By: Bob Collie, FIA, Chief Research Strategist, Americas Institutional
OCTOBER 2012
A perspective on retirement
security: Who stands behind
America’s pensions?
This article broadens the discussion of the security of pension promises
by considering the funding of those promises as well as investment
strategy and the question of whether a backstop will step in should
additional future contributions be required.
In particular, I argue that too little recognition is currently awarded to the
importance of the plan sponsor as a backstop and that too little thought
is given to how this role affects funding and investment decisions. This
role should not be seen as a contingency but as a fundamental
component of retirement security.
A more solid foundation for debating retirement provision
Retirement provision is a big business. A huge amount of effort and a large part of the
financial services industry is devoted to providing income to individuals in their retirement
years. The approaches to retirement provision include state-provided benefits, employersponsored plans, and individual savings vehicles. The merits and robustness of these
various approaches are the subject of considerable debate. The challenges are made all
the greater by a weak economy and volatile markets.
However, the debate is not always as informed and rational as it should be. Advocates of a
particular approach can be guilty of seeing only its strengths (and thus fail to take the
necessary steps to ensure the potential weaknesses are properly managed) while critics
can be equally focused only on weaknesses. Too often the important questions get lost in
the rhetoric.
This article offers a more-solid foundation for this debate by providing a better-defined
framework for thinking about the security of pension promises.
This article was
first published in
Investments &
Wealth Monitor,
1
Sept/Oct 2012. .
1
Collie, R. (2012, September/October). “A perspective on retirement security: Who stands behind America’s
pensions?”. Investments & Wealth Monitor by Investment Management Consultants Association (IMCA), 35-40
Russell Investments // A perspective on retirement security: Who stands behind America’s pensions?
Frank Russell Company owns the Russell trademarks used in this material. See “Important information” for details.
Nothing is certain
Nothing is certain in life, and the provision of retirement income—played out as it is over
decades—is an especially uncertain game.
Let’s consider three aspects of this uncertainty:
1.
Funding. How much money is set aside today?
2.
Investment. How much risk is being taken in the investment of those assets?
3.
Backstop. What happens in case of a shortfall?
Each question is relevant to a proper understanding of the security of the benefits provided
by the various approaches to retirement provision. The third question—the question of a
backstop in the event of a shortfall—is, however, often overlooked. It is an important
question because it addresses what happens if the funding regime proves inadequate and
also because it affects the approach to the first two questions. The stronger the backstop,
the wider the choices in funding and investment strategies. So it is important not only to look
at each of the three questions listed above, but also to consider how they interact with each
other.
First, a quick word about Social Security. I treat Social Security here as a given, a fixed
reality on top of which other systems operate. In reality, of course, Social Security has a
funding regime, an investment program (albeit an investment program that takes place
entirely within the government’s books), and a backstop—the U.S. government—should
funding prove inadequate. However, the size and legal basis1 of Social Security put its
further discussion beyond the scope of this paper.
Funding: Money set aside today to provide for tomorrow’s retirement
Most approaches set money aside to back the targeted retirement income. The amounts
vary considerably. At one extreme are employment-based pensions provided to federal
employees before 1986 under the Civil Service Retirement System (CSRS). A significant
part of these promises have not been pre-funded; they are paid when they fall due out of
current federal government revenues. Despite a substantial unfunded liability of roughly
$750 billion as of September 30, 2010 (OPM, undated), these pensions are backed by the
full faith and credit of the U.S. government. The funding arrangement is exceptionally weak,
but the backstop is exceptionally strong.
By contrast, consider the assets that must be set aside to fund benefits paid by insurance
companies. Insurance companies are required to hold reserves against their book of
annuity business based on cautious assumptions about interest rates and mortality. Those
required reserves are materially larger if the assets are invested in anything other than the
safest investments. This approach reflects the fact that insurance companies have no
backstop, nowhere to turn for additional funding in the event of a shortfall. So if the
insurance industry is to survive through thick and thin, it must take a cautious and long-term
approach to funding and investment.
The stronger the
backstop, the
wider the choices
in funding and
investment
strategies. So it is
important not only
to look at each of
the three
questions listed
above, but also to
consider how they
interact with each
other.
