So we have now covered how PSER contributions are determined, and we previously discussed how PSER benefits are calculated. Contributions and benefits come together in pension fund valuation and accounting! (OK, maybe not the most interesting topic, but so necessary to understand what it means when we say a pension plan is under-funded.)
The objective of pension accounting is to communicate the health of the pension program – will the money coming in to the program be enough to pay for all of the benefits that have been promised and earned by participants? While this is a simple concept, pension accounting requires estimations and modeling, and those come from actuarial science – a discipline that applies math and statistics to assess risk and to value assets and liabilities.
Let’s take a simple example to understand how pension health is determined. Imagine a pension fund with only one participant, Anne, who earns $50,000 per year for 40 years (no raises) and contributes 5% of every paycheck to the fund, along with a 5% matching employer contribution. The fund invests contributions in bonds, receiving 4% per year in income. Upon retirement, Anne receives an annual pension of $40,000, calculated using the PSERS formula of 40 years x 2.0% factor x $50,000 = $40,000.
- How much money has been contributed into the fund when Anne concludes her service?
- How much money is in the fund when Anne starts drawing her pension benefit?
- How many years of benefits can the fund pay before it runs out of money?
- How much money will be paid out before the fund runs out of money?
- When Anne begins retirement, is the plan fully funded?
To answer this I made a very simple model in Excel.
- $200,000. Anne contributes $208.33 per month, as does her employer. There are 480 monthly contributions of $208.33, or $100,000 from both Anne and her employer.
- $492,484. If balances in the fund earn compound interest at the annual rate of return of 4%, the balance will more than double over the 40 year period.
- The fund will run out of money after 17 years, when Anne is 82 years old.
- The fund will pay Anne $676,667 in benefits. Remember that the balance continues to compound at 4% during the payout period. So the funds deposited more than triple in value over Anne’s 57 years as a plan participant.
- It depends! If actuarial expectations for Anne’s life expectancy have not changed, and if fund investment results (4% per yaer) have been realized exactly as modeled when the plan was established, then the plan should have precisely enough money to pay Anne until she passes away. Or in the language of finance and accounting, the Assets on Anne’s first day of retirement ($492,484) will precisely equal the present value of the future liabilities ($676,667) discounted at 4% back to the date of retirement.
Let’s look at four additional scenarios. What happens if we only change one element of the plan …
- Scenario # 2: Returns on the investments average 6% instead of 4%?
- Scenario #3: Returns on the investments average 2% instead of 4%?
- Scenario #4: The employer (due to decisions in Harrisburg) stops contributing for ten years in the middle of Anne’s employment
- Scenario #5: Harrisburg is feeling generous and increases the benefit multiplier from 2.0% to 2.5%, without adding any funding to the system.
In Scenario 2, the plan is now overfunded! Investment returns led to $829,788 in the pension fund when Anne retired. Monthly payouts to Anne were $3,333. But monthly income on the $829,788 balance (at 6%) is $4,149. So the fund balance keep growing every month, despite the payouts to Anne. The fund will have a surplus, even if Anne lives to 150 years of age.
In Scenario 3, with low investment returns, Anne (or the fund) now has a problem. There is only $306,015 in the fund when Anne’s retirement begins. And the money runs out after only 8 years. This is what happens if there is an underfunded plan. In this example, the pension plan is underfunded by 37%. In the real world, Anne keeps getting paid, but someone has to come up with the money that will be paid to Anne. That money comes from either other participants (through higher contributions or lower benefits), from the employer, or from higher-than-planned investment returns.
In Scenario 4, when the employer takes a break from contributing for 10 years (as hypothetically mandated by state law), the fund also has a problem. It is not quite as severe asin Scenario 3, as the plan now only 13% underfunded.
In Scenario 5, if benefits are increased without changing contribution levels (how could you go back in time and change Anne’s historical contributions??) then of course the plan becomes underfunded. Increasing benefits by 25% leads to a 19% underfunding of the plan, and running out of money to pay Anne 5 years too soon.
- Pension plans can be derailed by many factors, including:
- Under-performance of the investment portfolio
- Political interference in employer contributions
- Granting of new benefits
- To determine the health of a pension fund, you must compare the present assets to the present value of future liabilities (payments).
- A healthy fund should have 100% of the assets needed right now to meet all of its future liabilities.