"Most managements I know, and virtually all elected officials in the case of governmental plans, simply never fully grasp the magnitude of liabilities they are incurring. 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 remain a mystery to most Americans." - Warren Buffett in 1976 and 2014
Pension mathematics are indeed a complicated issue. The fact that they are also relied upon by so many people makes them very important to understand, but very few people actually do. In fact since our local and federal governments have also incurred huge pension liabilities over the years, we are all on the hook as taxpayers for the misunderstanding of our elected officials. This is a problem which is going to get worse before it gets better.
The reason why there is so much confusion over pension liabilities is that they can seem relatively painless when they are first incurred. A promise to pay in the future, doesn't seem nearly as painful as an obligation to pay right now. However when you calculate the actual costs of some of the pension commitments you begin to realize the magnitude of the problem. Let's do an example to illustrate.
Let's say you have a business with 4 employees, each of which you promise to pay the amount of $3000 a month for life after they reach the age of 65. All of the employees are 55 years of age at present. If you make that promise today, you have reduced your net worth today by about $1,750,000. Why are you immediately $1,750,000 poorer? Well if you set aside $1,750,000 and invest it in a 10 year government bond earning 2.5% interest, and let all such interest remain in the fund to be compounded, the principle of the fund will grow to about $2,250,000 in ten years when your employees reach 65.
To buy each employee a lifetime annuity which will pay them $36,000 a year will cost about $560,000 each, utilizing the entire capital of the fund. So if you make the promise and it is binding, legally or morally, you have essentially spent $1,750,000, even though you don't have to pay out a dime of cash for ten years. You would have been far better off to simply give the employees $1,000,000 ($250,000 each) today rather than entering into this pension arrangement.
Now let's assume that your employees are each earning $6000 a month but, instead of promising them $3000 per month upon retirement, you promise them 50% of their salary at the time they retire. If their increases run at 3% a year (and they could be much higher if inflation increases), they will be earning $8,000 a month by the time they reach 65. It will now cost you $2,350,000 today, to purchase annuities for them to fulfill your promise. Many pension plans use final average pay (usually the average of the last five years, or the highest consecutive 5 years in the last 10 years employed).
Because these are massive liabilities which are being incurred, private companies have begun to wise up. Defined Benefit Pension plans (plans where the monthly payment to the employee is guaranteed) are on the rapid decline and virtually no new defined benefit pension plans like these are being created today. However, this still leaves the plans that have already been established and are still being relied upon by many employees in both the private and especially the public sector.
In many cases in the public area, the bill will be handed to the next generation, to be paid by increased taxes or by accelerated use of the money printing press. In private corporations the bill will have to be paid out of current, and future profits, with interest. Can these pension plans afford it? Well it is looking increasingly likely that most cannot. In the United States, unfunded pension obligations have risen from $292 Billion dollars in 2007 to $1.9 Trillion dollars in 2017.
Credit ratings firms have begun to downgrade states and municipalities whose pensions risk overwhelming their budgets. New Jersey, and the cities of Chicago, Houston and Dallas are some of the issuers who are receiving scrutiny.
The situation in Canada is just as bad. OSFI did a study for federally registered plans in 2016 and found that as of December 31st 2016, 80% of the defined benefit pension plans that OSFI supervises were underfunded, with 16% of funds being severely underfunded. In order to try and fix this problem, public pension plans have invested in riskier assets. In 1952 the average public pension plan had 96% of its portfolio invested in bonds and cash equivalents. Assets matched future liabilities. However by 1992 this fixed income and cash had fallen to an average of 47% of holdings. By 2016 these had declined to 27%.
This drop in fixed income and cash has coincided with the drop in interest rates, which is of course no coincidence. However public pension plans in the US discount their liabilities using the rates of return they assume their portfolio will earn. These assumptions are increasingly unrealistic in a low interest rate/very expensive stock market world.
The average pension plan in the United States is assuming annual returns of 7%. In Canada pension plans are assuming similar rates of return. Long term government bonds are currently yielding closer to 2.5-3%. If we look at the current price of stocks they are also unlikely to yield more than 3-4% on average over the next ten years. If pension funds assumed that rate of return was going to be closer to 3-4%, they would immediately have to inject a great deal more cash into their pension plans to meet their obligations. In many cases this is cash that they don't have.
