Retirement benefits paid by both defined benefit and defined contribution plans are in large part financed through current cash contributions by both employers and employees. These cash contributions in turn are invested in various assets, but primarily in stocks and bonds. Thus, cash contributions plus investment returns on those contributions equal the amount of funds later available to pay promised benefits to retirees. At this point in the story, defined benefit pension plans and defined contribution 401k plans may appear to be quite similar. But here's where the similarity ends.
In a defined benefit plan, the amount of the pension is defined or fixed, regardless of how well it's funded or how well the money which comes into the fund is later invested. The employer is obligated to provide the promised benefit no matter what else may happen. On the other hand, in defined contribution plans no such promised or defined retirement benefit is to be paid. The employee's eventual payout is at risk, unlike the pension benefit.
To their plan sponsors, therefore, one very important difference between pension and defined contribution plans is the importance of investment performance. That's because with pension plans benefits are due and owing without regard to whether cash contributions and the investment performance of the fund are sufficient to satisfy the payment obligation. If unforeseen and unanticipated "makeup" contributions are to be avoided down the road, both cash contributions and investment performance must be sufficient to pay the benefits. No such required predetermined and fixed employer payment exists with respect to defined contribution plans.
Despite this guaranteed payment obligation, many pension plans initially are substantially underfunded. This is particularly so with many public sector pension plans. In these instances, taxpayers are assuming potentially huge future liabilities whether they intend to do so or not. In fact, they may not even know or understand that such makeup payments are going to be the inevitable result of any cash underfunding or lower than assumed plan investment performance.
To recap briefly, in pension plans the employer is firmly on the hook in the end, and where public sector employees are involved, that means the taxpayer will pay any shortfall as the ultimate guarantor. In 401k plans, however, the taxpayer isn't responsible for providing any guaranteed benefit.
Whenever it is determined that public pension plans are underfunded, as they usually are, and unless the taxpayer guarantee is invoked, some combination of the following events must take place: (1) future employer and employee contributions have to be increased, (2) benefits have to be reduced, or (3) actual investment returns have to outpace the assumptions used to determine future contributions. This often places stress on the investment managers to "overachieve", which in turn represents an unnecessarily risky approach to investing.
Let's briefly review the present commonly used rate of return assumptions for pension investments. According to Stocks Aren't an Rx for Pension Ills , most pension plans in the public sector are using ~8% as a total expected annual rate of return assumption. This breaks down into an ~11% annual return for stocks and ~4.5% for bonds, assuming a weighted mix of approximately 60/40 stocks to bonds in the portfolio. Both assumptions appear on the whole not unreasonable, but based on history the 11% assumed for stocks is somewhat optimistic. Although perhaps reasonable at 4.5%, it's hard to make a case for bonds outperforming that benchmark over time. That's due to the probability that interest rates will likely increase over the next several decades, barring an extended and unforeseen deflationary scenario.
However, that's not the biggest concern for taxpayers. Many public pension funds are substantially underfunded currently, even assuming that they are able to earn the assumed blended ~8% rate of return in the future. In fact, state pension funds are estimated to be approximately $3 trillion underfunded today. As you might guess, those states with the biggest public pension headaches have the most heavily unionized work forces (California, Illinois, Massachusetts, Michigan, Nevada, New Jersey, New York, Ohio and Wisconsin). In those nine states, almost 60% of public sector employees are represented by unions compared to what is still a very high 40% nationally. These highly unionized work force percentages compare to private sector union representation of ~7% in America as a whole.
There's more than a little irony here, since these public pension plans (and taxpayers) are betting heavily on the outstanding performance of private sector companies in the years ahead. Only through the strong operating and investment results of these companies and their stock prices will the money be available to pay the promised pension benefits. The even bigger issue concerns our nation's economy and the future growth prospects of companies. While we definitely need to be doing everything possible to encourage private sector investment and hiring, we don't seem to be heading down that path as a nation. Far too many members of the political class seem to be treating the private sector as a public enemy instead of as the goose that must lay the golden egg.
In any case, weak private sector growth resulting from ever growing government receives far too little attention today. Meaningful private sector growth is the only way we will be able to make good on those pension promises to our nation's public employees, the unavoidable reality being that the public sector and its retirement benefits are funded by the wealth created by the private sector. The money first has to be earned in order for it to be later distributed.
With respect to investment results, pension funds generate returns based on their investments, which in turn depend upon the profitability and financial success of the companies in which they own shares. When companies perform well or poorly, the benefits of future retirees are affected accordingly. We the people -- all of us -- depend upon the private sector's wealth creation for our financial stability, security and economic well-being.
