Minimizing Risks in Defined Pensions - Theirs, That Is...

Pension Vocabulary: Minimizing Risks in Defined Pensions – Theirs, That Is…

My parents used to love watching Hitchcock films.  As soon as the movie began, they’d try to be the first to spot Alfred embedded in his film, and then they’d put all of us in the same kind of plot situation and discuss how we’d react as a family.  Thank goodness I was too old to watch Psycho with them, but I clearly remember Lifeboat; John Hodiak trying to decide whom to shed and whom to keep.  Being chubby, I remember offering my reason to stay on board our imaginary family raft in tossing seas.  “I won’t have to eat much for a long time, “ I offered.  Stern Captain Dad and First Mate just stared and smiled…

It’s much that way in the private world of pensions nowadays, only the situation is hardly imaginary.  In fact, castaway pension plans are readily around in all areas: public pensions, private pensions and even the work of pension investment firms.  In the world of business, anyone in a pension is someone who “eats too much” or certainly diverts necessary funds that would be better appreciated as profits.

And, when private world collides with public worker pensions, what begins as confusing can become quite disastrous…for retirees.

One means of removing the “extra baggage” of an obligation like a pension for retired workers nowadays has become a strategy called “de-risking.”  Some companies, especially larger ones like huge telecommunications giant Verizon, is to move all pension obligations to an annuity through an insurance company.  This is a win-win for the company because the insurance company purchases the entire pension obligations at a price determined by the actuarially determined likelihoods.  In other words, National Insurance assumes your $100 million pension obligation for $80 million, because they anticipate having to pay out only $68 million after running the numbers on your retirees.  The insurance company stands to win $12 million in the transaction.  Your company is able to unload nearly $80 million in obligations and add that windfall to the income line of the ledger, making the stockholders adore your business acumen.  In short, one company receives a way out of promised obligations; the other bets on the odds of people dying before collecting. 

Of course, those retirees uncomfortable with the idea are problematic, so these same companies provide a lump sum payout for the fiscally squeamish.  According to a recent article in AARP Magazine, this two-pronged strategy is in vogue in the private world, where “58% of companies offered lump sums to former employees or a plan to do so.”  Another “38% expect to transfer pension obligations to an outside agency within the next five years”  (http://www.aarp.org/work/retirement-planning/info-2014/retirees-pension-plan-change.html).

And the companies have reasons beyond the profit margin: since the Great Recession, mandatory payments to the Pension Benefit Guaranty Corporation (to provide pension payments in case of company default) have escalated – with more companies defaulting – and returns on money invested for pensions have lessened. 

“This transfer began in earnest in 2012 when changes to pension law fully kicked in, making it more attractive for employers to offer lump sums… A rash of companies made cash offers that year, including Ford Motor Co., J.C. Penney, Lockheed Martin Corp. and Archer-Daniels-Midland Corp.

“Retiree advocates are concerned. Traditional pensions have been disappearing for years in the private sector, where only 16 percent of workers were covered last year, down from 35 percent in the early 1990s, according to the Bureau of Labor Statistics. This latest trend, though, leaves retirees without valuable federal protections and increases their chance of outliving their money, particularly if they take a lump sum and don't invest wisely.” (http://www.aarp.org/work/retirement-planning/info-2014/retirees-pension-plan-change.html).

But even if private business retirees were to take the leftovers of PBGC, the amounts of the annual benefit is capped when the employer goes bankrupt.  The maximum annual benefit is just over $59,000, BUT no other benefits are provided – not health or cost of living. 

Things in the private world are harsh, but as retirees in a public service sector position, we need not worry about the PBGC coming to our rescue, in case Illinois’ Protection Pension Clause is ignored or over-ruled by the Illinois Supreme Court: They won’t. 

Because the municipals and the states did not need pay into the pension insurance program for those of us in the public sector (just as they did not need pay into social security), we cannot claim a loss to the PBGC if we were to lose our pensions.  The state’s having waived sovereign immunity when it comes to obligations and promises, one might ask what would cause such a bleak scenario.  On the other hand, the recent pronouncement of would-be governor Rauner that he would immediately move current pubic employees to a 401K program (and thereby stop further funding of pensions) certainly raises that scenario for union leaders and business people alike. 

Sadly, it takes only a quick north to see how such a catastrophe might play out on at least the municipal level.  According to an enlightening article in the Detroit Free Press entitled “Pension Safety Net Will Not Help City of Detroit Retirees,” journalist Susan Tompor warns that the city already inured to the many failed manufacturing businesses and the intervention of the PBGC to assist as best it can; the same is out of the question for teachers, firemen, and police. 

