“HE IS NO WISE MAN THAT WILL QUIT A CERTAINTY FOR AN UNCERTAINTY”

– SAMUEL JOHNSON

How the Market Will Change as Pensions Disappear

Pension plans and their liabilities/funding calculations are very complicated. We will try to simplify the calculation by using just one participant. Let’s assume that an individual is going to retire in 20 years and at the time of retirement, a lump sum of $500,000 will be needed to cover that person’s pension expenses for the rest of their life. Since the individual is retiring 20 years in the future, the plan does not need to have $500,000 put away today. In order to find out how much the plan needs today to fund the retirement in 20 years, the plan needs to find out the present value of the $500,000 using an assumed rate of future return – in the pension world this is called the “discount rate”. The discount rate used can make a world of difference in pension calculations. In our example, if the discount rate was 8% – in other words, the 20 year average annual return on the investments is 8% per year – the present value needed today to have $500,000 in 20 years is $107,250. If the discount rate is lower – say 6% – the amount needed today would be much higher because the assets are not assumed to grow as rapidly – at 6% the pension would need $155,900 today. If the return is lower, plan sponsors need to put more money in their pension plans today to fund future obligations. In our example, if the pension was fully funded at a discount rate of 8%, it would now be underfunded by $48,650 if the discount rate was lowered to 6%.

Many pension plans used discount rates of 8%-9% a few years back. However, with interest rates at historic lows, an assumed return of 9% on a pension plan today that is 60% invested in stocks and 40% invested in bonds is unrealistic. Why? If bonds earned 4% – which is higher than the 30- year US Treasury Bond yield – the stock portion of the pension plan would need to generate an annualized rate of return of 12.3% in order for the entire plan to grow by 9%. So reducing the discount rate to a more realistic return of 7% would mean that many corporations would need to make significant contributions to their pension plans. This is why companies such as IBM and GM – for non-union workers – have frozen their pension plans and have all new employees participate in a 401(k) plan. This trend is also occurring at the state and local government level.

When Chris Christie took over as Governor of New Jersey, New Jersey’s pension plan had a deficit of $46 billion. This was a huge liability to the state and if the state went under financially, the workers in New Jersey would suffer with reduced pension payouts. Governor Christie made strides in reducing this liability by raising the retirement age, making the formula less lucrative for retirees and eliminating a 9% pension increase made in 2001. Even with these adjustments, the fund is not fully funded. On March 16th of this year, Andrew Cuomo – the Governor of New York – signed legislation that would allow some employees a chance to choose between a pension and a 401(k) plan. New York’s current pension shortfall of $120+ billion is unsustainable. To just get the teachers’ pension to fully funded status would require an immediate increase of 18% in real estate taxes throughout the state. In California, the largest public retirement plan – CALPERS – voted on March 14th to lower their discount rate from 7.75% to 7.5%. What this means is higher contribution rates for schools throughout California will be needed to fund teachers retirements. This increase will only add to the financial strain these school districts are already under.

Market Implications

As the old pension system dissolves, employee control over their own investments through 401(k) plans will change the nature of the markets. Pension plans are considered “smart” investors while individuals are “emotional” investors. The change from a pension system to a 401(k) system would mean more volatility for the stock market in the future. Why? Pension plans tend to be very diligent in rebalancing assets during market corrections. In other words, they tend to buy stocks when the market is down and sell stocks when the market is up. This is why pension plans are considered “smart” investors. Individual investors, on the other hand, tend to be emotional and sell when the market is down and buy when the market is up. As more individuals gain more control over their investments, expect market swings like we have experienced in the stock market over the past 4 years to continue.

Planning Note

Given the low interest rate environment we have had in the past couple of years, many of our clients have refinanced their mortgages. If you haven’t refinanced, you may want to consider doing so. In our opinion, the interest rate cycle will turn in the months ahead and interest rates will head higher. If you need assistance, please call our office and speak with Neal. We have several mortgage brokers we work with to compete for the lowest rate available. He can also run an analysis to see if refinancing is worth considering. This may be the last time to lock in these historically low rates.