Between these two extremes lies a range of approaches to funding. At the heart of any
funding approach is a discount rate, which provides a means of placing a present value on
future money. In other words, how much of today’s money will it take to get a payment of $1
at some point in the future?
Table 1 shows the value that would be placed on a payment stream of $1 a year for each of
the next 40 years using a variety of discounting approaches.
Russell Investments // A perspective on retirement security: Who stands behind America’s pensions?
/ p2
Table 1: Present value of a 40-year, $1/year liability stream under various
discount rates
Discount rate
Value
Fixed rate of 8%
$11.92
Fixed rate of 7%
$13.33
IRS Yield Curve as of January 1, 2012
$17.69
IRS Yield Curve as of January 1, 2009
$13.61
IRS Smoothed Segmented Yield Curve as of January 1, 2012
$13.25
Treasury Yield Curve as of January 1, 2012
$24.72
Public pension plans (such as those for state or local government employees) tend to use a
fixed discount rate in their funding; 8 percent has been typical though lower rates are now
becoming more common, reflecting the fall in yields on most fixed income investments over
recent years.
Corporate plans use discount rates that are tied explicitly to high-quality corporate bond
yields. We see that the same liability stream, priced off those yields, would have increased
in value by around 30 percent between January 1, 2009, and January 1, 2012, due to the
fall in interest rates. The average segmented yield curve is not strictly a separate yield curve
but rather a 24-month moving average of the full Internal Revenue Service (IRS) yield
curve, as adjusted under the provisions of the Moving Ahead for Progress in the 21st
Century Act of 2012 (provisions that were intended to stabilize funding requirements at a
time of unusually low interest rates). The average segmented curve is widely used in
practice to value liabilities because it reduces the volatility of the valuation results. As of
January 1, 2012, it produces a liability value some 25 percent below that based on the full
IRS yield curve.
Pension arrangements in the United States typically are funded based on corporate yields,
but this is not the case elsewhere in the world. Funding rules in the United Kingdom and
Japan, for example, key off of government bond yields. The Treasury yield curve represents
the closest thing available to a U.S. risk-free discount rate and hence is an indication of the
impact of basing funding policy on risk-free rates, without counting on future investment
returns greater than those that can be locked in today. (This sum includes no margin for
mortality risk or other contingencies, so it is only risk-free on the investment side.)
Because of the
uncertainty of
investment returns
and the possibility
of future capital
injections, funding
can be seen as a
question of
choice.2
Table 1 shows the assets that would produce a 100 percent funded status using each of the
various discount rates. The funded status of a plan varies in practice, and today most
arrangements are less than 100 percent funded. The amount of money actually set aside
against the same liability under different systems therefore varies even more than indicated
in table 1. For example, a plan that is 95 percent funded using a fixed discount rate of 8
percent may hold $11.32, while a plan using the full IRS yield curve as of January 1, 2012,
and holding $15.92 would be 90 percent funded—and would have been more than 115
percent funded at the start of 2009.
In other words, because of the uncertainty of investment returns and the possibility of future
capital injections, funding can be seen as a question of choice.3 That choice, however, is
tied closely to investment strategy and the nature of the backstop, which I examine below.
Russell Investments // A perspective on retirement security: Who stands behind America’s pensions?
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Investment strategy: A trade-off of risk and return
A cautious approach to funding, such as that required of the insurance industry, goes hand
in hand with a cautious approach to investment, and more-aggressive funding approaches
tend to be associated with more-aggressive investment strategies.
This relationship makes sense to the extent that a risk premium exists, i.e., that riskier
investment strategies tend to deliver higher returns over time. In table 1, we noted that a 40year $1 liability stream would be valued at $11.92 using a discount rate of 8 percent and at
$13.33 using a discount rate of 7 percent. In other words, $11.92 will be adequate to fully
meet that liability assuming an 8 percent annual return, but if we are going to earn only 7
percent, then we need $13.33.
We see this expectation of earning a future risk premium in the return expectations
published by various institutions. For example, corporate accounting statements (e.g., 10-K
filings) indicate that the expected long-term return on assets for the typical corporate
defined benefit (DB) plan is 7-8 percent a year. Because the effective yield on Treasuries
when those expectations were published was around 4 percent a year, the implied expected
risk premium is 3-4 percent a year over Treasuries.
