There is good reason to predict an upcoming wave of pension crises. The following article you are about to read combines information gathered from several key institutions. The information is gathered throughout various sources to provide the reader with fundamental information to understand the potential problems that exist in the ongoing defined benefit pension plans. This article is divided into 4 chapters. The chapters analyze the different stages of the potential crisis and the events that will potentially occur. It is with great hope that readers would be able to receive value in this article and prepare themselves accordingly.
The First Chapter: The Freezing of Defined Benefit Pension Plans
The first wave of the pension plan crisis starts with the increasing trend of pension fund "freezing". A pension fund "freeze" means that corporations who have focused on giving defined benefit plans will no longer distribute retirement benefits based on the defined benefit. Instead, a switch to defined contribution will occur. Essentially, it means that employers will effectively shift the responsibility of retirement pensions towards the employee.
"In its survey of single-employer DB sponsors, the Government Accountability Office (2008) found that about half had one or more frozen plans; 23 percent of plan sponsors had completely frozen their plans with no further benefit accruals (hard freezes), and 22 percent had frozen either the years of service or the salary pension base. In 2007, a survey of private-sector DB plan sponsors by Mercer and the Employee Benefits Research Institute found that over a third of DB sponsors had recently frozen their DB pension plans, and a third of the remaining employers expected to freeze or close their plans in the next 2 years (Vanderhei 2007). Some experts expect that most private-sector plans will be frozen or terminated within the next few years (Aglira 2006; Gebhardtsbauer 2006; McKinsey & Company 2007)."
The above paragraph, taken from http://www.ssa.gov/policy/docs/ssb/v69n3/v69n3p1.html showcases the increasing trend of corporations and sponsors of defined pension funds freezing funds. Such a trend "threaten to shake up the American retirement system as we know it because of vast differences between DB and DC pension plans, including differences in coverage rates within a firm, timing of accruals, investment and labor market risks, forms of payout, and effects on work incentives and labor mobility."
Further into the above report,
"This is essentially what happened in the United Kingdom (U.K.) with private-sector DB pensions. When the British adopted transparent financial accounting standards and the government taxed pension plan accumulations it deemed to be excessive, the percent of assets "in terminated or frozen status" increased from 35 percent in 1998 to 70 percent in 2006 (Munnell and Soto 2007)"
The "freezing" of pension funds in the United Kingdom was due primarily to the changes in transparency. It was found that the assets which corporations reported were inflated and excessive.
Disbursements versus Assets
The above tables showcases the assets and payouts of pension plans, both defined benefit and defined contribution. The growth is as recorded below.
Compounded 20 Years Growth
Defined Benefit Assets
Defined Benefit Payout
Effectively, over a 20 year period, the payout growth has exceeded the growth of assets by 0.29% compounded annually. The resulting difference over the 20 year period generated a 13% difference as of 2011. There is reason to believe, however, that the differences will accelerate. We will revisit this issue in the next chapter.
A cross check between the above table and the official report from the 2011 Annual Survey of Public Pensions: State and Local Data (www.census.gov/govs/retire/)
The total cash and investment holdings stand at USD 3.02 trillion.
Chapter 2: The Catalyst
- Characteristics of Financial Markets
While Table A showcases a slight difference in compounded growth (0.29%), there is a "catalyst" which will accelerate the difference. The listed assets above are invested in financial markets. Financial markets are prone to swings, booms and busts. The following Table B and C describe the differences between the two periods of market declines (dotcom bubble & financial crisis) of the last 15 year period.
Table B (Periods 1999-2002)
Defined Benefit Assets
Defined Benefit Payout
Table C (Periods 2007-2008)
Defined Benefit Assets
Defined Benefit Payout
In market declines, assets of pension funds generally decrease. However, pension fund payment does not cease but instead, continue to grow. The combination gives way to a short squeeze when the market declines excessively.
- Pension Funds vs. Wages Growth
The below is an excerpt from Berkshire Hathaway's Annual Report 2013, where Warren Buffett addressed the impending pension fund problems in a letter to Katherine Graham.
