A chorus of financial experts has declared that Americans face a “retirement crisis.” Their long-standing warning: Individuals are not saving enough. Their more recent concern: Financial ignorance and diminished mental capacity in old age leave many retirees poorly equipped to manage their retirement savings, and susceptible to all sorts of financial pitfalls, from unnecessary frugality to being scammed out of their life savings.
When they observe this crisis, some experts have a tendency toward nostalgia, to look backward to “the good old days.” For retirement, that means longing for an employer-sponsored, defined-benefit pension plan. Check these headlines or lead sentences from recent blog articles:
“Understanding Your Pension—If you’re lucky enough to have one!”
“Pensions are becoming a thing of the past—so if you’re still entitled to one, consider yourself lucky.”
“If you’re lucky enough to have a pension plan at work, be thankful—it may be one of your greatest financial assets.”
“Pensions are terrific, if you’re lucky enough to still have one.”
You no doubt sense a theme. But what’s so great about a pension that makes you “lucky” if you have one? From the perspective of these personal finance experts, a defined-benefit pension resolves the biggest issues in retirement: An employer funds the plan, and guarantees a lifetime income (typically based on average annual earnings and years of service). The weak link—the individual who hasn’t saved or can’t manage money—is removed from the equation.
Ah, the good old days. If only the present could be as we remember the past. Unfortunately, the financial behavior of pension plans isn’t much different than that of individuals.
If You Thought Individuals Didn’t Save…
To make good on their financial promises to retirees, employers must make ongoing deposits to fund the plan. But like many American households, most employers haven’t saved enough to meet their retirement obligations. To use the jargon of the industry, their pensions are “underfunded.” According to 2016 data analyzed by Wilshire Consulting, “Large pension plans currently have just 70% of what they need to pay future benefits to their retirees.”
This underfunding is true of both private and public pension accounts. Even after a year in which many pensions experienced above-average investment returns, the August 8, 2017, Wall Street Journal reported that “Many of America’s public pensions remain severely underfunded, meaning they don’t have enough assets on hand to fulfill all promises made to their workers.” A June 2017 Bloomberg News report found that “New Jersey, Kentucky and Illinois continue to lose ground and now have only about one third of the money they need to pay retirement benefits.”
And Pensions Compensate for Under-Saving Just Like Individuals, Too...
Just like individuals, pensions can make up for under-saving by assuming a higher rate of return on the savings they do have. For years, pension administrators have used optimistic return assumptions to cover their funding shortfalls. In 2017, Illinois’ state pension system estimates a $127 billion funding deficit while Moody’s Investor Service says it’s closer to $250 billion. The difference: “a function of the state using more optimistic investment assumptions than used by the rating agency.”
But this issue goes deeper than unrealistic investment assumptions. Pursuing higher returns almost always comes with greater risk, which means a greater likelihood of plan failure. Yet a September 8, 2017, Wall Street Journal report found that “As the developed world’s population ages rapidly, pension funds are pushing into riskier assets.”
Given these realities, it is hard to think pensions are really the cure-all. In fact, when retirees rely on plans that don’t save enough and take on more risk, it puts a whole new spin on the idea of “getting lucky with a pension.”
What Happens to Under-Funded Pensions?
Historically, many pensions are either discontinued or diminished. The typical endings:
The plan is frozen. Current retirees and some not-yet-retired employees will continue to receive benefits. But the plan will not accept new participants, and some current employees may receive lump-sum payouts representing a present value calculation of their pension benefit (most likely using an optimistic return assumption) that can be rolled into another retirement plan.
The plan is terminated, and the employer pays an insurance company to assume responsibility for future payments. General Motors and several other large corporations have done this with blocs of employees. The cost of transferring the risk to an insurance company is usually more than the assets in the pension (because it was underfunded), but the additional cost to the employer is worth it because it eliminates future liabilities.
The plan is terminated, and taken over by the Pension Benefit Guaranty Corporation (PBGC). The PBGC is a federal insurance agency funded by premiums from pension plans to protect participants in private-sector defined-benefit plans. If a pension does not have sufficient funds to pay retirees, the PBGC uses its reserves to cover the difference, up to certain limits. The PBGC says, “Most people receive the full benefit they had earned before the plan terminated.” However, highly compensated retirees with benefits in excess of the agency’s limits will experience a reduction in monthly payments.
The plan reduces benefits. For federal, state and local government pensions, underfunding eventually leads to reduced benefits. In March 2017, the California Public Employees Retirement System (CalPERS) approved a reduction in benefits for a small group of retirees from a defunct public agency because the plan failed to meet its contribution requirements. This action resulted in a 63 percent reduction in benefits for 62 retirees.
Of the possible endings for struggling pensions, paying an insurance company to guarantee the payments is the outcome that provides the most certainty for retirees. The plan is fully funded, the incomes are guaranteed and no additional action is required by the retiree—no additional deposits, no management responsibility. Any hiccups that might arise, such as poor investment returns, or off-base actuarial assumptions, are covered by the insurance company’s reserves.
No Pension? You Can Still Get Lucky
Transferring the funding and investment risks in a retirement plan to an insurance company is also an attractive option for those without a pension. When individual retirees allocate a portion of their retirement savings to buy a lifetime annuity, they receive the same benefits: Their funding is complete, their income is guaranteed and they are relieved of ongoing investment management responsibilities. (Insurance company guarantees are subject to the claims paying ability of the issuing insurance company.)
There are significant challenges to managing your own retirement and providing an income from savings. But those challenges have practical insurance and management solutions that don’t require a reliance on an underfunded pension plan that takes excessive investment risks.
This material is intended for general public use. By providing this material, we are not undertaking to provide investment advice for any specific individual or situation, or to otherwise act in a fiduciary capacity. Please contact one of our financial professionals for guidance and information specific to your individual situation.
2017-47104 Exp. 9/29/2019
This article was prepared by an independent third party. Material discussed is meant for general informational purposes only and is not to be construed as tax, legal or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice.
Registered Representative and Financial Advisor of Park Avenue Securities LLC (PAS), 355 Lexington Avenue, 9 Fl., New York, NY 10017, 212-541-8800. Securities products/services and advisory services offered through PAS, a registered broker/dealer and investment adviser. Financial Representative, The Guardian Life Insurance Company of America (Guardian), New York, NY. PAS is an indirect, wholly owned subsidiary of Guardian. Wealth Advisory Group LLC is not an affiliate or subsidiary of PAS or Guardian.
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Submitted by Elozor M. Preil