The riskier
investment
strategy does not
Table 2: Estimated typical investment strategies of various retirement systems
offset the weaker
(U.S.)
funding regime,
Real estate
Other
System
Equity
Fixed income
Federal DB
100%
but rather
Public sector DB
55%
30%
5%
10%
compounds it.
Table 2 shows my estimates of representative investment strategies for various types of
retirement arrangements in the United States.
Corporate DB
45%
40%
5%
10%
Multi-employer DB
50%
35%
5%
10%
Insured arrangement
-
100%
-
-
Defined contribution (all types)
60%
10%
-
30%
Remember, however, that risk in the investment program opens up the possibility of loss.
Risk may be rewarded over time and lead to higher investment returns, which is obviously
the intention—but this outcome is not certain. A riskier investment strategy should generate
better returns, but it certainly will not do so over every time period and the periods of
underperformance can be long and severe. The perspective of benefit security requires that
we consider the likelihood that the backstop will be called upon (rather than the average
expected outcome over the long term) so, from this perspective, the riskier investment
strategy does not offset the weaker funding regime, but rather compounds it.
Therefore a case could be made that increased investment risk should lead to an increased
funding requirement. We can see this, for example, in the funding system used in the
Netherlands, a country with pension regulation based on insurance principles. Those
principles have been summarized by Ansley et al. (2010) thus:
 “When you make a pension benefit promise, define its value by reference to the value
of the assets that most closely match those liabilities in timing and size.
 No assets match perfectly, so add the requirement for risk capital to the extent of 5% of
this value. The minimum acceptable funding level is therefore 105% of this value.
 It is perfectly reasonable for a sponsor to want to exploit the long-term likelihood of
being rewarded for taking equity risk in the capital markets, and thereby reduce the
long-term cost of providing benefits. But all risk first requires risk capital to back it.
Russell Investments // A perspective on retirement security: Who stands behind America’s pensions?
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Depending on the extent of the equity risk taken, there is a prescribed amount of
additional risk capital required. For high equity exposures, this could require risk capital
of a further 25% of the liability value, creating a minimum acceptable funding level of
130% of the liabilities.
 Shortfalls relative to the minimum acceptable funding level must be made up quickly,
within 3 years (though this has recently been extended to 5 years).”
The Dutch insurance-type approach aims to minimize the likelihood of a shortfall. This leads
to more assets being set aside and a cautious investment strategy, and if a less-cautious
investment strategy is followed, then an even more-cautious funding strategy.
Most U.S. approaches, however, aim to reduce the cost of retirement provision by targeting
higher investment returns and being less cautious in funding. This increases the likelihood
that at some point a shortfall will arise and additional capital will be needed from
somewhere. A proper understanding of that “somewhere” is therefore essential to any
analysis of the various systems in operation in this country. The backstop role should be
seen as an integral part of the system design and a material element of benefit security.
Contingency: Who provides the backstop?
If the funding regime and the investment strategy prove inadequate, retirement security
depends on a backstop and how far the backstop will go to ensure that the targeted benefit
is actually paid. The weaker the funding regime and/or the riskier the investment approach,
the more important the backstop becomes.
FEDERAL EMPLOYEES, BACKED BY THE FULL FAITH AND CREDIT OF THE U.S.
GOVERNMENT
Consider, for example, federal government employees. We described above how no assets
at all are set aside against a large part of the liabilities of the Civil Service Retirement
System. The good news is that the backstop is the full faith and credit of the U.S.
government, which would be high on just about anyone’s list of preferred guarantors of a
financial promise. Indeed, because that same full faith and credit backs Treasury bills and
bonds, one could choose to see benefit security as similar to that of a cautious funding
regime invested entirely in U.S. Treasury securities.
So CSRS beneficiaries can probably rest easy. Taxpayers may be less happy with this
arrangement, of course, because it can lead to overpromising; the true cost of a valuable
employee benefit can be overlooked if it is not funded. Indeed, this is a large part of why
CSRS was replaced in 1984 by plans with clearer accounting for the costs of benefits. For
the DB component of federal employee retirement, the successor to the CSRS is the
Federal Employees Retirement System (FERS) annuity. Unlike CSRS it is a funded system,
although it is funded with “budget authority,” or special-issue bonds that involve intraagency accounting transfers. Because FERS is an agency of the U.S. government, not a
separate legal entity, the books all roll up to the same place; hence the funding all takes
place within the books of the U.S. government. As an aside, this is the same approach that
is taken to funding Social Security.
