Detroit is a long way from California, and it’s easy to believe that this once magnificent city’s financial troubles have little to do with those of us in the rest of the nation. But such a belief is more than mistaken; it could be fatal to your retirement plan.
The primary lesson to be drawn from Detroit’s bankruptcy filing is that pensions are not sure things. The Detroit bankruptcy isn’t a headline just because it is the largest public bankruptcy in U.S. history. It’s incredibly newsworthy because a federal judge has just affirmed that the city’s pension obligations are no more protected than any other creditor’s claims against the city. In other words, pensions can – and will – be renegotiated in a bankruptcy.
The point is that no matter how deserving the retirees are, pensions are not a guaranteed source of retirement benefits. We have to understand that there are circumstances in which pension benefits might not be paid. And that is an extremely significant issue for retirement planning.
The reality of this situation flies in the face of public perception. Most Americans think of pensions as somehow being inviolate. It’s what’s been promised to them for years of hard work, and they’ve counted on it being there when they retire. For those who have them, pensions are usually an incredibly large part of their retirement plan. Unfortunately, pensions are just promises. In many situations, they are incredibly safe promises, but in others – as Detroit’s bankruptcy is proving – they are shaky at best.
A pension is a promise to pay a certain amount of money on a specific date. Sometimes the amount to be paid is actually a stream of payments which is supposed to continue for life, while other times it is a lump sum which is supposed to be paid at the retirement date. As with all promises to pay in the future, they are liabilities. Whoever makes them (a city, a state, a private company) needs to record the liability on its balance sheet so everyone knows what is owed and when. Pensions are regulated, and the laws require the provider (again, the city, state, or private company) to put aside money to meet the future obligation. Unfortunately, providers do not have to put aside the full amount of the future obligation. Pension providers are allowed to maintain a certain amount of the liability as “unfunded”. When we hear the term “unfunded liabilities” in reference to our city, state, or federal budgets, it is in reference to these promises that have been made to public workers of which a portion hasn’t yet been covered.
The size of the unfunded liability determines the risk of default and should therefore be considered by anyone who is a beneficiary of a pension. There are two critical decisions to be made in retirement planning where pensions are involved.
The first decision is naturally how much reliance to place on the pension. If your pension represents the lion’s share of your retirement assets, then a large unfunded liability may mean your pension benefit is at risk and therefore so is your retirement plan. On the other hand, if you have also consistently been saving money for retirement, then your pension might not represent as large a part of your retirement assets. The lesson is obvious: save for your retirement – do not simply rely on your employer.
The second decision concerns how you take your pension benefit. In many pension plans, the retiree is given an option at retirement as to whether they want to take a lump sum payment or a stream of payments for some portion or all of the remainder of their life. There can be a lot of options, and it is very often difficult for the average person to determine which option is best for them.
However, the Detroit bankruptcy changes the dynamics of this decision considerably. Before Detroit, it was a matter of figuring out which option was best for you, but there was never a concern that some options might not be real. Whether you took the money all at once, or took it over the rest of your life, it was a pretty safe assumption that the money would be there. Detroit just demonstrated this is not a safe assumption.
From now on, retirees will have to factor in the risk that if they take a stream of benefit payments, those payments might not be there in later years. Under such a scenario, taking the lump sum is the better option. Once the check clears, you’re home free.
So how bad are some of the nation’s public employee pension systems? How much should we worry? The following sample illustrates a nationwide problem:
Illinois: 76% unfunded
Connecticut: 75% unfunded
Kentucky: 73% unfunded
Kansas: 71% unfunded
Mississippi, New Hampshire & Alaska: 70% unfunded (each)
California: 68% unfunded
National Average: 61% unfunded
These numbers are staggering in their own right, but are even more surreal when you consider that private pensions (those offered by private companies to their employees) are held to a higher standard. According to Bill Bender, a partner at Bender, Lippert & Associates., a pension benefit administration firm in Westlake Village, CA., private pensions are effectively limited to being no worse than 20% unfunded.
The statistics above are painful. As these numbers show, pension dangers are not isolated. Even if your pension is from a private employer, who wants to see their retirement benefit potentially shaved by 20%? Detroit is simply the canary in the goldmine. We can complain, and there is certainly justification for at least complaining, but to be wise we need to take action. Detroit’s bankruptcy – like Stockton’s and Vallejo’s before – should prompt everyone who has a pension to promptly reevaluate the safety of their retirement plan and take corrective actions if necessary.
“Never spend your money before you have it” Thomas Jefferson