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Studying for a test? Prepare with this lesson on American civics.
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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.