If the funding
regime and the
investment
strategy prove
inadequate,
retirement
security depends
on a backstop and
how far the
backstop will go
to ensure that the
targeted benefit is
actually paid.
Thus, the funded liabilities depend on the U.S. Treasury making good on its obligation
regarding the special class of bond, while the unfunded liabilities depend on the U.S.
Treasury making good on its obligation regarding the benefit promise itself. In other words,
in this case the main difference between funding and not funding seems to be its treatment
in government accounts and the calculation of the national debt, not any substantive
difference in the degree of benefit security.4
Russell Investments // A perspective on retirement security: Who stands behind America’s pensions?
/ p5
DEFINED CONTRIBUTION HAS NO BACKSTOP AT ALL
A DC approach is quite different. DC includes individual retirement accounts, 401(k) plans,
403(b) plans, 457 plans, and the federal-employee Thrift Savings Plan (TSP).
DC approaches have no backstop. The existing assets and the investment returns earned
on them are the only layers of security; if the money turns out to be inadequate for a
particular level of benefit, then the retiree must settle for less. (It’s worth noting, however,
that DC also provides its participants the benefit of any upside.)
The absence of a benefit promise removes the possibility of an explicit shortfall and hence
the need for a backstop. Which is not to say that DC plans cannot fail; they can. Failure
simply takes a different, vaguer shape. A lifetime of saving may result in an inadequate level
of retirement income if investment experience is poor. Indeed, it is the nature of a DC
system that different individuals will experience different levels of investment return; cohorts
with key savings years that coincide with the strongest markets will enjoy more-prosperous
retirements than their unlucky counterparts a few years ahead or behind them. It is
inevitable that some groups will fare far better than others.
INSURED ARRANGEMENTS HAVE GUARANTY ASSOCIATIONS AS BACKSTOPS
I described earlier the way in which the funding and investment regimes of insurance
companies are designed to make insolvency unlikely. This means that the backstop plays a
less-central role than in other arrangements. Nonetheless, occasional insolvencies can and
do occur. When they do, there is a backstop in the form of state guaranty associations. The
protection these associations offer is limited and varies from state to state, but the key point
is that even with cautious funding and investment rules, the backstop role remains relevant.
CORPORATE DB, WITH THE CORPORATION AS PLAN SPONSOR
Having examined approaches where benefit security rests entirely on the backstop (CSRS),
entirely on the funding reserves (DC), or almost entirely on the funding reserves (insured
arrangements), we can move on to the finer nuances of other arrangements.
Among these
corporations,
there is enormous
variation in
ability to
underwrite
fluctuations in
pension plan
experience.
A sizeable minority of U.S. corporations still offer DB pensions. Of the 3,000 largest U.S.
listed corporations, more than 900 sponsor DB plans.
Among these corporations, there is enormous variation in ability to underwrite fluctuations in
pension plan experience. For example, Collie (2008) compares the airline industry to the oil
industry (based on 2007 10-K filings as captured by Factset) and notes that:
 “Seven airlines in the Russell 3000® Index have defined benefit plans. Six corporations
in the integrated oil sector of the same index have defined benefit plans. The pension
plans of the two industries, in aggregate, appear to be quite similar: somewhat
underfunded, and with benefit accruals that are modest relative to existing assets …
 The oil companies have total DB assets of $49 billion. Their combined projected benefit
obligation (PBO) is $59 billion. So the funded status for the industry as a whole is
around 83%. The combined service cost of the six corporations (i.e., the cost of the
benefits accruing in 2007) is $1.66 billion, just under 3% of the PBO.
 On the surface, that is not very different from the airline industry. The seven airlines
show total DB assets of just over $23 billion and a combined PBO of $31 billion: an
industry funded status of 76%. The service cost of $537 million is slightly below 2% of
PBO …
 (However), the oil companies’ PBO is equivalent to about 6% of their combined market
capitalization. For the airlines, the comparable number is more than 150%. Indeed, the
unfunded portion of their PBO is equivalent to almost 40% of the airlines’ combined
total market capitalization.”
