traditional pension plans in the US: trouble ahead

the basics

Corporate pension plans of one type or another have been around in the US since the late nineteenth century.  In their simplest form, they offer specified payments in retirement to company workers who meet criteria spelled out in advance.  Since 1974, these plans have been subject to federal regulation under the Employee Retirement Income Security Act (ERISA) which sets out standards companies must comply with.

Although pension plans are an obligation of the firm, companies don’t ordinarily keep on hand in the plan today enough money to meet all future obligations.  Instead, they (or outside actuarial firms they hire) make intricate calculations of what future payments are likely to be and when they are likely to occur.  Then, using the investment returns that on average they believe their investment managers can achieve, they figure out how much must be in the plan right now to fund expected obligations.

open secrets, sort of

–We know professional analysts have a hard time forecasting what will happen even one year ahead.  What does this say about forecasts that claim to look decades into the future?

–Most traditional pension plans have less in the till today than actuarial calculations say they need.

–The return assumptions used are typically, let’s say, heroic.

public sector workers

The uncertainty inherent in what I’ve just written is why most publicly traded US companies have long since switched from traditional pension plans, where the corporation has responsibility for the risk of miscalculation, to 401ks, where the employee bears it.

There still are significant numbers of traditional pension plans, however.  They’re in the public sector.

dealing with underfunding

To my mind, a substantial reason for the popularity of hedge funds over the past fifteen years or so has been their claim of superior performance as far as the eye can see.  The director of an underfunded pension plan knows that his story is not going to end well as things stand now.  He has two choices:  ask his boss, the governor/legislature, for instance, to fix the problem by allocating (a ton of) more money to the plan; or he can find managers who can consistently exceed the returns the actuaries assume and gradually close the funding gap that way.  Not wanting to be the bearers of bad news, directors have by and large chosen door #2.

the actuarial assumptions

Adding to the woes of pension plan directors, the California Public Employees Retirement System (CalPERS), a leader in the public pension plan sphere, has begun to call into question the assumption that it can churn out average annual gains of +7.5%.

The surprise here, if any, is that CalPERS has finally decided to deal with this chronic problem.

More tomorrow.




Leave a Reply