average Joe to secure a stream of income for the rest of his natural life after work.
Unfortunately, this basic relationship has been co-opted by companies and governments for their own purposes, and has created a monster that’s taking over balance sheets and budgets. Companies have realized their mistake, while governments just keep charging ahead taking taxpayers with them…
There’s nothing inherently wrong with a company or government (city, state, federal, etc.) managing pensions, as long as they realize that the laws of math apply to them. The law of large numbers is easy to see; it’s not the problem. Trouble arises when these entities try to supercharge returns by branching out from the traditional holdings of pension funds — bonds.
Pensions as Benefits
These boring fixed income investments pay known streams of income, interest and principal, at known times. Pension funds match up this income against their expected benefit payments as determined by contributions and the expectations of how long people will live.
But using bonds wasn’t good enough for most government or corporate pensions. They branched out, investing in equities and other securities.
Companies and governments promised pensions, either in full or in part, that employees wouldn’t have to pay for. This benefit was a recruiting and employee retention tool and was used in lieu of higher salaries. Of course, this meant that the company or government was on the hook for making the necessary contributions, which could be quite substantial.
In order to lower the contribution amount required, pension managers began investing in securities that, on average, had higher returns than bonds. With higher assumed returns, the contributions required by the company or government fell like a rock. It was magic!
Right up until it didn’t work.
Obviously stocks don’t have a preset return, so investors can make more than they can on bonds… they can also lose and there’s the rub. Once pension funds stray from holding very predictable long-term investments, there’s the real possibility that funds can come up short. Since the promise to employees still exists, the company or government must look elsewhere to make up the difference, either out of their own balance sheet or by charging taxpayers.
This situation was made worse as pension sponsors failed to make their required contributions, hoping that future equity gains would bail them out. Eventually, many plans fell below 100% funding, with some holding less than 50% of what is required to make good on all of their obligations.
The reality of the situation is not lost on the plan sponsors. Companies have been off-loading or unwinding their pension obligations for decades, attempting to move employees to 401(k)s if possible. Many cities, states, school districts and other government bodies that offer pensions have tried negotiating lower benefits and higher contributions from employees.
Their efforts are stymied by the fact that the blame for the current state of the pensions falls mostly with the sponsor itself.
The Unpopular Solution
General Motors recently handed off its pension to an insurance company and Motorola is about to do the same thing. The insurance companies are expected to manage the funds in a more traditional way, matching up long-term streams of income with long-term liabilities (benefits). Since the pensions are managed by a third party, the companies can no longer fudge their contributions or expected returns.
Government entities could do the same thing — shift their pensions to true pension companies that use a conservative approach to investing. But the move isn’t free.
When a company takes over a pension like this, it has to be fully funded. If the pension is not fully funded, the pension sponsor remains on the hook for the balance. A current Moody’s report showed the 25 largest public pension funds are underfunded by $2 trillion.
Where in the world will government entities get the funds to make up such a large difference?
They’ll come to you and me… as taxpayers. This is the cost we all will bear for years of mismanagement that we failed to stop at the ballot box.