Are Defined Benefit Pension Plans Affordable?

Are Defined Benefit Pension Plans Affordable?

The sustainability of defined pension plans has come into severe doubt over
the past decade or so.

Most defined benefit pension plans are under-funded. Many of these plans have more than doubled the percentage of salaries going into the plan and yet they remain under-funded.The under-funded situation was caused by poor market returns and even more so by plummeting interest rates. When interest rates are low it takes more money to fund a given pension.So, the question arises” Are defined benefit pension plans affordable or are they inherently unsustainable?

Is it reasonable to expect to work for 30 or 35 years and then collect a pension for an average of some 20 to 35 years in retirement? What kind of stock market returns would be needed and what percentage of salary would need to be saved each year to fund an average 20 to 35 year retirement?

Features of a Good Pension

From a retiree’s perspective, the very best pension plans around are those that pay out 2% of the ending salary level (often defined as the average of the highest five years salary) per year of service. For 30 years in the plan this works out to 60% of the ending salary level. The best plans offer full or at least partial inflation protection.

Many of these plans are funded by equal contributions from the employer and employee. Traditionally the percentage was about 5% of wages from each for a total of 10%. More recently the contributions are often running at about 10% to 17% from each for a total of 20% to 34% of salary set aside to fund the pension. Some of the recent very high contributions are however temporary and intended to remedy funding deficits.

What length of retirement must a Defined Benefit pension plan assume?

Typically a defined benefit pension of say 50% of final earnings applies for the life of the pensioner. If there is a spouse the pension is typically actuarially reduced reduced to say 40%
of final earnings but then pays out until both the pensioner and the spouse pass away albeit often further reduced by one third upon the first death to occur. The (smaller) yearly amount paid out over the joint life of the two is meant to be equivalent to the higher amount that would be expected to be paid out over the life of a single pensioner.

While an individual saving on their own may need to plan for the “risk” that they and/or their spouse will live to see age 95 or greater, a defined benefit pension plan only needs to plan for the average ages of death. This makes group plans cheaper to fund than individual plans. In any group of pensioners some will die younger than average and some older. One of the great benefits of defined benefit pensions is that this “longevity risk” is automatically pooled.

The best pension plans often allow people to retire on 50 to 60% of final earnings by age 60 and with some qualifying as early as age 55. Using average age of death, a defined benefit plan needs to plan to fund retirements for an average of perhaps 25 years for a single pensioner. (Longer for couples but the yearly pension is reduced accordingly.)

The question that is now arising is whether even 20% to 30% of salary saved results in enough money being built up over 30 to 35 years to fund a pension for that 25 years (or whatever the number is) average retirement?

How to Model a Sustainable Pension

It is impossible to know precisely what percentage of salary needs to saved over 30 years to fund a given pension. There are numerous variables including the achieved rates of return, age at death, the salary escalation over the working life and the extent to which investment returns rise with inflation (or not).

In engineering school I was taught that the way to model and understand something complex is to start with a simple model. (Engineering students learn the behavior of motion in the absence of friction before they go on to add in the complexity of friction).

I have competed a simple model of pension funding to see what percentage of salary needs to be saved to fund a pension. In my simplified model I assume no inflation (But this is equivalent to assuming that returns always compensate for inflation).

In my simple model I assumed constant wages and a fixed real return on investment.

If pension plans can’t be demonstrated to work under idealized assumptions then they are even less likely to work in the real world. In the real world pensions have to try to deal with wages (and hence pension entitlements) that rise faster than inflation and with inflation that may occur just when returns are lower and with uncertain returns and uncertain longevity of retirees.

What is Required for a Pension to Work?

One thing that is required is some minimum level of positive percentage real returns.

Imagine trying to fund a pension in a world of zero real returns. In that case if you worked 30 years and wanted a pension of 50% of your wages for 30 years, you would need to save precisely 50% of your wages while working. That is a non-starter. Faced with a need to save 50% of earnings, people would conclude that a retirement that lasts as long as the working life, or anything close to it, is simply unaffordable. If you are going to fund a long retirement you definitely need positive real returns.

The U.S. Stock market over various 30-year periods has made real returns that range from just over 4% per year to over 10%. The 10% return levels were last seen in the 30 years ending around 1970. Based on history, and considering that not all of the assets will be in stocks, a reasonable target real return assumption for a pension portfolio is about 4% per year.

Savings Percentages Needed to fund various retirement scenarios assuming 4% real returns:

With a 4% real return, one would have to save 15.4% of earnings for 30 years to fund a pension of 50% of earnings for 30 years.

Here is a summary of what is possible under the simplified assumptions including a 4% real return level.

The first table has a 4% real return and a 50% pension.

Years Worked 30 35 35 35 40
Years Retired 30 30 35 20 20
Real Return 4% 4% 4% 4% 4%
Pension % of earnings 50% 50% 50% 50% 50%
Percent Savings Needed 15.4% 11.7% 12.7% 9.2% 7.2%

This table shows that it is feasible to fund a lengthy retirement at 50% of the wage level while working. However if one only works 30 years then it takes a savings rate of 15.4% (which could be shared between the employer and employee) of earnings to achieve this. It becomes much more feasible if we work for 35 years and fund a 20 year retirement. In this case the savings required is a more reasonable 9.2% of earnings.

The next table has a 4% real return and a 40% pension.

Years Worked 30 35 35 35 40
Years Retired 30 30 35 20 20
Real Return 4% 4% 4% 4% 4%
Pension % of earnings 40% 40% 40% 40% 40%
Percent Savings Needed 12.3% 9.4% 10.1% 7.4% 5.7%

This table shows that it is quite feasible to fund a lengthy retirement at 40% of the wage level while working. (Perhaps on the assumption that government pensions like CPP and old age pension mean that 40% is adequate.) I believe that this shows that at least a decent pension can be achieved with a 10% total savings level.

The next table has a 4% real return and a 60% pension.

Years Worked 30 35 35 35 40
Years Retired 30 30 35 20 20
Real Return 4% 4% 4% 4% 4%
Pension % of earnings 60% 60% 60% 60% 60%
Percent Savings
Needed
18.5% 14.2% 15.2% 11.1% 8.6%

This table shows that in order to fund a 60% pension one may have to save and invest a hefty amount of about 15 to 20% of earnings each year, although only 11% is required if we work 35 years and fund a 20 year retirement. And less than 9% savings is required if we work for 40 years followed by 20 years retired.

Conclusions:

The overall conclusion is that Defined Benefit pension plans are affordable. It is possible to fund a lengthy retirement if investments earn an average 4% real return. Defined benefit plans have the advantage of being able to plan for average life span rather than maximum life span and this increases affordability. Certain feature of defined benefit plans like unreduced pensions at age 55 or 60 may not be affordable. A minimum savings of about 10% of earnings is required. And a minimum 35 year working career should be assumed. A retirement age of 65 (or perhaps even higher) should be assumed otherwise the years in retirement become too many and the years working too few.

If one assumes a 40 year working period and 20 years retired then it only takes a 5.7% savings rate at a 4% real return to fund a 50% pension. A 20 year retirement assumption is not feasible for individual plans where it becomes prudent to fund for something close to maximum lifespan. A group defined benefit plan need only fund for average life span and with a retirement age of 65 or older, a 20 year average retirement period may be a reasonable assumption.

Certain overly generous provisions of certain defined benefit pension plans like not requiring any reduction to the pension for early retirement if age and years of service sum to 85 or greater have no basis in mathematics and may not be affordable.

END

Shawn C. Allen, CFA, CMA, MBA, P.Eng.
President
InvestorsFriend Inc.
April 6, 2013

Scroll to Top