As above, the main problem with defined benefit pension funds is the core concept. Most defined benefit pension funds are created to pay an average of the last five years of employment. Should wages and labor costs grow beyond the return on pension fund's growth rate, there is reason to believe that pension funds risk being underfunded in the future. The following excerpt shows the average growth rates of pension funds in America.
The geo mean in the last 10 year period (2002-2011) grew on average, 4.1%.
The following Table D shows the projected growth rates between 1975-2015.
1975 (Annual Wage)
Growth (20 Years)
2015 (Annual Wage)
Wage and Labor
A difference between 2.9% garners an underfunded pension of 66.68% over the course of 40 years. The next question readers would ask, "Who would fulfill the obligations should pensions be underfunded?"
Chapter 3: The Insurance Fails
Pension Benefit Guaranty Corporation's (OTC:PBGC) Role
"PBGC is a federal agency created by the Employee Retirement Income Security Act of 1974 (ERISA) to protect pension benefits in private-sector defined benefit plans - the kind that typically pay a set monthly amount at retirement. If your plan ends (this is called "plan termination") without sufficient money to pay all benefits, PBGC's insurance program will pay you the benefit provided by your pension plan up to the limits set by law."
PBGC as above, aims to insure the pensions should the employer defaults. However, the following paragraph uncovers one of PBGC's clauses;
"Under the law PBGC may take action on its own to end a pension plan if termination is needed to protect the interests of plan participants or of the PBGC insurance program. For example, PBGC will end a plan if it will be unable to pay benefits when due."
The question in which readers should ask would be; "is there any reason to believe that PBGC will be unable to fulfill its obligations as an insurer?"
Key takeaway's from Director's Letter
"We currently protect the retirement hopes of nearly 44 million participants in more than 27,000 ongoing pension plans."
"Over the years we've become responsible for about 1.5 million people in more than 4,300 failed plans. Every month, on average, we pay $458 million for 873,000 retirees."
*Each retiree = 458 million / 873,000 = $524.63 p/month
Per Year Payment Per Retiree = $524.63 x 12 = $6,295.53
Potential Backlash (44 million Participants) = $6,295.53 x 44,000,000 = USD 277 billion
"In the past year, as a result of additional failures, the financial deficit of our multiemployer program increased sharply, from $1.4 billion last year to $2.8 billion as of September 30, 2011. The greater challenge, however, comes from those plans that have not yet failed: our estimate of our reasonably possible obligations (obligations to participants), described in our financial statements, increased to $23 billion."
"PBGC's obligations are clearly greater than its resources. We cannot ignore PBGC's future financial condition any more than we would that of the pension plans we insure."
- First and second column FY 2011 and FY2010 respectively
To the credit of PBGC and the independent auditors, they have provided a comprehensive and factual analysis of the upcoming problems which PBGC will face in the future.
Auditor's Opinion on PBGC's Financial Reporting (Key Take-Aways)
"PBGC did not have effective internal control over financial reporting (including safeguarding assets) and compliance with laws and regulations and its operations as of September 30, 2011"
"By law, PBGC's Single-Employer and Multiemployer Program Funds must be self-sustaining. As of September 30, 2011, PBGC reported in its financial statements net deficit positions (liabilities in excess of assets) in the Single-Employer and Multiemployer Program Funds of $23.27 billion and $2.77 billion, respectively. As discussed in Note 9 to the financial statements, loss exposure for the Single-Employer and Multiemployer Programs that are reasonably possible as a result of unfunded vested benefits are estimated to be $227 billion and $23 billion, respectively."
"The extended time required and the lack of meaningful progress in PBGC's multiyear approach to correct previously reported deficiencies at the root cause level, introduced additional risks. These include technological obsolescence, inability to execute corrective actions, breakdown in communications and poor monitoring. BAPD's weak internal controls create an environment that could lead to fraud, waste, and abuse."