“As we hear more about the prospect of a Chapter 9 bankruptcy filing for the city of Detroit, it is key to understand that the PBGC will not be a safety net for those retirees. It’s just not in the PBGC’s wheelhouse.

“The PBGC also insures 915 ongoing pension plans sponsored by Michigan companies, covering more than 1.5 million people. But again, not municipal workers.

“The PBGC was created by the Employee Retirement Income Security Act of 1974. It does not receive money from taxpayers. Instead, it collects insurance premiums from employers that sponsor insured pension plans, earns money from investments and receives funds from pension plans that it takes over.

“For a state or municipal pension, the taxpayer is typically the backstop. Yet Detroit’s finances are in such a hot mess that raising taxes or finding another revenue source to fund pension promises is highly unlikely. Dramatic changes regarding pensions and retiree health care seem inevitable, even with any possible brutal legal battles ahead” (http://www.freep.com/article/20130627/COL07/306270021/Detroit-bankruptcy-retirees-PBGC-Susan-Tompor).

In addition, closer scrutiny of Rauner’s plan to switch to a defined contribution plan bears more thorns than fiscal fruit according to the Director of the Illinois Retirment Security Initiative, Ms. Bukola Bella. 

“Some state legislators want to change Illinois’ current defined benefit system to a defined contribution system that will cost more to implement and produce lower benefits. Estimates of that change alone will cost taxpayers $275-$610 million per year (in administrative costs) if all current participants in the five Illinois state pension systems are covered by this change.”  And while Ms. Bella argues accurately that 401K;’s are simply supplemental savings instruments, not retirement plans, her seminal dispute is revealed in the additional costs of such a shift and persistent expenditures.

“In fact, both Nebraska and West Virginia experimented with shifting from a defined benefit system to a defined contribution system and shifted back. The reason – simple. The investment management fees, record-keeping fees, educational programs and other administrative line items associated with a defined contribution system were substantially greater than the cost under the old defined benefit system. The failed defined contribution system didn’t provide enough income to live on and both Nebraska and West Virginia experienced former state employees having to go on welfare.

"It's true..I'll drive 'em nuts.."

“The National Institute for Retirement Security reviewed this issue and made a very clear finding, “for any given level of benefit, a defined benefit plan will cost less than a defined contribution plan. This makes defined benefit plans, in the language of economists, more efficient since they stretch taxpayer, employer and employee dollars further in achieving any given level of retirement income.” Switching to a defined contribution plan from a defined benefit plan will not solve Illinois’ public employee pension crisis or eliminate the $54.4 billion current unfunded liability. It will, however, cost taxpayers more money and result in public employees having less to live on” (http://www.ilretirementsecurity.org/news?id=0007).

 Finally, if and when (Gov.) Rauner’s promised 30-man group of the best and brightest minds of Chicago businesses were to  meet and determine that 401K’s were the direction best taken in “pension reform,” who would benefit most?  Likely good friends like hedge-fund manager Ken Griffin, at least according to a recent expose by David Sirota regarding the movement of investment strategies of public pension funds to Wall Street friends of politicians like New Jersey’s Governor Chris Christie.   And he is just one of many states to do so…New Jersey, Rhode Island, Maryland, North Carolina, Kentucky, etc. 

“Those investments are managed by private financial firms, which charge special fees that pension systems do not pay when they invest in stock index funds and bonds. The idea is that paying those fees — which can cost hundreds of millions of dollars a year — will be worth it, because the alternative investments will supposedly deliver higher returns than low-fee stock index funds like the S&P 500.

Unfortunately, while these alternative investments have delivered a fee jackpot to Wall Street firms, they have often delivered poor returns, meaning the public is paying a premium for a subpar product.

In New Jersey, for example, the state’s alternative investment portfolio has trailed the stock market in seven out of the last eight years, while costing taxpayers almost $400 million a year in fees. Had the state followed the advice of investors like Warren Buffett and instead invested its alternative portfolio in a low-fee S&P 500 index fund, New Jersey would have had more than $5 billion more in its pension fund. In all, as New Jersey plowed more pension money into alternatives, its pension returns have routinely trailed median returns for all public pension systems” (http://www.nationofchange.org/2014/09/28/pension-jackpot-wall-street/).

Sirota’s final warning highlights the most dangerous rippling effect of the current trend to extract the money of public workers:

“That spotlights a pernicious dynamic that may be at work: The more public money that goes into alternative investments, the more fees alternative investment firms generate, the more campaign contributions are made by those firms, and thus the more money politicians devote to alternative investments, even as those investments deliver poor results for pensioners. It is a vicious cycle whereby the financial industry wins and taxpayers, once again, lose.”