What makes this even worse is that these pension plans remain underfunded even with a very strong bull market over the past 10 years. They now have large amounts of their assets invested in one of the most expensive stock markets in history. If the stock market was to crash, the pension plan underfunding would get much worse very quickly.
Another potential problem would be if there was sustained periods of high inflation. Inflation destroys the value of savings and it would greatly reduce the value of any amounts already saved in a pension fund, while at the same time greatly increasing the pension liabilities of the plan due to increased wages. You can see from the example above that even very minimal inflation will result in much more costly pension liabilities in the future. By eroding the value of existing savings, inflation also eats into the endowments established to fund those pension liabilities.
Here's an Example
Let's look at the example above with a higher unexpected inflation. If you promise your four workers 50% of their highest salary in 10 years, and you assume there will be 3% wage inflation annually during that time, you could duly set aside the $2,350,000 you need and invest it in a Government of Canada 10 year bond earning 2.5%, and in ten years you would receive the approximately $3,000,000 you will need to purchase the annuities for all four of your workers.
But let's say that wage inflation runs a little higher than you thought at 5% a year. The $4000 a month you thought you were obligated to pay out is now closer to $5000 a month. And the $3,000,000 you have saved is about $700,000 short. That extra $700,000 has to be paid out of the profits of the business. If the profits of the business are insufficient, then the business may need to raise prices or suffer a shortfall. If the shortfall gets too large, then bankruptcy results.
In the case of public pensions, the particular government can try to raise taxes to fund the pension. However even this has limits as the City of Detroit has discovered. As taxes get raised, the population starts migrating to lower taxed jurisdictions, which further reduce the tax base causing the taxes to be raised even higher, which results in a vicious downward spiral.
For those people who are already receiving pensions, inflation is a huge problem because it decreases the value of their pension income over time. As things get more expensive, their pensions are fixed and therefore they get relatively poorer all the time.
So with all these problems what are we supposed to do with our pensions? Well the first thing to do is to properly plan for your future, using realistic assumptions. If you assume that your pension is going to be able to fully fund your retirement indefinitely, then you may be setting yourself up for trouble. Through proper planning you can plan around potential pension deficiencies and ensure that you are not left strapped for cash.
For those individuals who are nearing retirement and have the option of transferring out the commuted value of their pensions, this may be well worth considering. By taking the commuted value of your pension, and investing it yourself, you gain control of your own pension and you don't have to rely on the pension plan being fully funded in the future. You also have the ability to invest in investments which will be more resistant to inflation problems which will help in a higher inflation environment.
These are often tough decisions and all of the factors involved need to be considered carefully. Pensions are something that individuals work their whole careers to build up. You should make sure that your pension is protected.
- Craig White, BA, LL.B., CIM
Craig White is an Investment Advisor at Endeavour Wealth Management with Industrial Alliance Securities Inc. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families. Industrial Alliance Securities Inc. is a member of the Canadian Investor Protection Fund and the Investment Industry Regulatory Organization of Canada. iA Securities is a trademark and business name under which Industrial Alliance Securities Inc. operates.
This information has been prepared by Craig White who is an Investment Advisor for Industrial Alliance Securities Inc. (iA Securities) and does not necessarily reflect the opinion of iA Securities. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.
4 years ago, back in April 2018, I was visiting family in Adelaide Australia. I was there for my cousin’s wedding. I remember it being enjoyably ho...
July 4, 2022
There are various strategies that could be used to either reduce, eliminate, or defer taxes that you pay. Most strategies will make use of multiple...
June 27, 2022
As a business owner, you take on risks and leave behind the security of things like health benefit plans when you decide to go off and start your ....
June 20, 2022
Wondering whether you’re ready to incorporate? Download our guide to know more.
Learn how a pension plan can help you retire earlier while reducing your taxes at the same time.
Simple strategies every dental clinic owner should be implementing.
Download your free guide to financial freedom.
Download our free guide to learn how best to protect yourself, your family, and your retirement.