Pension obligations

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 an understanding because it has major implications for the fiscal situation of many many many states in the u.s. so a pension is essentially a defined benefit plan defined defined benefit plan for retirement defined benefit plan and we can compare that to a defined contribution plan defined contribution contribution plan defined contribution plan so the defined contribution plan and this is more typical in a lot of private companies right now every year that you work so let's plot a little graph here so this is years that you're working and this is this is this is this is kind of compensation this is compensation right over here so in a defined contribution every year that you work you're obviously going to make your salary let's say you're making sixty thousand a year you're obviously going to make your salary every year that you work and 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 so at 65 you're no longer going to be making your salary anymore you're not working for that company anymore but what the company will do is set up some plan and a lot of these are 401ks 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 so every year you're going to set some money aside and I'll do this in green so you're going to set maybe maybe 10% of your income aside and every year so these are every year and actually the years we're going to be much smaller than that if we're thinking this is about 30 years so 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 in it with it you're buying mutual funds who knows what you might be doing with it so you're setting this money aside so that when you retire it's it will hopefully have grown because it will one it's there and if you've invested it and 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 so let's say that you set aside sixth ow a year on average for 30 years so you've set aside 180,000 dollars and let's say you invested it pretty well and now that has grown to I don't know it's let's say it's grown to a million dollars because good because it was vested well we could do the math to figure out what it could grow based on different growth rates so you have this huge this huge lump sum of money now so I'm not even drawing it to scale so you have this huge lump sum of money 1 million dollars assuming it was invested well if it was invested badly maybe that hundred eighty thousand dollars is maybe 180 thousand dollars is still a 180 thousand dollars in theory maybe it was invested really badly it could be even less than 180 thousand dollars but whatever that number is whether it's a 1 million dollars or whether it's two hundred thousand dollars 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 or your healthcare might be this is going to be this is going to be the money that you have to live on so it might be more than enough money if you invested well and you put enough money aside it might be a lot less than you need in which case you're going to be truck in trouble and a defined benefit plan and this is typical it a lot of state employees have defined benefit plan in a lot of more traditional industries oftentimes that are unionized you also have a defined benefit plan or a pension the situation is a little different just like any organization you will get you will get your salary every year that you work and let's just say that this is over the course of 30 years so once again you retire at age 65 you retire at age 65 but in a defined benefit plan the employer is going to set aside some money and sometimes the employee set some money aside as well so some money is set aside so once again the money is set aside the money is set aside and it is invested hopefully in a safe way and it's invested but regardless of what that money and regardless of what that turns into through an investment you are guaranteed a certain degree of benefits so in this case you are you're guaranteed let's say that if you've done more than 20 years of service here you get 60% of your last 5 years salary and there's different ways of defining that defined benefit it could be like that it could be you get a hundred dollars per month for every year that you work at the organization you get a hundred dollars per month extra when you retirement when when you retire but they tend to be for life for the rest of your life from 65 until you pass away you are guaranteed you are guaranteed this defined you are guaranteed this defined benefit and so if the money set aside if it was set aside and invested well and happened to be a lot more money than necessary that's great but you all the employee would get is this kind of guarantee but if the money is less than necessary then the company is still promising that they are going to pay this pay this benefit and 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 were the person setting aside this money to figure out what you have to set aside in order to give this defined benefit well you're going to have to hire a bunch of statisticians of essentially actuaries to say well how long are people going to live so you're going to have to care about lifespan and obvious you can't predict any one person's lifespan 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 so 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 so you're going to have cost of living so this is a cost of living adjustment when people talk about colas they're talking about well 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 this money that you set aside what is the assumed growth rate what is the assumed 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 put put set aside even more money and this is one of the cruxes of the issue because you can imagine let's say that we're talking at a state level and people are you know right now you're let's say that you your current actuaries the 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 I'm just I'm just estimating these numbers right over here let's say we have to set aside six thousand a year six thousand a year especially when were 30 years in advance actually need a little bit more than that let's say ten thousand ten thousand per year and let's say that the the person in charge the state official goes to those actors said well what are you assuming about how much we're going to get on our investments here and the actuaries are saying well we're going to assume we're going to assume a fairly conservative we're going to assume that we're going to get three percent three percent return on our money but then the state official says oh well you know ideally they would want some of this ten thousand dollars per year to spend on other things and so they would like this to be lower and so they say well that seems very conservative you know in the last ten years in the stock market we've gotten 10 percent return or you know I know an endowment that's recently gotten six percent return so why don't we assume a higher return here so if we assume a higher return why don't we assume why don't we assume five percent return and all of a sudden if we're assuming a five percent return then we'll have to set aside less money that year eight thousand a year and 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 are not you know that you have to spend ten thousand dollars a year to to kind of be able to properly fund these pensions in the future you do have some types 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 ten thousand dollars a year in order to credibly give this defined benefit for this employee thirty years in the future but thirty years in the future is a long time and you have present difficulties you have present shortfalls in your and say okay I recognize that I have to put $10,000 a year but you still don't do that so you under fund the pension so 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 the state will eventually work things out and what we'll see over the next video this notion of underfunding pensions under funding 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 and 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 cut their budgets for the employees that are working right now and 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 if they're starting to squeeze out key services that the state is doing it's it turns into a major major hairy issue