How Safe Is Your Pension?

April 1st, 2009

We are well aware of how declining stock prices affect our investment portfolios. However, little attention has been paid to how the recession is affecting pension plans, even though most pensions hold risky investments, such as stocks and real estate, in their portfolios.

So, how safe is your pension? Let’s look at each type of pension.

Federal Government. Federal pensions are an exception; they are safe. Both CSRS and FERS pensions do not invest in the market. Instead, they pay monthly checks out of federal budget allocations, which are directly funded by taxpayers and government borrowing.

State and Local. The safety of state and local pensions is harder to determine because they do hold risky investments and their future will depend on political decisions. They also have huge liabilities, in the form of benefits promised to current employees and retirees, in excess of money saved for those promises.

Estimates are that state and local governments’ unfunded pension liability exceeds $700 billion (almost the size of the economic stimulus plan passed by Congress in February). To cover this shortfall, states will have to raise taxes, cut current services, and/or reduce pension benefits. Sparks will fly when state and local governments finally address this issue.

Private. Private pension plans have two big exposures to the weak economy. First, corporate pension funds typically hold a large portion of their investments in stocks and other volatile securities, which have fallen in value substantially. Second, the security of private pensions depends on sponsoring companies fully funding their obligations. When companies are in financial trouble, they try to delay contributions to their pension plans. Obviously, the recession will cause many companies to be unable to pay their obligations.

To protect employees and retirees from bankrupt private pensions, the government established the Pension Benefit Guarantee Corporation (PBGC), which insures annual pension benefits up to $54,000 per year. The PBGC Act is effective for pensions with moderate benefits, but employees with larger pensions are exposed to the health of the company plan. The PBGC does not cover municipal and state retirement plans.

Some private pensions offer lump-sum payout to participants, which enables them to convert the monthly checks they would receive for the rest of their lives into cash that can be invested in an IRA. This lump-sum payout might be available immediately, or it might come in a series of payouts over a few years.

Obviously, giving up the security of a monthly check in order to hold investments in risky markets does not make sense for many people. But there are cases where it really makes sense, including:

• Participants who have benefits that are greater than the amount insured by the PBGC. They are at risk of losing a large part of their retirement benefit if their pension fails.
• Participants who are more interested in leaving an inheritance to their children. The returns on a long-term stock investment are likely to exceed a pension’s returns.
• Participants who do not expect to live long lives. In order for a monthly check to be worth more than a lump sum, a retiree should anticipate receiving those checks for a long time.
• Participants who want to buy investments when the market is low and earn a higher return than their pension provides.