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Thinking about pensions, defined benefit plans, defined contribution plans and how pensions tend to get underfunded. Created by Sal Khan.
Want to join the conversation?
- Are these 'Defined Benefit' very common in the US? or do most people have 401(k)s or IRA's?(12 votes)
- They are slowly being phased out as more and more pension plans become unsustainable. The trend is definitely towards the "defined contribution" pension plan. But they will persist for a while yet, especially in heavily unionized sectors (teachers and nurses) and for government employees.(18 votes)
- Why are some pensions underfunded?(1 vote)
- It could be for a number of reasons.
1. You decide that it's better to spend the money on something else. This implies you will make up for it later (kicking the can down the road).
2. It could also be because where the money was invested is worth less money. (eg. Housing in US)
There could be other reasons such as a change to the calculation assumptions etc.
Primarily it's because governments are under pressure to spend more money than they have and don't pay all of it.(9 votes)
- Most people begin with a low salary and move to a higher one so they do not have the same amount of money to invest in their retirement over 30 years. What does investment look like when the first 15 years of income is significantly lower than that average of 60k over a 30 year career?(3 votes)
- Depends if it's a defined benefit or a defined contribution plan.
In a defined benefit plan the company's projected benefit obligation has built in assumptions about the expected increase in an employees salary. In other words, the company's pension obligation is based on your current salary and any expected increases in salary from now until retirement.
Defined contribution does not have such assumptions. In defined contribution, you just get out of it what is put in it, plus any investment returns.(2 votes)
- Just to clarify...
Isn't a Defined Contribution plan also a pension? It sounds like you are saying only a Defined Benefit plan is a pension...(3 votes)
- Are there any laws on underfunding assuptions?(2 votes)
- Don't know as I am an European, but from an economical point it would be hard to implement, as you cannot accurately predict the future development of the economy accurately (otherwise we wouldn't have the issues were having now, would we?) and therefore you cannot define when a pension is underfunded.
Making such a law would be very hard and therefore very expensive and the potential short term benefits of the law would be probably lost in the cost for maintaining it.(1 vote)
- what If you run out of money and have no social security?(1 vote)
- Wow, that's a pretty highly charged question, politically speaking. If the Social Security program did not exist, those who found themselves in need would be taken care of by either extended family members or private charitable organizations (of which there are many). The argument against Social Security is that the private sector could solve the problem of poverty more efficiently.(1 vote)
Very interesting discussion about the assumed rate of return and how it affects the amount of contributions needed and I assume the actual unfunded liability.
Question is in your map showing the funding percentage by state, was the same assumed rate of return used for each state? Couldn't a state make their unfunded liability "appear" to go away simply by raising their projected rate of return?(1 vote)
- Each state runs their pension plan on their own. They are free to determine which assets to invest in and therefore what the expected rate of return would be.
There is some leeway in regards to pension plan accounting because the pension plan has to make a lot of assumptions. But, the assumptions have to make sense. The funded status of a pension plan is publicly available knowledge, which investors scrutinize. Finding an assumption that completely eliminates an unfunded liability would be a very straightforward thing for someone to find. If something like that were to be discovered it would probably lead to a credit downgrade for the state, which would increase the state's borrowing cost.
Furthermore, if they were able to hide it, they couldn't hide it forever. Not all pension plan accounting is based off of expected return. Over time the pension does have to recognize the difference between expected and actual return.(1 vote)
- Is flipping the risk onto the individual retiree a sound solution with a deregulated financial industry that continues to engage in unsound speculation? Does a successful society owe its working public a safe and dignified retirement?(0 votes)
- I think we owe it to the public to make social security a locked box and to require states to fund their public pensions regardless of the economic times. We owe it to the public to protect their contributions and the contributions of their employers by vetting any investment and holding the pension administrators and the companies they invest with liable where appropriate. A hard economic cycle should not mean underfunding of pensions defined or otherwise. We pay our debts to our work force before we discuss our other obligations.
We owe the going out workforce what we promised them while they were working. A corporation should not be able to declare bankruptcy, jettison their pensions (putting it on the taxpayer at 50c on the dollar) and stay in business. Nor, should a corporation be able to profit from managing a pension fund.