Russell Investments // A perspective on retirement security: Who stands behind America’s pensions?
/ p6
This variation in the size of the plan relative to the corporation, which is variation that exists
among corporations within an industry as well as across industries, is important in
assessing the role of the corporation as backstop. If the plan is relatively small, the
backstop role is easy to play and not disruptive to the general operation of the plan sponsor.
If the plan is large, then even the normal year-to-year variation in plan experience can
disrupt the corporation’s financials.
It is difficult for plan fiduciaries to question the strength of the plan sponsor’s covenant when
making decisions about funding and investment; doing so might be seen as disloyalty or
being unsupportive. Thus it is uncommon to give meaningful consideration at the plan-byplan level to the plan sponsor’s role as backstop. Nonetheless, that role is critical whether it
is formally acknowledged or not.
Should the corporation fail, the Pension Benefit Guaranty Corporation (PBGC) provides the
next level of backstop. This independent agency of the U.S. government is funded by
premiums charged to DB plans. The PBGC takes over plans of failed corporations by taking
over the assets and assuming responsibility for paying the benefits, usually at a reduced
level; individual benefits are capped at $4,653 a month for 2012. As of September 30, 2011,
the PBGC was trustee for 4,292 single-employer plans, with assets totaling $79 billion and
liabilities valued at $102 billion, for a shortfall of $23 billion (PBGC 2011).
As the number of open DB plans continues to shrink, the premium base of the PBGC can
be expected to fall. There is no explicit government backing for the PBGC, so more
attention has been paid over the years to ensuring that it is able to meet its liabilities. The
Pension Protection Act of 2006 (PPA) resulted in part from a desire to reduce the incidence
and size of plan failures and the pressure on the PBGC caused by each new plan failure.
The PPA includes measures designed to shore up funding of corporate DB plans, and
represents a step in the direction of fuller funding and a reduced reliance on plan sponsors
as backstops. But, as is made clear by the analysis in this paper, it did not remove that
reliance; the backstop role of the plan sponsor remains important.
CASH BALANCE BENEFIT SECURITY OPERATES LIKE A DB PLAN
Cash balance plans are classified as DB plans but the benefit offered is based on an
account balance rather than a targeted annual benefit amount. The account balance does
not vary with actual investment experience (as in a true defined contribution arrangement)
but is increased each year with an interest credit. Sometimes called hybrid schemes, cash
balance plans are distinct enough from pure DB and DC that they deserve separate
consideration.
Public sector
plans vary more
than private
sector plans
because they are
not governed by a
single set of rules
or regulations,
but by legislation
that is passed
state-by-state.
There is no PBGC
or equivalent to
act as a second
layer of backstop.
The cash balance plan benefit is more akin to a DC benefit than a DB benefit, but its
security works like a DB arrangement. The plan sponsor funds the benefits as they accrue
and investment policy typically involves some risk-taking in pursuit of higher returns. In the
event of a shortfall, the plan sponsor is required to make additional contributions. If the plan
sponsor fails, the PBGC can take on the assets and liabilities. So as far as benefit security
is concerned, cash balance plans are very much like other DB plans.
PUBLIC SECTOR DEFINED BENEFIT HAS SIGNIFICANT VARIATION
Public sector plans vary more than private sector plans because they are not governed by a
single set of rules or regulations, but by legislation that is passed state-by-state. There is no
PBGC or equivalent to act as a second layer of backstop.
Public plans vary in size from very small to the mighty CalPERS, which had 1.6 million
members and $227 billion in assets as of May 31, 2012 (see www.calpers.ca.gov). Public
plans vary in the strength of their funding and in investment strategy. They also vary in the
nature of the backstop. An extreme example is Prichard, Alabama, which stopped paying
Russell Investments // A perspective on retirement security: Who stands behind America’s pensions?
/ p7
pensions in September 2009 because its pension plan assets completely ran out (Cooper
and Walsh 2010). Alabama law requires the city to pay the pensions, but Prichard found
itself unable to do so. Retirees sued, and a settlement was reached in March 2012 for
benefits to be paid at a significantly reduced level. There is no PBGC backing or other place
to turn apart from the municipality itself, which has twice declared bankruptcy.
