Lessons from Ailing Pension Plans
Benjamin Franklin wrote that nothing in this world can said to be certain, except death and taxes. If he lived today, he might add underfunded pensions as a third certainty. The Pew Charitable Trusts¹ reported this month that the most recent data from 2014 state pensions shows a 75% average funding ratio, with values as low as 41% in Illinois and Kentucky. As shown by the map below from Morningstar², it seems the commonality of poor pension funding is one thing that unites these United States.
We are routinely asked to help evaluate different financial scenarios and provide guidance on many different challenges that our clients face. This may be retiring early, taking a buyout, selling a business, taking a lump sum vs. a pension, etc. Recently, we have had the opportunity to review several large pension plans for clients and have come to appreciate the problems in today’s public and private pensions. The challenges faced by pension plans across the country provide three great lessons that can be applied by families.
Watch the Numbers, and Pick the Right Number to Watch
In reading the annual reports and annual letters regarding one pension plan, the key statistic reported and discussed was always the Net Position, the amount in the fund after paying this year’s retirement benefits. This amount trended up over the past five years thanks to good investment returns. Buried deeper in the report was the Net Actuarial Value, the present value of the fund taking into account the future obligations to current workers. This, the important number, trended down as retirement benefits increased faster than contributions.
This mistake in focus likely delayed the alarm being raised as the fund deteriorated. To avoid such mental pitfalls, we help our clients track their Net Worth, the best barometer of wealth over time.
Lifestyle Inflation Is Hard to Reverse
Another pension plan received employer and employee contributions until the 1990’s, when a study showed the plan was overfunded. For nearly twenty years, the plan took a break from these contributions and funneled that money into capital improvements and new ventures. These projects expanded the budget such that when management realized the pension was in trouble, they couldn’t afford retirement contributions.
It is very easy for families to fall into this trap, spending now with the plan to save later. This cycle can last decades even with increasing earnings. The power of understanding behavioral finance and planning to save and invest automatically cannot be overstated.
Years of Plenty are Planning Opportunities
A final plan with expanding liabilities didn’t provide public commentary on its decreasing viability until 2006. At that point it was 102% funded. Management procrastinated in finding a solution until the fund lost double digits in 2008. If they had implemented a solution as soon as they saw the problem, only modest changes would have been necessary. As it sits today, the plan is $12 billion underfunded and would need to contribute 28% of payroll to keep that number from expanding.
This is the biggest takeaway for families. A problem only gets worse by being ignored. The best course of action with any financial predicament is to make a frank assessment and put a repair plan in place as soon as possible. It is amazing to see the anxiety of the unknown wash away as people learn their numbers and are empowered to improve their situation. We’re happy to talk through finding such a solution anytime.
¹The Pew Charitable Trusts http://www.pewtrusts.org/~/media/assets/2016/08/thestatepensionfundinggap2014.pdf