"The risk of inaccurate, inconsistent, and redundant data is increased because PBGC lacks a single integrated financial management system. The current system cannot be readily accessed and used by financial and program managers without extensive manipulation, excessive manual processing, and inefficient balancing of reports to reconcile disbursements, collections, and general ledger data."
"PBGC failed to determine the fair market value of plan assets at DoPT as required by this regulation."
It seems that, from the auditor's point of view, the insurance entity which protects the pensions of retirees is facing an upcoming storm of financial problems. The total obligations in which it promises to pay are a numbing 227 billion while its assets stand at 80 billion.
Furthermore, there is reason to believe that the assets are not accounted for as accurately as the auditor's would like. The assets are prone to understatement. This, in combination with the 283.75% of potential liabilities to assets that the insurer faces, poses much threat towards the 44 million pensioners in the future.
The US population as of 2012 stands at 313.9 million people. 44 million pensioners account for 14.017% of the population. 1.4 in every 10 Americans risk the potential of not receiving the benefits as laid out by their current and past employers.
Chapter 4: The Liquidation of Assets
If anything, should the rate of pension defaults start to occur, retirees are faced with the following solutions;
- Go back to work
- Liquidate assets
- Cash Savings
There is concern for investors if most retirees were to opt for point 2. Liquidation of assets by retirees poses a threat to the financial market. Especially when done in a panic. Chapter 2 has addressed the financial market characteristics of booms and busts. Retirees who aim to liquidate assets are prone to do so when the market is fueled by panic. Most retirees are neither financially trained to understand investing and financial markets. Cash savings for most retirees are tied up by 401(k). A recent report published by Reuters suggests that;
"Data released today by Fidelity Investments shows that 35 percent of all participants in plans it administers cashed out their 401(k) balances when leaving their jobs last year, and the trend was even worse for young and lower-income workers. Four out of 10 workers (41 percent) age 20 to 39 cashed out, and 51 percent of workers who left jobs grossing under $30,000 cashed out.
Fidelity has been tracking cash-out data only since 2009, but a study of the overall retirement market released last year shows an accelerating trend. HelloWallet, a firm that provides software-based financial guidance tools for employers and employees, analyzed Federal Reserve data and found that $60 billion was cashed out from workplace plans in 2010, up from $36 billion in 2004."
It is to the advantage of the reader to note that most baby boomers are not in the 401(k) defined contribution plans but defined benefit plans. As such, there is no element of forced savings for most pensioners in the upcoming years. The most diligent saver who does not contribute to 401(k)'s as Fidelity stated, "At age 67, the nest egg would be worth $87,500 in today's dollars, Fidelity calculations show, assuming a 4.7 percent annual real return and no additional contributions."
$87,500 in today's dollars is not enough for most Americans to get by their retirement. With increasing healthcare costs and costs of living, defined benefit pensioners cannot rely on their cash savings.
Your author believes, with the above 4 chapters that there has been sufficient evidence indicating an upcoming crisis in pension funds. Warren Buffett in his annual letter suggested in his last paragraph,
"Local and state financial problems are accelerating, in large part because public entities promised pensions they couldn't afford. Citizens and public officials typically under-appreciated the gigantic financial tapeworm that was born when promises were made that conflicted with a willingness to fund them. Unfortunately, pension mathematics today remains a mystery to most Americans. Investment policies, as well, play an important role in these problems. In 1975, I wrote a memo to Katharine Graham, then chairman of The Washington Post Company, about the pitfalls of pension promises and the importance of investment policy. That memo is reproduced on pages 118 - 136.
During the next decade, you will read a lot of news - bad news - about public pension plans. I hope my memo is helpful to you in understanding the necessity for prompt remedial action where problems exist."
His conclusion, together with the evidence gathered above, provide significant issues that pension funds are about to face in the next decade.
Your author hopes that the above article has been useful for your use and information, and he welcomes discussion and further references to any other evidence that may agree or disagree with statements above.