Tuesday, June 5, 2012

The Grim Future of Our Pension Plans

Updated December 2013

One news item that I have found particularly interesting in recent days has not been covered all that heavily by the mainstream media.  To me, this is very important for one reason; the demographics of developed nations is just entering the years where many of its workers will be retiring over the next 10 years, putting a severe strain on the private (and public) sector pension plan system.  This story will impact all of us, whether we are close to retirement or not.

Last year, General Motors announced that it was reducing its pension burden by offering to buyout the pensions of select salaried retirees and that it will offer other retirees continued monthly pension payments paid by the Prudential Insurance Company of America.  The combined actions are expected to reduced GM's United States salaried pension obligation by a whopping $26 billion.  Here is a chart showing the options available to retirees, based on their date of retirement:


General Motors estimates that approximately 118,000 United States salaried employees will be impacted by these changes, depending on their retirement date.  Approximately 42,000 salaried employees and surviving beneficiaries will be eligible to receive the single lump-sum payment option; those choosing that option have until July 20th, 2012 to make their choice.  To fund the Prudential plan, GM will purchase a group annuity contract and Prudential is expected to take over the payment of benefits by January 2013.

How did General Motors get itself into this mess?  Here is a screen capture from the company's 2011 Annual Report showing how deep GM's pension hole is:


That's right, at the end of 2011, General Motors' pension plan was underfunded by $25.4 billion, up 14.4 percent from $22.2 billion one short year earlier.  A great deal of the underfunding was due to actuarial losses due to discount rate decreases (discount rates are used to calculate the pension plans' long term obligations - the lower the discount rate, the more conservative the plan) and service and interest cost increases.

Here is a chart showing the defined benefit pension plan contribution levels for 2010 and 2011:


Notice the massive drop in contributions from one year to the next; from 2010 to 2011, contributions dropped by 42.6 percent from $4.872 billion to $2.798 billion.  To assist with the shortfall, GM contributed 61 million common shares of its own stock worth an estimated $2.2 billion at the time of contribution.  This is on top of a $4 billion special, voluntary payment that General Motors made to the U.S. pension plan in 2010. 

Here is a chart showing the net pension benefit payments expected over the next 10 years:


If you look at the last two charts, you'll see where the problem lies.  In 2012, GM's defined benefit pension plan payouts will total $9.951 billion.  Unfortunately, in 2011, employees only contributed $2.798 billion, leaving a shortfall of over $7.1 billion.  Somehow, this shortfall will ultimately have to be covered, an issue that is particularly difficult in this time of ultra-low interest rates.

Pension plan managers have historically invested in long bonds with a duration of 15 to 30 years.  This measure has provided pension plans with a stable investment return over the long-term horizons necessary to ensure that defined benefit plans can keep their "promises".  Pension plans have historically used a 7 or 8 percent rate of return as a benchmark to ensure the long-term viability of their payouts, however, that is becoming increasingly difficult thanks, in no small part, to Mr. Bernanke and others of his banking ilk.

Here is a graph showing the interest rate on a 30 year bond over the past five years showing just how difficult it is to get a decent rate of return on a long-term, relatively risk-free investment:


With an interest rate of less than 5 percent for all of the past five years, it is no wonder that pension plans of all types, both private and public, are finding that they have growing funding shortfalls.  On top of that, in a desperate search for yield, pension plans are increasingly investing in higher risk equities, a sure-fire way to increase losses, an experience many pension plan managers had in 2008 - 2009.  

Basically, the pension system is turning out to be a giant Ponzi scheme.  The last in, get screwed.  While General Motors' pension situation may be somewhat unique because of the company's poor financial history over the past 5 years, it is quite representative of the challenges facing the pension plan system that protected the livelihood of the generation before us.  This protection will not be there for the baby boomer generation; my suspicion is that boomers will most certainly not have any assurance that their retirement years will be back-stopped by a guaranteed level of pension income, particularly as companies abandon the old defined benefit plans for the new defined contribution plans which rely more heavily on higher risk investments to assure one's future income.  As companies see that there is no hope that they can fund their future pension liabilities as there are fewer and fewer employees paying into the system, they will make changes to the system and attempt to distract their older employees with shiny baubles, mirrors and a bit of cash.  After all, there's nothing like off-loading your responsibility onto the sweaty masses, is there?

9 comments:

  1. APJ:
    I understand the federal employees' pension is severely underfunded.
    Being a level 1 obligation - an explicit liability - it is listed as a $5 trillion liability on the balance sheet.
    In addition, the FASAB, the accounting advisor for the federal government, recently came up with Federal Accounting Standard 43, which states that federal pensions are no longer to be considered dedicated collections - money collected from primnarily an external source, specifically targeted to beneficiaries.
    Instead, it is merely a plan between an employer and its employees.
    Don Levit

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  2. Paying into the company's (UK) defined contribution scheme is the only thing I can sight to prove I'm not a complete doomer.

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  3. Don

    As are many of the state pension plans which are terribly underfunded. Your comments are interesting and more than a bit frightening, particularly for millions who are counting on pensions to put cat food on the table after retirement.

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  4. What is really the state of most private and public pensions? Should we generalize from GM's example? Shouldn't more normalized interest rates and financial markets correct many under funded liabilities? Has any academic unit taken a serious look at this?

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  5. Great article, specifically the state of these pensions plans that have been hit hard over the last few years. http://lumpsumanalysis.com/

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  8. One needs to invest with extra caution, specially when it comes to long term investment like pension plans etc. I call it an eye opening post for many reasons.

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