America has a pension problem. It has been reported in financial journals for years and has trickled into the mainstream spotlight a few times, but given the size of the potential shortfall in America’s pension system, it is a wonder that it has not been discussed more broadly or urgently.
Defined benefit pension plans (commonly referred to as just a “pension”) are offered by private and public sector employers as a benefit to employees — incentivizing long tenure. The longer an employee works for a company or government and the more money they make, the bigger their payout will be when they retire. Employers guarantee these payments and assume the risk involved.
These future benefits are determined by actuaries using complex calculations that factor in assumptions about life expectancy, expected tenure and expected earnings. The aggregation of these benefits is known as the pension liability. Employers decide how they want to fund this liability. They can fully fund the present value of the payments today and lock in this funding using a low risk investment strategy. Alternatively, they can partially fund now and rely on riskier investments to make up the difference over time. Naturally, most entities have opted for the latter strategy, investing largely in stocks and other risky assets. When times have been tough, employers have even opted to skip contributions into the plan altogether.
Over time this has led to an increasing divergence between the pension liability and the assets stowed away for payment. Pension plans have gotten into trouble by assuming high rates of return on their assets and failing to update those assumptions as market dynamics change. Additionally, the pension liability is a moving target. Future benefits adjust based on changes in life expectancy, employee income, and employee tenure. Taking those future payments and discounting them back to present day adds even more volatility to the mix, as prevailing market interest rates are used. These dynamics created a perfect storm in the 2008 financial crisis when asset values plummeted at the same time that interest rates were falling (pension liabilities go up when interest rates fall). This created a funding shock that took years to come back from. Now, in 2020, the same effect is recurring with the coronavirus pandemic. Pension plans were better prepared, but the effect of ultra-low interest rates and decades of underfunding is hard to overcome.
So where does this leave us today? The graph above shows the current state of pensions in America. Overall, we are seven trillion dollars short on funds needed to fully pay out benefits. This is more than twice the size of the total coronavirus relief supplied by the U.S. government to date. Private pension plans are in a reasonably comfortable position, with approximately 89 cents of every future benefit dollar accounted for. State and local governments are much worse off at just 45 cents saved for every dollar needed for the future. The Federal government is not far behind, with 57 cents on the dollar. The Federal government has some levers to pull for financing, but state and local governments are in a dire position. Funding health varies from state to state, with some municipalities faring better than others. Budgets are always tight for states though, and the pandemic is pulling no punches on finances.
These days, it is rare to find a company that is still offering traditional pensions to new employees. The vast majority have restricted new entrants and/or frozen benefit accruals altogether. Within the public sector, the story is much different. Pension plans exist in abundance for government employees and are an attractive benefit, relative to self-funded defined contribution plans like 401(k)s (where employees take on the investment and funding risk). Digging out of this hole will likely require benefit cuts or potentially even a bailout from the Federal government. If Detroit’s bankruptcy is precedent, however, the biggest impact from debt restructuring may fall on the pensioners, with no help from Washington.
