Wednesday, November 14, 2012

What Is A Defined Benefit Pension?

By Ron York

A defined benefit pension is an arrangement where an employee agrees to receive less money for the years of active employment in exchange for the employer agreeing to pay the employee for the rest of his life.  It is a very simple concept.

 A person that has a 401(k) plan with an insurance company can elect upon retirement to get a guaranteed check for life or a guaranteed check for 10 years, without regard to the date the employee dies.  The amount of the checks under the two options are not the same.

Let's apply this same explanation to a new employee coming to work at a police department.  To simplify the computations and make it easier to grasp, I have made the following assumptions:

  • There are no step or longevity raises.  The base is the same for every police officer.

  • Wages will grow at an average annual rate of 4%.

  • The discount rate, assuming it is invested properly, is 8%.

  • The employee will work for 30 years and live 20 years after retiring

  • The pension plan is 90% of final pay

  • Annual pay for an employee covered by the pension is $100,000

  • Employees contribute 10% of pay to the pension

  • Take home pay is $90,000 per year

  • The annual pension check is $90,000 

  • Under this scenario, the employee will receive $90,000 per year for 50 years.

    Last year, the city decided to phase out the defined benefit pension.  The employees will be paid in full during their employment years, but to keep from ruffling anybody's feathers, the city will let the employees pick which plan they want.

    Here are the options:

  • 50 annual checks in the amount of $90,000 (without COLA adjustments)

  • 30 annual checks in the amount of $112,683 (without COLA adjustments)

  • Using the above assumptions, both plans are of equal value, if compared at present value.  Before you pension haters have a cardiac arrest, forget about the validity of the assumptions.  You can use any assumptions you want.  This presentation is only shown as a concept, and is not being held as typical or average.

    Let's review the pension arrangement.  In exchange for a lower paycheck during the active years, the employer agrees to pay the employee for the rest of his life.  Notice, it is not a commitment by the employer to make deposits into a pension plan.  The employer only commits to annual checks, not some advanced funding mechanism.  Screw GASB!  GASB does not apply!  GASB has nothing to do with funding of pensions.  GASB is only about ink on paper, not reality.  GASB only rules in Kubla Kan or some other abstract place.  The deal is between the employee and the employer. GASB has no standing.  The employer can pay the deferred amount however it wants.  It can pay the full amount on the first day of employment or pay the deferred amounts as they come due, or anything in between.

    If there are any of you brain dead GASB parrots left, then go ahead follow the non-applicable rules handed down by the idiots in Norwalk, which allow you to contribute nothing for years, followed by years where you have to pay out the wazoo. The rest of you with a still functioning brain restructure how you are paying for the deferred amounts.  Don't assume that investment returns will be in crapper into infinity.

    Has anyone seen my unfunded liability?  No!  I do not have a description.  All I have ever seen is some ink on a piece of paper that claimed to be a proxy.  Boy, that unfunded liability is as elusive as "Red John" or the "one-arm" man.

    Before I go, let's have a pop exam.  How much cash does a billion dollar unfunded pension liability demand?  Envelope please.  And the answer is none - zero.  You see, the very fact that it is shown on the balance sheet is proof that it is an unliquidated claim.  Only liquidated claims (the pension checks as they come due) require cash.  But, GASB!  But, GASB!  Yeah, yeah!