Inflation has a significant and sometimes severe impact on the overall economy. The impact on prices can be felt far and wide in the world of commerce, but an even greater concern is the impact of inflation on the investment sector. With rising interest rates, the stock market has whiplashed up and down with volatility. The bond markets have also been roiled, but most troublesome could be what can happen to pension funds.
Defined-benefit pension plans: For decades pensions worked on the premise of what became known as the defined-benefit pension plan. Employers would offer plans to their employees that paid set amounts in the form of an annuity at regular intervals throughout the employee’s retired life. The plan would compute the potential liability in much the same way that insurance companies compute the liability for whole life insurance. In more recent times since the 1980’s these calculations have become obsolete as the average length of time an employee lived in retirement grew extensively. The amount of capital originally set aside for the payouts proved time and again to be inadequate. Many companies began to move away from defined-benefit plans to other forms such as the 401K, where the employee shoulders a portion of the investment risk, and makes his own decisions about withdrawals.
Fixed Incomes: Most retirees live on fixed incomes. They receive a direct hit from inflation when their costs of living go up, and there is no opportunity to increase income. Defined-benefit pensions are sensitive to inflation as the investments are usually placed into corporate bonds which are safer in the long run than equities. When interest rates rise to fight inflation, the value of existing corporate bonds begins to decline as new issues are released with higher coupon interest rates. The decline in capital from this macroeconomic process is accentuated by rising life expectancies. Before long, pension managers can easily see that their capital supply cannot cover the entire scope of the future payouts.
State and local governments still use the defined-benefits approach: As much as $13 trillion of defined-benefit pensions are managed by state and local governments for public employees. The plans are often managed outside of government and are funded regularly via tax receipts. Some of the biggest ones, however, are run by public institutions such as CALPERS, the California Public Employee’s Retirement System. They can be impacted by the double-edged sword of rising interest rates and bad investments. The system works as long as the plan is fully funded, meaning that the capital it has invested generates enough money to cover the liabilities of the payouts. Some states such as California are fully or nearly fully funded, whereas others are not. In certain states the funding is very low adding to fiscal misery that could become burdensome to taxpayers in the unforeseen future. The funded ratio is determined by the combination of three factors: the value of the current capital amount, the discount rate used to determine the present value of the future payouts, and the strength of the stream of the future payouts. Inflation can disrupt any or all of those three factors.
Underfunded pension plans: Underfunding a pension plan occurs when either the contributions paid in by the sponsoring entity are not high enough and/or the managers of the assets make some investing blunders. Bad investing years can also cause a decline without mistakes by managers as stock and bond values fall unexpectedly pressuring the amount of capital needed for payouts. The funding ratios can decrease only so much before the plan has serious problems. When the funding reaches as low as 40%, the fund likely cannot generate enough income from its capital to fully make the payouts. As a result, the capital itself is consumed causing the future income stream to decrease even more. When the capital is mostly gone, the fund is working on a “pay go” system whereby the latest contributions are consumed to make the current payouts assisted by little or no investment income.
Social Security: Social Security in America works slightly differently than other defined benefit funds in that it is almost entirely on a “pay go” basis. Money that is paid in via the employee tax is not invested in the usual sense in that any residual is generally borrowed by the federal government’s general fund to help cover the deficits with government bonds as collateral. Some of the payouts are managed by the yield on the bonds, but much of it comes from “pay go” meaning that the tax receipts go directly over to pay the recipients. The mathematics behind Social Security tells us that the system is “solvent” until at least the next decade. The program has been facing huge increases in recipients coming from the baby boomer generation, but the number of new recipients is expected to be offset by the increased number of deceased recipients in the approaching future. The system is really a program that was created by the government and has very little to do with the actual management of a pension fund.
Conclusions: Retirements formerly were something that could be relied upon just as the security of a steady job brought in current income. An employee would receive as a benefit of employment a guarantee of a certain percentage of income in retirement for life. This process has steadily declined over the years in popularity in the private sectors, but still remains a mainstay in the public sector. Inflation has the potential to push private sector plans managed in the financial markets to the point of dissolution.
Sources: The Economist, The Incredible Shrinking Plan, December 10th, 2022.
Thank you.