A person who knowingly refuses to fund or support their own retirement years deserves what they get, but people who work with integrity, put their money away and must rely on the good faith of the financial industry and their employers to see light at the end of the day should see light. And, I think any society that accepts the notion that it may not owe its people that guarantee is a failed society.(2 votes)
- Is regulation of the financial industry, pay-to-play demands upon the "job creators", and a locked box pension and social security requirements sufficient to forestall a pension crisis?(0 votes)
- That's a big question that no one has an answer to. Ultimately the world seems to be moving towards defined contribution pension plans, which has it's own pros and cons. But, it remains to be seen if that move is sustainable in the long term.
I think it has been proven that on a long enough time frame, a corporation cannot sustain a defined benefit pension plan and remain in business. GM is a good example of this. Now we seem to be moving on to underfunded local and state government pension plans. So, I guess we'll see how far up the food chain this moves. I would be VERY hesitant to say that we will have a pension crisis regarding anything that is funded by the federal government. It would take a remarkable set of circumstances for an entity that can tax, spend, legislate, invade and print money, in whatever way it wants, to run into a problem with pension payments. But, everyone else below that on the state, municipal and certainly corporate level, is at some risk of not being able to sustain a defined benefit pension plan.(2 votes)
Voiceover: Talking about pensions isn't always viewed as the most interesting thing to do, but hopefully this video and the next one might convince you that it is at least worth talking about and understanding because it has major implications for the fiscal situation of many, many, many states in the U.S. A pension is essentially a defined benefit plan. Defined benefit plan for retirement. We can compare that to a defined contribution plan. Defined contribution plan. The defined contribution plan, and this is more typical in a lot of private companies right now, every year that you work, let's plot a little graph here. This is years that you're working, and this is kind of compensation. This is compensation right over here. In a defined contribution, every year that you work, you're obviously going to make your salary. Let's say you're making $60,000 a year. You're obviously going to make your salary every year that you work. In a defined contribution plan, let's say this is when you retire, let's say for simplicity, we're assuming that you're going to retire at 65. At 65, you're no longer going to be making your salary anymore. You're not working for that company anymore. What the company will do is set up some plan, and a lot of these are 401(k)s, IRAs, where some combination of you and the company will set some money aside, and it's usually done in a tax-deferred way, so you don't have to pay taxes on it in that year. Every year, you're going to set some money aside, and I'll do that in green. You're going to set maybe 10% of your income aside in every year, so these are every year. Actually, the years are going to be much smaller than that, if we're thinking this is about 30 years. Over the 30 years, you're setting some level of money aside, and you're investing it: you're putting it in the stock market; you're buying bonds with it; you're buying mutual funds. Who knows what you might be doing with it? You're setting this money aside, so that when you retire, it will hopefully have grown. Well, one, it's there, and you've invested it. Hopefully, if you've invested it well and the stock market didn't do anything crazy, it will have grown, and it will be just a big lump sum of money. Let's say that you set aside $6,000 a year on average for 30 years, so you set aside $180,000. Let's say you invested it pretty well, and now that has grown to, I don't know, let's say it's grown to $1 million, because it was invested well. We could do the math to figure out what it could grow based on different growth rates. You have this huge lump sum of money now. I'm not even drawing it to scale. You have this huge lump sum of money, $1 million, assuming it was invested well. If it was invested badly, maybe that $180,000 is still $180,000. In theory, maybe if it was invested really badly, it could be even less than $180,000. Whatever that number is, whether it's $1 million or whether it's $200,000, or whether it's something smaller, that's essentially the money that you have to live on for your retirement. Regardless of how long you live, regardless of what the cost of living might be, regardless of what your needs might be, regardless of how expensive your healthcare might be, this is going to be the money that you have to live on. It might be more than enough money, if you invest it well and you put enough money aside; it might be a lot less than you need, in which case you're going to be in trouble. A defined benefit plan, and this is typical; a lot of state employees have defined benefit plan, a lot of more traditional industries oftentimes that are unionized. You also have a defined benefit plan or a pension, and the situation is a little different. Just like any organization, you will get your salary every year that you work; and let's just say that this is over the course of 30 years. Once again, you retire at age 65. In defined benefit plan, the employer is going to set aside some money, and sometimes the employee sets some money aside as well, so some money is set aside. Once again, the money is set aside, and