Tuesday, August 14, 2012

A Primer on Pensions

Okay. Here is something to get your blood going: Pension plans. There are two key types of Pension plans and the big differences between them. This is all before we hop into accounting of it all with terms such as: actuarial balances and pension benefit obligations. If you don't understand the basics, then you won't understand the complicated stuff that comes next.

-Pays out until the employee dies
-Pays out until the money is exhausted
-Non-transferable to a beneficiary
-Transferable to a beneficiary
-Usually administered by the Employer 

-Usually administered by the Employer
-Usually relatively more money on an annual basis compared to Direct Contribution 
-Usually relatively less money on an annual basis compared to   Direct Benefit
-Employee contribution expected 
-Employee contribution not expected
-Fixed payment plan, cannot cash out
-Individual can structure own payment plan, including cash out option

Why are we hearing about pension plans more now more so than we were before?

A lot of the defined benefit plans were signed 20-30 years ago and now that group of employees are beginning to retire. Private businesses and the government doesn't have the money to pay these pensioners.

Why didn't they put enough money away to pay those obligations?

Most did, but all the money was tied up in stocks, bonds, and other financial instruments to make healthy returns. When the economy collapsed, their portfolios decreased in value considerably. Those employers with defined benefit plans were still on the hook for a whole lot of money that they thought they had.

Why the sudden move to defined contribution plans then?

Because the party with the risk changes. Once the employer forks over the money to the individual (or the fund on their behalf), then they are completely off the hook. If the economy nose-dives again, then its the individual who loses out and not the government.

It's also a way for employers to give a lot less in benefits to those who have a hard time doing math. The same logic goes for why the lottery raises a lot of money. It's a tax on people who are bad at math. This is why being good at math goes a long way in life.

Why didn't employers do this before?

If the economy is growing, then the employer has to pitch less money in to fund the pension plan because the financial instruments are covering more of their obligation. The employer gets to harvest the upside risk. In a good economy, the employer wants defined benefit and the employee wants defined contribution. In a bad economy, its the other way around. Basically, no one is predicting strong growth any time soon and therefore everyone is moving over... or getting rid of future pensions entirely.

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