In a defined benefit plan, the amount of the pension is defined or fixed, regardless of how well it's funded or how well the money which comes into the fund is later invested. The employer is obligated to provide the promised benefit no matter what else may happen. On the other hand, in defined contribution plans no such promised or defined retirement benefit is to be paid. The employee's eventual payout is at risk, unlike the pension benefit.
To their plan sponsors, therefore, one very important difference between pension and defined contribution plans is the importance of investment performance. That's because with pension plans benefits are due and owing without regard to whether cash contributions and the investment performance of the fund are sufficient to satisfy the payment obligation. If unforeseen and unanticipated "makeup" contributions are to be avoided down the road, both cash contributions and investment performance must be sufficient to pay the benefits. No such required predetermined and fixed employer payment exists with respect to defined contribution plans.
Despite this guaranteed payment obligation, many pension plans initially are substantially underfunded. This is particularly so with many public sector pension plans. In these instances, taxpayers are assuming potentially huge future liabilities whether they intend to do so or not. In fact, they may not even know or understand that such makeup payments are going to be the inevitable result of any cash underfunding or lower than assumed plan investment performance.
To recap briefly, in pension plans the employer is firmly on the hook in the end, and where public sector employees are involved, that means the taxpayer will pay any shortfall as the ultimate guarantor. In 401k plans, however, the taxpayer isn't responsible for providing any guaranteed benefit.
Whenever it is determined that public pension plans are underfunded, as they usually are, and unless the taxpayer guarantee is invoked, some combination of the following events must take place: (1) future employer and employee contributions have to be increased, (2) benefits have to be reduced, or (3) actual investment returns have to outpace the assumptions used to determine future contributions. This often places stress on the investment managers to "overachieve", which in turn represents an unnecessarily risky approach to investing.
Let's briefly review the present commonly used rate of return assumptions for pension investments. According to Stocks Aren't an Rx for Pension Ills , most pension plans in the public sector are using ~8% as a total expected annual rate of return assumption. This breaks down into an ~11% annual return for stocks and ~4.5% for bonds, assuming a weighted mix of approximately 60/40 stocks to bonds in the portfolio. Both assumptions appear on the whole not unreasonable, but based on history the 11% assumed for stocks is somewhat optimistic. Although perhaps reasonable at 4.5%, it's hard to make a case for bonds outperforming that benchmark over time. That's due to the probability that interest rates will likely increase over the next several decades, barring an extended and unforeseen deflationary scenario.
However, that's not the biggest concern for taxpayers. Many public pension funds are substantially underfunded currently, even assuming that they are able to earn the assumed blended ~8% rate of return in the future. In fact, state pension funds are estimated to be approximately $3 trillion underfunded today. As you might guess, those states with the biggest public pension headaches have the most heavily unionized work forces (California, Illinois, Massachusetts, Michigan, Nevada, New Jersey, New York, Ohio and Wisconsin). In those nine states, almost 60% of public sector employees are represented by unions compared to what is still a very high 40% nationally. These highly unionized work force percentages compare to private sector union representation of ~7% in America as a whole.
There's more than a little irony here, since these public pension plans (and taxpayers) are betting heavily on the outstanding performance of private sector companies in the years ahead. Only through the strong operating and investment results of these companies and their stock prices will the money be available to pay the promised pension benefits. The even bigger issue concerns our nation's economy and the future growth prospects of companies. While we definitely need to be doing everything possible to encourage private sector investment and hiring, we don't seem to be heading down that path as a nation. Far too many members of the political class seem to be treating the private sector as a public enemy instead of as the goose that must lay the golden egg.
In any case, weak private sector growth resulting from ever growing government receives far too little attention today. Meaningful private sector growth is the only way we will be able to make good on those pension promises to our nation's public employees, the unavoidable reality being that the public sector and its retirement benefits are funded by the wealth created by the private sector. The money first has to be earned in order for it to be later distributed.
With respect to investment results, pension funds generate returns based on their investments, which in turn depend upon the profitability and financial success of the companies in which they own shares. When companies perform well or poorly, the benefits of future retirees are affected accordingly. We the people -- all of us -- depend upon the private sector's wealth creation for our financial stability, security and economic well-being.
So what will our pension plans actually earn on their investments over time? That depends upon how well our economy performs over time. And on how our companies perform. And that will determine what the level of employment in the private sector will be. And on what tax receipts will be as well. It's the same answer every time because to paraphrase President Clinton, "It's the private sector, stupid."
It's not the public sector that creates sustainable jobs and income. It's the private sector. If the private sector doesn't perform, the money won't flow to the public sector. It's really that simple.
Thanks. Bob.
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