Promises Made Which the Checkbook Can’t Cash
There are two type of pension plans. Defined Contribution Plans are just what they sound like. Employers and/or employees contribute to a pension plan and hold an individual account in the plan The benefits are determined on how much is contributed and how much those assets earned. The more contributed and the higher the rate of return the higher the pension. A Defined Contribution Plan has no unfunded liability. What you see is what you get.
The other type of pension plan is a Defined Benefit Plan. When the history of the 20th century is written, this type of pension plan will be designated as one of the worst, if not the worst financial idea of the century and certainly one of the worst financial concepts of all time. In this type of plan the contributions go into a pension account and from that account benefits are paid. These benefit are specific, guaranteed amounts regardless of the value of the plan, how much money was contributed and how much the pension fund earned.
Most of the private sector plans have been converted to Defined Contribution Plans, of which the 401k Plan is the most prevalent. But surprisingly, there are still Defined Contribution Plans out there and they are in trouble.
The number of Americans covered by defined-benefit pension plans has dropped sharply in past decades as companies have shifted to 401(k)s and other plans that don't guarantee payouts. But 14% of the country's private-sector work force still participates in some sort of defined-benefit plan, according to the Washington-based Employee Benefit Research Institute.
So what the problem? Well it’s this.
Weak stock markets and falling interest rates have left a $440 billion hole in the nation's 100 largest plans, with the shortfall more than doubling in the third quarter.
Just to put this in perspective, the shortfall was about $6.7 billion at the end of the third quarter of 2008, just before the late unpleasantness. But that is only part of the bad news.
Milliman says discount rates dropped to around 4.54% at the end of September, the lowest since it started tracking them 11 years ago. In October, the rates fell further—to 4.53%. Meanwhile, the value of pension-fund assets suffered from a slide in the stock market, with the Standard & Poor's 500-stock index falling 14% in the third quarter.
Let’s make sure everyone knows what this is saying. The discount rate is the rate of return expected on the pension plan assets. The lower the rate of return, the greater the shortfall in the pension fund and the more money that has to be contributed to meet fund obligations. So right now private funds are basing their projections assuming they will earn about 4.5% a year.
Now investing at a rate of 4.5% is doable. It is not easy, with even long term government bond rates at or below that level, but a combination of stocks and bonds could achieve that return on the long term. So what’s the problem? It is this.
State and local governments are the exception to the pension plan structures. They still have predominantly Defined Benefit Plans. So they have the risk of not knowing how much they will have to pay out and how much they will earn on the plan assets. But they are making assumptions and their assumptions are in the 7-8% range! And even at that assumed rate of investment return, the plans are hundreds of billions, maybe trillion short of adequate funding.
So imagine what the shortfall is if the pension plans of state and local governments earn only 4 to 5%? No wait, don’t imagine it. Trust us, if you imagine that scenario you will not be a happy person.