Unintended consequences, the end of the DB plan ?

Towers Watson DB graph

Towers Watson is an international leading professional services firm. They maintain stats on a hypothetical defined benefits plan. Their model plan is 60% in equities and 40% in bonds. They use the corporate 10-year bond rate as the discount rate as they believe that is most applicable to the corporations that sponsor these plans. Their plan is at that stage where distributions are equal to the contributions so it is essentially assumed to be mature. Over the past 10 years, coinciding nicely with the low-yield environment, the value has dropped by slightly more than 47%, from a small surplus to a large deficit. In most cases the corporations are responsible to take corrective action (often too late) and or make good the shortfall.  Little wonder then that they are bailing out in droves and are stopping to provide DB plans (Royal Bank recently did just that). Governments have stepped to the plate by providing insurance in the event of bankruptcies etc. but have no credible funds set aside so the taxpayer is ultimately on the hook.

With regard to employees of the government itself the largesse continues unabated. The CD Howe institute just (Jan 4) published a report that is worth reading in its entirety. For the sake of brevity below is the focus of the message;

cdhowe pension report

Unlike corporations governments are not obliged to fund these obligations, and , apparently  are not even required to report them properly. In rough numbers, the Federal obligations are just under $150 bln. According to the CD Howe institute the “real” liability is a little over $225, $80 bln. more than they acknowledge. (The Federal deficit in total is around $795 bln.) The institute goes on to calculate that using the Real Return Bond yield as a discount, the government has to put aside 40/45% of the total payroll to keep up with the increasing obligations! In other words the gap the I have added in the above chart is going to widen exponentially if interest rates stay at these levels.

The easy way to understand all this is when you use the extreme case of interest rates at zero. Then there is absolutely no compounding and consequently you have to save a dollar for every dollar in retirement. If a person works 30 years and then retires for 30 years he/she would need to put aside 50% of income to receive 50% for the entire 60 years. This, by the way, is not that far from reality. As this is unreasonable where does it end?

unfunded liabilities

This chart is from one of J Mauldin’s letters. Canada is not on there but had it been it would have blended in quite nicely. Greece is the poster child in this array of countries. Obviously pension obligations are not the only government programs causing this imbalance but they are growing in importance.

Most papers publish annuity rates over the weekend. If you want to figure out what a DB plan “costs” at the time of retirement, say 65, all you have to do is pick the joint-last-to-die at age 65 column and presto you have the answer. Right now the average you get per month for $100,000 is $396. Suppose you want a $50,000 annual pension you would have to put down $1,054,852. It is easier to marry a government employee.