DB Pension Plans: Elementary My Dear Watson by IceCap Asset Management
New money printing, negative interest rates and more bailouts has created even more confusion in the financial world. Fairly soon; pensioners, companies, governments and their consultants will be scratching their collective heads trying to figure out the latest financial mystery and how to get out of it.
We suggest they start first by reading IceCap’s latest Global Market Outlook.
One more thing…
If you’re into mysteries, there’s certainly no shortage of them around the world. Enjoying them is one thing, solving them is quite another.
In the mystery solving world, Sherlock Holmes was clearly heads, hands and feet above everyone else. His unorthodox thinking was the key to solving the mystery behind the Hounds of Baskerville, while shrewd decision making always proved valuable when up against the maniacal Moriarty.
Lieutenant Columbo meanwhile, was also a sharp cookie. Whereas Sherlock dove straight into a mystery and aggressively confronted his foes, the affable Columbo excelled at bumbling around the problem which caused his foes to underestimate him. Which of course, always helped everyone’s favorite detective gather more clues and crack the case.
Mysterious hounds and mysterious criminals certainly help keep our minds razor sharp as well as entertained. Yet, perhaps the biggest mystery in the world today involves – pension plans.
Many people have them, and most people fully know what their eventual pension payout will be. Unfortunately, the average person doesn’t know how their pension plan is actually taped together, and fewer still, appreciate that the “promise” of their “eventual pension payout” is not as guaranteed as they may believe.
One more thing… Let’s leave no doubt – considering the mysterious complexity of these plans, to understand them one must certainly be a sharp cookie – that’s the easy part.
However, to fully understand them, one must use unorthodox thinking and make shrewd analytical decisions. Last but not least, never underestimate how today’s financial environment is about to leave many pension plans scratching their heads with confusion and despair.
Our previous Global Market Outlook “Right on Target” discussed Defined Contribution Pension plans and why they will be significantly affected by the upcoming crisis in the bond market.
For this Global Market Outlook, we are writing about Defined Benefit Pension Plans. They too will be affected by the bond crisis. But whereas individuals will be affected in Defined Contribution Pension Plans, both individuals and their employers will be affected in Defined Benefit Pension Plans.
The big difference of course, is whether your employer is a company or a government entity.
DBP vs DCP – the big difference
The main difference between Defined Benefit Plans (DBP) and Defined Contribution Plans (DCP) all boils down to who ultimately bares the risk.
For DBP, the ultimate risk is with the employer. After all, if the investments do not grow to what is needed to make pension payments – the employer must make up the difference.
On the other hand, DCP are set-up so that the employee bares all the risk. On retirement day, if there isn’t enough money in the investment pot – tough luck. Don’t go running to your employer – you, and only you are responsible for ensuring you have enough set aside.
If you don’t have enough, you’ll have to either scrape and scrounge to make ends meet, continue working, or maybe move in with your kids (provided they are not already living with you).
Recognizing this key fact will help you understand why practically all employers today have moved towards DCP. After all, if you had a choice whether to accept or reject any risk that carried no return – you would choose to reject the risk, every single time.
This is exactly what employers have done by moving towards DCP.
The Defined Benefit (DBP) Pension Plan
Few people today know why, when or how pension plans were created. They’re just there, and if you are a member of a pension plan, the financial burden of retirement has been greatly relieved.
If only that were true.
It’s complicated In fact, today pension plans have become so large and systemically important – not only from a financial perspective, but also from a social and political perspective, that they are fully entwined and exposed to the perils created by today’s bizarre investment environment.
The key to understanding pension plans is knowing that they are one gigantic pool of money – meaning there are a lot of individuals, agencies, consultants, investment managers, accountants, actuaries, lawyers, record keepers, administrators, corporate trustees, performance measurement analysts and other service providers lined up to offer their help; all for a fee of course.
Weeding through this convoluted scheme, there is only one thing you need to know to solve the pension mystery:
– pension funds rely upon an estimated rate of return for valuing the financial health of the fund, and
– it has become virtually impossible for them to achieve this return
The First Step
The first step in de-mystifying the DBP, is simply understanding that it has 2 dimensions: 1) Assets 2) Liabilities
Things get tricky
The Assets for all DBP’s are a consolidation of the contributions from the employer and the employee and the resulting investments. Investments can include many things but commonly include stocks, bonds, and real estate.
The Liabilities represent all the money that needs to be paid out of the fund and is called the PBO (pension benefit obligation). The most prominent obligations are the current and future pension payments, as well as healthcare premiums.
This however, is where things get a bit tricky due to a fair bit of educated guessing taking place. The very best actuaries sharpen their spreadsheets and guess:
- when most employees will die
- what their future salary will look like
- how long she will work for her employer
- the rate of inflation
- an appropriate discount rate
There are a few other moving parts, making it even easier to see how slight changes in one component can really change the liability picture for a pension plan.
Now, the next step is where the pension mystery really turns interesting. The difference between what the pension fund owns and what it owes is called either a surplus or a deficit.
See full slides below.