Defined benefit pension plans are supposed to be pre-funded. During the years an employee is earning benefits, the plan should receive enough contributions to payout all of the retirement benefits promised to that employee. Structurally, this is different than Social Security where current workers are taxed to pay the benefits of current retirees, also known as pay-as-you-go. In effect, when a public sector employee in a defined benefit plan retires, the plan should have on hand the total dollars needed to purchase a lifetime annuity on that employee’s behalf. Defined benefit plans should not rely on the contributions of todays workers to fund retiree pension benefits.
How much should be saved every year to pre-fund the benefits is, thus, one of the most important aspects of pension financing. There are two primary components determine how much employers and employees should contribute in a given year to fund the payment of future defined benefits:
- First, the annual cost to pre-fund promised pension benefits, known as normal cost; and
- Second, the cost to pay off pension debt, known as unfunded liability amortization payments if normal cost is miscalculated, employers don’t make their required contributions, or investment returns underperform.
1. Normal cost is determined by an actuary, who estimates how much will be needed in the future to provide the benefits promised to existing workers, in part using actuarial assumptions about benefits (e.g. salary growth rates, inflation rates) and demographic trends (e.g. retirement rates, turnover rates, disability costs, and life expectancy). These assumptions are typically selected by a board of directors for a given plan, appointed by elected officials. Contributions for projected obligations are then reduced using an assumed rate of return on assets to figure out how much should be paid into the system’s coffers in a given year to ensure long-term solvency of the system. Thus, the annual normal cost rate for any given employee theoretically should be the total amount of contributions necessary in order for the plan to honor the promised stream of payments in retirement to that employee.
By contrast, Social Security explicitly draws on the revenue from taxing active employees to pay benefits for retirees, and the contribution rates are determined through a political process that is disconnected from any actuarial analysis of the program’s members.
For most defined benefit plans,normal cost is divided between contributions from the employer and the employees. The exact percentage of normal cost that employees pay varies from plan to plan, however, in a typical defined benefit plan, employees contribute only to the normal cost. Unlike a ponzi scheme where the people paying into the plan are covering the costs of those drawing benefits from the plan (the way Social Security works), employee contributions to a pension plan are only for the benefits that they have earned.
2. Unfunded liability amortization payments are the annual contributions that an employer needs to make to pay down pension debt. The unfunded liability is the difference between the value of assets in a plan, and the net present value of accrued liabilities.
Importantly, employee contributions are never supposed to subsidize amortization payments made to support the pensions of other employees. Defined benefit plans can be designed so that active members pay a share of any unfunded liability payments that arise for their own benefits, but current employees’ contributions are not supposed to fund the retirement benefits of others, including current retirees.
This is a critical difference between the intended pre-funded design of a defined benefit pension plan and pay-as-you-go funded Social Security. Legally, employees in defined benefit pension plans have a right to withdraw from a plan at any time and receive back at least the full value of their own contributions (oftentimes with interest), so if employee contributions were regularly put toward general unfunded liabilities, it would mean employees simply quitting their jobs would increase the contributions required by remaining members, hurting retention and undermining the solvency of a plan.
How Defined Benefit Plans Become Underfunded
Defined benefit plans are exposed to three kinds of risk: underfunding, underperformance, and unanticipated distributions. Each of these risks underscores the ways in which a defined benefit pension plan can become underfunded in the first place.
Underfunding can be explicit and/or implicit. Explicit underfunding happens when an public sector employer – such as a state agency, school district, or city department – does not contribute the full actuarially determined amount of normal cost and amortization payments. There are many places in America where there is no legal requirement that public sector employer actually make the contributions they are actuarially “required” to pay. Implicit underfunding happens when the actuarial assumptions used to determine normal cost or the amortization payment are not accurate, reasonable, or risk-adverse. For example, if a defined benefit plan estimates the longevity rate of its members using estimates of how long people lived in the 1990s (which would be inaccurate and unreasonable) then the actuarially determined rate will be inherently too low, thus implicitly underfunding the plan.
Underperformance is primarily related to the management of assets of the pension plan, how much risk is in the portfolio of pension assets, and what the assumed rate of return is on those assets. If a pension plan’s assets earn less than the amount assumed, unfunded liabilities will accrue.
Unanticipated distributions are any pension checks paid out that are more than actuarially assumed would be paid. There are several possible reasons that distributions would be more than expected. People could live longer than expected (the morality and longevity assumptions), the interest rate and inflation assumptions might be wrong, or people might work in the plan for more years than assumed accruing higher benefits. All of these possible causes are related to the actuarial assumptions of a plan, and whether they are set at rates that ensure normal cost is high enough to cover all earned pension benefits. If the assumptions are overly optimistic then the plan will save less money over time than the amount of pension benefit checks it will have to pay. If the assumptions are risk-adverse, there is less chance that unfunded liabilities will accrue.
Content for this backgrounder was drawn from Reason’s policy study “Did Pension Reform Improve the Sustainability of Pension Plans?” and policy brief “The ‘Transition Cost’ Myth.”