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.