Returns assume dividend reinvestment and do not include any types of management fees, transaction costs or expenses. 

Your Retirement Plan is Offsides

The primary issue of contention in the recently concluded NFL referee lockout were changes the owners wanted to make to the pension plan. Specifically, the owner's wanted to freeze the existing pension and move the referee's to a 401(k). This is an issue we will continue to see, particularly for government employees, as strained budgets and poor performance have left many pension plans seriously underfunded. 

Pensions and 401(k)'s are common examples of the two primary forms retirement plans can take. Pensions are a type of 'Defined Benefit' plan. This means that the benefit to the participant in retirement is guaranteed. This number is generally a product of a percentage of the participant's salary and the number of years the participant worked for the company. As an example, an employee who worked for a company for 30 years and got a 2% credit for every year of service would be entitled to an annual pension valued at 60% of his final salary. 401(k)'s are a type of 'Defined Contribution' plan where the contribution to the plan is defined, not the benefit. They are often funded by the participant themselves, although many companies do offer matching and profit-sharing contributions.

A noticeable feature of a pension plan is that the employer is responsible for making contributions to the pension plan regardless of profitability. The company also bears the investment risk of the pension plan assets. So if the market performs poorly, a company has to make up the balance. In contrast, 401(k) participants bear the market risk of their retirement funds so that low returns mean the employee will have less in retirement.

It is these differences that make 401(k) more attractive to companies. The mandatory contributions can be particularly difficult in declining businesses (see our History piece above) as seen in recent years in the steel, airline and auto industries. Estimates of underfunding of private sector pension plans runs north of $700 billion. This does not just affect the company and their pensioners as some pension plans are insured by taxpayers through the Pension Benefit Guarantee Corporation (PBGC). The PBGC currently has a $26 billion dollar deficit which is the difference between the assets in the pensions it has taken over and the payments it expects to make on those pensions. This number hasn't changed in the last couple of years despite the improvements in financial markets:

Corporations are also extremely unwilling to take on the market risk associated with a pension plan. This is because of the extreme uncertainty associated with the return forecasting that is implicit in pension funding. The chart below shows the moving average rate of return over different periods for the California Public Employees' Retirement System (CalPERS):

Early this year CalPERS lowered its expected rate of return from 7.75% to 7.5%. That 0.25% drop cost the state general fund $167 million. If the actual return achieved is much lower than expected, the costs to the state grow substantially; a 6.2% return would mean a a $290 million shortfall, a 4.5% return would mean a $498 million hit. The problem of rosy return predictions is particularly problematic in the public sector because elected officials too often enhance pension benefits that seem 'free' based on those unrealistic expectation. Stockton, Ca. recently declared bankruptcy in large part because of generous increases in pension payments it authorized in 1999. At the time, CalPERS discount rate of 8.25% meant those increases didn't hit Stockton's budget.

The deal the NFL and its referees struck continues the pension plan until 2016, at which point it freezes and they will shift over to a 401(k) style plan. The league did agree to make significant contributions to the referee's 401(k)'s, from $18,000 to $23,000 a year plus a small match if the referees contribute to their own plan. By this deal, the NFL does commit to helping fund the referees retirement plan but they have relieved themselves of the investment performance risk of those plans. We expect that you will see similar moves in the public sector in the next few years as the full price of pension obligations begins to overwhelm the taxpayers ability and willingness to fund them.