The Complete Guide to Pension Plans
Mr. Dutt is a 56-year old mechanic from Newark, California who has been working in the automotive industry for 32 years. When he retired in 2013, he was assured that he would be receiving his pension as long as he lives without any deductions. Recently, he received notice that his pension would be cut by 69%, decreasing it to only $1,500 per month, and dropping his income below the poverty line.
Unfortunate as it is, Mr. Dutt’s story is one that is told by many others in the country.
Pension Benefit Plans
There are two types of pension plans, The Defined Benefit plan and The Defined Contribution plan.
Defined Benefit Plan
Under the DB plan, the pension that you receive is calculated based on a formula that takes into account the years of service and salary received. Benefits are then provided through regular and fixed payments, for life, after retirement. This is an obligation that your employer must fulfill.
Defined Contribution Plan
The Defined Contribution (DC) plan, on the other hand, specifies the amount to be contributed by an employer to the benefit plan while you are employed. The contributions are put into an account but the potential benefit is not known at the time of contribution. Funds are usually invested in schemes that are available under the plan. What you get upon retirement will depend on how much money you have put into the plan, the company’s contributions, years of service and how profitable the investments were.
The Defined Benefit plan describes how public pensions are provided while the Defined Contribution plan is the preference of most private companies.
What went wrong?
Many attribute the current pension crisis to Defined Benefit (DB) plan. The plan is preferred by employees because it ensures that benefits stay the same regardless of how the economy performs. However, it is quite expensive for employers.
A pension fund does not only depend on contributions for revenue. It also relies on investment earnings; thus, it is vulnerable to changes in the economy. When the 2008 financial crisis hit, pension assets declined trillions of dollars. Nevertheless, it is not only the recession and ineffective investment strategies that have resulted in pension funds being in financial trouble. There are other factors as well.
Retirees are living longer lives. Fifty years ago, the average life expectancy for both men and women was 69.7%. Today, it is 79%. This means pension payments will have to be made for more years. Retirees are also increasing in number as the baby boomer generation in reaching retirement age. According to statistics, there are more than 10,000 baby boomers turning 65 every day. The list of pension beneficiaries keeps getting longer.
Low interest rates and bond yields
Even without the number of retirees increasing, pension funds will still be feeling the pinch. Low interest rates and low bond yields have made pension payments more expensive. Since investments returns are lower, plans are not earning enough to fund their pension obligations. According to reports, there is an existing gap between the money that pension plans currently have and what they promised to workers in benefits. Some estimate this gap to be 3 trillion dollars and it is still growing.
The California Public Employees Retirement System or CalPERS announced last July that investment returns achieved in the last fiscal year was only 0.61%, a far cry from the targeted 7.5%. Currently, it has only 68 cents for $1 in liability. CalPERS is not the only pension fund in this situation as there are several others that are underfunded.
You may think of your pension as a financial lifeline in your retirement years. This notion might not be true anymore. The passing of the 2015 Omnibus spending bill included provisions from the Multiemployer Reform Act of 2014. These provisions allowed cuts in pension benefits of those who are covered by multiemployer plans, even those who are already retired.
A multiemployer plan is a type of plan that is the result of collective bargaining between a labor union and multiple employers within related industries. These multiemployer Defined Benefit (DB) plans number about 1,400, with more than 10 million participants who are mostly employed by small businesses in the construction industry. Other participants also work in manufacturing, mining, trucking and retail trade.
Pensions are insured by the Pension Benefit Guaranty Corporation (PBGC). According to the PBGC, 10% of existing multiemployer plans whose beneficiaries number about 1.5 million are in dire financial straits; and the PBGC funds that insure these plans are projected to run out of money within 10 years if no solutions are implemented.
Are you in danger of receiving lesser benefits next month? Maybe not, since modifying benefits is a complex process. However, considering how precarious the situation has become, it would be prudent to start bracing for some changes.
Updated: Oct 19, 2016