With the semester drawing to a close and the summer session getting ready to start soon my thoughts turned towards population issues. (I teach a population analysis class in the summer for the graduate students.) One of topic coming up in that class on a regular basis is pensions, particularly the math behind pensions. I thought a little post about the issues surrounding defined benefit pensions in order. JT also asked about alternative uses of the $3 billion available in the legacy fund when it becomes available in the future. So let’s start with this issue.

Defined benefit pensions should be a preferred pension approach. Why? They remove a significant amount of uncertainty, for both the employer and the employee. The employee side is obvious: there is a formula in place that indicates the amount you should expect to receive per month or year, typically based on an average of income in the years before retirement, number of years of service, and a set percentage. This is contrast to the defined contribution plan that dictates how much is put in, but the returns are variable and so the amount received in retirement is uncertain. The employee would likely prefer defined benefit, but why would the employer prefer it?

The employer is on the hook for a specific amount owed over the course of the employees retirement. Any excess returns above the amount needed to pay employees their pensions are kept by the employer. I have not looked up the numbers yet but my guess is that this used to be a good deal for the employers. However, people started living longer, which increases the financial resources needed to pay pensioners. In fact, the life expectancy at retirement age is a big issue when it comes to these commitments. It is one, however, we could plan for with minor changes and adjustments ahead of time to determine the robustness of the funding. I am working on an example for the students that I can post later if needed. There is another significant issue though: an incentive alignment issue.

Recently public employee pensioners have come under fire for being “greedy” and bankrupting cities (e.g. Detroit). These arguments are ludicrous. First of all, most employees do not have an option when it comes to retirement plan. They simply enroll in the plan offered. If anything it is the politicians and financial advisors for these cities that should be blamed. The way these plans remain “funded” is by poor assumptions that allow low contributions to occur. If I can assume an 11% return to investment I will be able to contribute less money today to the pension fund, which frees up funds to be used elsewhere on other projects. Very few seem to be willing to deal with these issues upfront when it comes to the public and the taxes needed to fund these plans. Unfortunately it seems like these issues are occurring/recurring all the time at this point.

Frankly, it surprises that any employees accept these pension forms anymore, given the intense (and misplaced) public backlash against them, as well as the renegotiation of terms by courts after the fact in the case of Detroit. This renegotiation can be particularly harsh for those already done with work or about to retire. These are major issues needing public attention now, even if the pensions are currently funded or over-funded. Circumstances change, people are continuing to live longer, and organizations seem reluctant to ever consider these circumstances when it comes to the pension math.

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