Understanding the Problem with Pensions
Eileen St. Pierre, The Everyday Financial Planner
Being an independent sort, I like managing my own money. I always opted not to join the pension plans at my previous employers and would not consider taking a job where a pension was my only retirement option. Pensions can be a wonderful source of stable retirement income when everything goes the way it should. But having an organization promise it will pay me money in the long-term future always made me a little nervous. Many are finding out why I have always been concerned as they see their pensions whittled away or disappear altogether.
I wanted to offer my readers straightforward reasons as to why we are seeing such a problem with pensions.
For the employer, it is a budgeting nightmare.
Pensions are called defined benefit retirement plans. What you receive each month during your retirement is determined by a formula, typically based on your salary and years of service. Your retirement could be decades away. But the employer needs to figure out what to set aside for you and all its other employees each year to meet its obligations. That amount can vary widely from year to year.
- There are lots of assumptions that need to be made to do the math. Your employer has to hire experts to help with this.
- If ANY of the assumptions change, the employer risks underfunding the pension requiring increased contributions later on.
- High employee turnover, typical in today’s work environment, makes the math especially difficult.
- Even giving all employees a small raise can significantly change the amount of money the employer needs to set aside.
Would you be able to effectively budget for this? It’s hard enough getting people to pay their bills on time.
Defined contribution plans like the 401k and 403b make budgeting easy for the employer. The employer sets the amount it will contribute each year. For example, it may match your contributions up to 3% of your salary.
The assumed rate of return on the pension’s investments may not be realized.
Because pensions are long-term obligations, your employer needs to invest a good chunk of the money in stocks. Many employees would never take on the amount of risk that pension plans need to be exposed to in order to generate portfolio returns. I have personally talked to state employees who felt that their pensions were such safe investments because of the promises made to them. Sorry to burst your bubble.
When the stock market is doing well, pension balances can grow quickly. This can reduce the amount of money that the company needs to set aside. This can lead to a false sense of security because the reverse can also happen. The housing market collapse and the resulting stock market downturn in 2008 greatly reduced pension fund balances. State pension plans were particularly affected. They have had to make some tough choices going forward.
How can you spot whether your pension plan is in trouble?
It’s obvious if the employer announces it’s switching to a defined contribution plan and suspending the pension. But here are some early warning signs:
- New hires no longer have the option to choose the pension plan. They have to choose the defined contribution plan. A less drastic step would be to change the pension benefit formula for new hires – they will have to work longer to get the same benefit as older hires.
- If health benefits were also promised as part of the pension payout, they are typically reduced or cut altogether.
- Cost-of-living adjustments (COLAs) are phased out.
- If these adjustments do not stop the bleeding, then the employer will start with cutting current retiree pension payments.
You may think I’m being pro-employer here. No, I am just a realist. It’s really hard to sustain pension plans in our new global work environment. Take responsibility for your own retirement. If you don’t do it, no one else will.