Pension math represents a ticking bomb

For anybody paying even a modicum of attention pension math has been a source of significant debate in the last decade. There are many aspects of pension math worthy of discussion and this recent New York Times article points out many of these issues in light of the Detroit bankruptcy filing and the public sector employee pensions. To put it bluntly, most pensions assume their result.

To be more precise think about the typical saving problem. You look at the end amount you have to pay, and make periodic contributions based on that amount and the rate of return earned. That rate is variable and the current monetary environment pulls most rates of return down. So as you go along saving to reach your goal, you vary your contributions based on income and the rate of return. There are two types of plans out there right now, defined-contribution plans and defined-benefit plans. The former specify the amount invested periodically while the later specify the amount that will be paid periodically at retirement. The problem is with the latter type.

With a defined-benefit plan you will have an estimate of the amount you will need to pay to retirees. Remember, people are living longer which may mean you need more than what you planned at the start of a workers 30 year career. Even if we develop a good estimate of the amount we will need to pay over time, there is the issue of how much we need to contribute, essentially set aside, today. Do we use a low return number, like a risk free bond? Not usually. Many plans just assume the rate of return, and keep that assumption constant over time. How do they know what their returns will be? Well, they don’t. That’s the problem, they just assume the return. And of course the assumed returns are always healthy, in the realm of 7 or 8 percent.

Why do this? Higher expected returns keep the amount of annual contributions down and makes the pensions look affordable. Remember, most of these are public employee pensions, so the contributions are taxpayer dollars. If the assumed returns were lower, that would require higher current contributions, which likely mean higher taxes on the public, or reduced spending in other areas. Likely, it means a bit of both depending on the different factors involved. When retirements occur and bills are due the accumulated funds are inadequate and suddenly it is a crisis, but one we should have seen coming. These assumed returns are so embedded in the thinking about pensions that it is hard to shake loose.

Now I am not saying that the workers do not deserve their pensions. When they signed up for the job this was part of their compensation package. So be it. If we need to blame someone I think most of the blame lies with  government officials that allow these plans to continue operating in this fashion. At some level it borders on dishonesty. There is a lie told to the taxpayer about the cost of retirement for the covered employees and attempts to correct it are left to the last possible moment.

The lesson from Detroit should be that past mistakes with the math are the past. Let’s get it right for the future and make corrections.

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