I am going to go on a little diversion this month and write less about the current markets. Instead, I want to discuss a trend we are seeing in regards to pensions.
Lately we have been coming across more and more clients who are receiving letters from their pension plan provider offering them various lump sum "buyout" distributions. There are many options one has to weigh when making this decision but the bigger issue is does this signal more trouble ahead and potential cuts in pension plans? It is too early to tell but the statistics are a bit alarming.
A defined benefit plan (pension) is a retirement plan in which an employee and employer (larger portion) contribute a specified amount each paycheck into a pool of assets which are invested in a conservative manner to eventually pay out a guaranteed income stream to the employee usually based on age, years of service and salary. While pension plans still remain for most state, local and federal government workers workers, they are slowly being eliminated in the private sector. According to a report by the researchers at the Center for Retirement Research at Boston College, 88% of private workers were covered under a pension plan in 1975 and that has dropped to 33% today.
Part of the reason they are declining in use is because they are not working. Roughly one third of all state pension plans are underfunded by 40% or greater. Of course one of the reasons for the underfunding is the increased longevity of retirees but that is only part of the story.
Low interest rates may have more to do with the struggle of pensions than any other factor.
Pension plans have strict investment guidelines and obligations to fulfill. Because of this the investment risk tolerance is usually kept at a moderate or lower level. This usually means more fixed income and bond positions. What do we know about yields over the past several years? They are extremely low. Pensions have two options. First, they can accept the fact they are underfunded and continue to get low yield or they move up the risk curve to try and getting a better return. Normal investors have faced the similar issue when looking at cash and CD rates. In the current environment, it is difficult to earn a "respectable" interest rate without taking on more risk.
Pension plans typically run their funding ratios based on assumed rates of returns and many of them based these assumptions around a "normal" interest rate environment. We haven't seen "normal" in years.
Some private pensions are even "selling" the management to large insurance companies who may be more suited to manage it in the first place given their histories.
A report by benefits consultant Towers Watson last year found that 58 percent of companies surveyed had offered lump sums to former employees or plan to do so, while 38 percent expect to transfer pension obligations to an outside company within the next five years.
I think this trend will continue.