Tuesday, July 28, 2009

Why are Company Pensions at Risk?

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.


  1. Maybe it would be better to find some way to ensure the contractual obligations are met, and the pension plan is actuaryily sound, rather than deciding that employees should now (have to) work beyond 65. Since it is possible for a company to go bankrupt at any time, the pension should be fully funded at all times. We just need a sensible means of determining this which is simple enough that the employees can understand the annual report.

    Possibly the pension should be considered the first (it likely being the longest held) ranking creditor in bankruptcy proceedings.


  2. DAvid: I agree with your suggestion for pension reform going forward, but that won't help the great many of people owed pensions from plans that are hopelessly underfunded right now. There just aren't enough resources to allow all baby boomers a comfortable work-free retirement starting at age 65 or earlier.

  3. Thicken: You're right that since it has become legal to underfund pension plans, Badco has some duty to shareholders to underfund its pension plan. I would prefer to see rules tightened so that as companies accrue new pension obligations, they are forced to properly fund them. If companies believed that this would actually happen, they might reduce their promised payouts. Employees may not like this at first, but at least they could plan for smaller payments instead of planning for bigger payments and getting smaller ones.

    1. The comment above is a reply to Thicken My Wallet's comment:

      Let me play Devil's advocate here. If you are a shareholder of Badco, how mad would you be that earnings were lower than their peers because they fully funded their pension liabilities and their peers did not?

      I agree with you but we seem to want things both ways. As shareholders we want sky-high returns but as employees we want fully funded pensions (rightfully so). Given our demographics, something has got to give.

      I waiting to see what buckles first: government, shareholder returns or employee entitlements.

      As for ranking pensions higher in priority, the bank lobby would kill that proposal in a second.

  4. @ Thicken My Wallet: However, the difference between pension funding and dividends is that the pension is a contractual obligation, whereas the dividend is not. How would shareholders of Badco feel if Badco ceased paying it's utilities, or arbitrarily decided to pay it's suppliers only 80% of the contracted price, as that too would increase profits. I find it shocking and disappointing that people feel that is is reasonable for companies like Badco to renege on their obligations to one group (employees) to satisfy the expectations of another (shareholders).