A reader made the following observations about company pensions:
I understood pension contributions were a contractual obligation between the employer & the employee, and the funds were essentially supposed to be held in trust for the employee. Maybe it's time we removed this responsibility from the employer, so it is no longer tempting for them to dip into these trust funds to prop up the company.
It’s true that pensions are a contractual obligation between employers and employees, and that the funds are held in trust for the employee. Furthermore, employers are not permitted to directly dip into pension funds. So, how can pension funds get underfunded?
The answer begins with a simple accounting game. Consider the example of Badco with a single 45-year old employee, Ed. Suppose that Ed is entitled to $1200/month (adjusted for inflation) from age 65 to 85. This is a total of $288,000.
However, Badco doesn’t have to set aside $288,000 right now. Whatever money gets set aside now will be invested and the returns will make it possible for Badco to set aside a smaller amount of money and still have it grow enough to cover Ed’s pension.
Suppose that Badco’s pension plan can be expected to earn an average return of 3% above inflation. A few simple calculations show that Badco must set aside $120,200 to cover Ed’s pension. This is much less than $288,000, but is still a lot of money.
What if Badco assumes that the pension plan will earn 6% above inflation? Then they only have to set aside $52,900 right now. One little change to an accounting footnote reduces Badco’s pension obligation right now by more than half.
Of course, if Badco’s pension plan can’t beat inflation by 6%, then the plan will grow too slowly and the pension will become underfunded. A downturn in the stock market would magnify this effect, and Badco’s pension plan could become severely underfunded very quickly.
Unfortunately, at the very time that Badco must make substantial contributions to its pension plan, the economy is in recession, and Badco’s business is in trouble. Instead of filling up the pension plan, Badco is unable to contribute much to the fund at all and is facing possible bankruptcy.
Many people are calling for the government to step in and guarantee pensions or create a new universal pension plan that guarantees all retirees a comfortable pension. Unfortunately, demographics make this impossible. Once the bulk of baby boomers have reached age 65, there won’t be enough young people paying taxes to support all these payments.
It is as though there are ten people in a room and ten cookies on a plate, but everyone is entitled to three cookies. Something has to give. The most logical fix is to delay payments past age 65. People are living much longer today than they were when the retirement age was set at 65.