it is invested, hopefully in a safe way. But regardless of what that money and regardless of what that turns into through an investment, you are guaranteed a certain degree of benefits. In this case, you are guaranteed; let's say that if you'd done more than 20 years of service here, you get 60% of your last five years' salary. There's different ways of defining that defined benefit. It could be like that, it could be you get $100 per month for every year that you worked at the organization. You get $100 per month extra when you retire. But they tend to be for life, for the rest of your life. So from 65 until you pass away, you are guaranteed this defined benefit. If the money is set aside, if it was set aside and invested well and happen to be a lot more money than necessary, that's great, but all the employee would get is this kind of guarantee. If the money is less than necessary, then the company is still promising that they are going to pay this benefit. They'll probably have to put more, or the state, or whoever is doing this, would have to put more money in in order to pay this compensation. Now, what are the things that you would have to estimate if you are the person setting aside this money, to figure out what you have to set aside in order to give this defined benefit? You're going to have to hire a bunch of statisticians, essentially actuaries, to say how long are people going to live. You're going to have to care about life span. Obviously, you can't predict any one person's life span, but if you're doing this for hundreds of thousands of employees, maybe you can figure out what a likely life span is. You're going to have to figure out cost of living. Inflation is a measure of cost of living, but it might be more specific to the region, or it might be negotiated in some ways with the union. You're going to have cost of living. This is a cost of living adjustment. When people talk about COLAs, if they're not talking about soda, they're talking about cost of living adjustments. You're going to have to think about this money that you set aside. What is the assumed growth rate? What is the assumed growth rate? If you make very optimistic estimates of how well your investments will do, you can set aside less money. If you think that your money isn't going to do well investment-wise, you're going to have to set aside even more money. This is one of the cruxes of the issue, because you could imagine, let's say that we're talking at a state level, and people are, right now let's say that your current actuaries or statisticians are saying, "Look, for this person, in order to guarantee them 60% of their salary when they retire," so that's $36,000, "In order to guarantee that, we have to put aside ..." and I'm just estimating these number right over here. Let's say we have to set aside $6,000 a year, especially when we're 30 years in advance. Actually, let me do a little more than that. Let's say $10,000 per year. Let's say that the person in charge, the state official, goes to those actuaries and say, "What are you assuming about how much we're going to get on our investments here?" The actuaries are saying, "We're going to assume a fairly conservative. "We're going to assume that we're going to get 3% return on our money." But then the state official says, ideally, they would want some of this $10,000 per year to spend on other things, and so they would like this to be lower. They say, "That seems very conservative. "In the last 10 years in the stock market, "we've gotten 10% return," or, "I know an "endowment that's recently gotten 6% return. "Why don't we assume a higher return here? "If we assume a higher return, "why don't we assume a 5% return?" All of a sudden, if we're assuming a 5% return, then we'll have to set aside less money that year. $8,000 a year. Sometimes, it's not even this, it's not even this playing with the assumptions, making more optimistic assumptions that allow you to spend less money in that current year, sometimes you might know that you have to spend $10,000 a year to kind of be able to properly fund these pensions in the future. You do have some type of unfunded pensions; but, in theory, a responsible party should try to fund these as much as possible. You might know that you have to fund $10,000 a year in order to credibly give this defined benefit for this employee 30 years in the future. But 30 years in the future is a long time. You have present difficuties; you have present shortfalls in your budget, and say, "I recognize that I have to put $10,000 a year," but you still don't do that, so you underfund the pension. Even if you recognize this, or if you recognize this, you still only put $5,000 a year. Really just kind of kicking the can down the road, hoping that the next guy or gal who's in your position is going to figure out something; or maybe you'll just be very optimistic that the growth will turn out, or that the state will eventually work things out. What we'll see over the next video, this notion of underfunding pensions is a big, big, big, big problem because we've had decades of underfunded pensions, and it's been especially pronounced in particular states. Because of that, those states, in order to fund the pension obligations that are hitting now, those expenses for employees that are retired are starting to grow beyond their budgets for the employees that are working right now. It's a tough issue. You can't cut these things very easily. People expected these. These are retirees. These are people who've been working their whole life based on this assumption. But, at the same time, they're starting to squeeze out key services that the state is doing. It turns into a major, major hairy issue.