So the security of public sector pension plan promises in the event of a funding shortfall
ultimately devolves to the municipality or state that sponsors the plan. As with corporate
plans, it can seem inappropriate for those close to the plan to question the strength of this
backstop. However, just as with corporate plans, it is only the existence of that backstop
that permits the funding and investment strategies we observe in practice.
MULTI-EMPLOYER DEFINED BENEFIT SHARES THE PAIN OF SHORTFALL
We round out our overview of U.S. pension systems with some observations about multiemployer plans. The Labor–Management Relations Act of 1947 (better known as the TaftHartley Act) established rules for the provision of benefits to unionized employees. These
have much in common with single-employer private sector plans as described above,
including the backing of the PBGC.
One unique feature of multi-employer plans is that the response to a funding shortfall must
be negotiated but generally will involve both an increase in contributions and a cut in future
benefit accruals. Thus workers have even more direct interest in the health of a multiemployer plan than a typical single-employer plan. If the multi-employer plan sponsors fail,
the PBGC can take over the liabilities, but the benefit cap—roughly $36 a month per year of
service—is much lower than for single-employer plans.
Conclusion: A full picture of retirement security must include the backstop
It is confidence in the role of the backstop that allows the funding and investment strategies
commonly seen in U.S. retirement provision. (The major exception is defined contribution
arrangements, which have no party to fill the backstop role.) These funding and investment
strategies are designed to reduce the cost of providing benefits, and it is a reasonable
expectation that they will do so in most cases. But these strategies have no guarantee of
success. Even if they are successful over the long term, we can be very confident that,
markets being what they are, those strategies will periodically lead to funding gaps.
For that reason, the role of the backstop is more central to retirement security than
generally acknowledged. Security for a pension promise rests not only on the funding of that
promise but also on what happens when investment returns fall below expectations and a
shortfall emerges. The role of the backstop—the plan sponsor or other entity that steps in to
make good on a shortfall—should be treated as an integral component of benefit security,
not merely a contingency plan.
The role of the
backstop is more
central to
retirement
security than
generally
acknowledged.
Security for a
pension promise
rests not only on
the funding of that
promise but also
on what happens
when investment
returns fall below
expectations and
a shortfall
emerges.
REFERENCES
Ansley, Craig, Gerben Borkent, Don Ezra, Michael Hall, and Steven Low. 2010. “As DB dies.” Russell Investments
Viewpoint (September).
Collie, Bob. 2008. “Where next for LDI?” Russell Investments Research Report (December).
Cooper, Michael, and Mary Williams Walsh. 2010. Alabama Town’s Failed Pension Is a Warning. New York Times
(December 22). http://www.nytimes.com/2010/12/23/business/23prichard.html?pagewanted=all.
Pension Benefit Guaranty Corporation (PBGC). 2011. 2011 PBGC Annual Report.
http://www.pbgc.gov/res/reports/ar2011.html.
U.S. Office of Personnel Management (OPM). Undated. Fiscal Year 2010 Agency Financial Report.
http://www.opm.gov/gpra/opmgpra/2010_AFR.pdf.
Russell Investments // A perspective on retirement security: Who stands behind America’s pensions?
/ p8
1
The 1960 Supreme Court Case Flemming v. Nestor ruled that “To engraft upon the Social Security system a concept of ‘accrued property rights’
would deprive it of the flexibility and boldness in adjustment to ever-changing conditions which it demands” and hence that entitlement to Social
Security benefits is not a contractual right.
2
This comment is made in the context of funding, not accounting. I argue in this article that hoped-for gains from an investment program and the
reassurance of a guarantor in the event that those gains do not materialize can provide acceptable grounds for setting aside less money today,
provided all concerned are aware that this is being done. Extending that argument to say that it is reasonable to take credit for those future gains
in current accounting statements would seem—on the surface at least—to be at odds with established accounting principles. Within an accounting
context a completely different analysis is necessary.
3
ibid
4
If push ever comes to shove, we likely will find an unstated seniority of some U.S. government obligations over some others. This prioritization
very nearly was tested on August 2, 2011, when political fighting over the raising of the debt ceiling almost led to the government defaulting on
some obligations—with contractor payments, welfare spending, and tax refunds rumored to be among the obligations at risk. Officially, though,
there is no stated order of priority in the event of default.
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Russell Investments // A perspective on retirement security: Who stands behind America’s pensions?
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