Problems with Pensions - Funding Status

An article by New York Institute of Finance pensions instructor Larry Morgan.

Among the many intriguing and diverting questions which the pension cosmos contains, three have presented themselves to me lately.

Pension beneficiaries and plan sponsors do not have the same interests. Oh, their interests are not so directly opposed to one another as are those of two speculators on opposite sides of a single trade, but often the less a beneficiary receives, the more a plan sponsor, in particular a corporate sponsor, keeps for itself.
Asymmetric information – a popular aspect of many financial questions these days – can affect what sponsors and beneficiaries decide to do.
The terms of a plan can change.
These questions come to mind because several weeks ago BP made news by proposing that current beneficiaries were offered a “pension increase exchange” (PIE this is “acronymmed”, offering scope for a lot of silly puns). BP and other firms already had offered PIEs to current workers, but this one was offered to those already retired.

The idea of a PIE is this:

Consider a defined benefit pension which pays an inflation-indexed annuity. In the first year it pays ₤10,000 (most of these seem to be in the United Kingdom – I haven’t encountered one in the U.S., but please tell me if you know of any); the next year that is increased by the rate of inflation, say to ₤10,200 if inflation is 2%; and on and on like that.

A PIE proposes to the annuitant that this be exchanged for a new annuity whose initial amount is larger, say ₤12,000 but which does not increase with inflation. Hence an “exchange” for a “pension increase”, therefore PIE. The annuitant can accept or reject the proposal.

Why would the sponsor propose this? Well, this gets to the first question, that sponsors’ and beneficiaries’ interests are not identical. If the sponsor anticipates inflation over the next, oh, 25 years, the amounts it will have to pay out to annuitants will increase year after year. Accordingly, it proposes to convert this increasing annual outflow to a stable, unchanging – but initially higher – annual outflow. It’s a simple matter to calculate a flat annuity whose present value is less than the present value of the inflation-indexed annuity and propose that amount for the PIE. Depending on the inflation rate expected and the real discount rate anticipated, the increase in the first year can be 30%, 40%, 50% and still reduce the payments from the sponsor.

The first graph below shows hypothetical annuity payments which begin at ₤10,000 and increase by 2% per year due to inflation (orange), and flat annuity payments of ₤12,000 (blue). Depending on where that fixed annuity level is set, the total payments from the plan sponsor may be greater or less than the payments for the indexed annuity, in current cash or in present value (shown in the second graph). So the sponsor will offer a fixed annuity at a level that means a smaller total outlay. The sponsor will naturally benefit from that for the sponsor sets the exchange terms.

Pensions Inflation-Indexed and Constant Annuities Inflation-Indexed and Constant Annuities

This leads to the second intriguing question, asymmetric information. For the most part, the plan sponsor is in a better position than the annuitant to evaluate the exchange – what will the rate of inflation be? how should the cash flows be evaluated? how will inflation erode the value of the fixed payment? Granted, for long-term macroeconomic projections such as inflation and discount rates, “symmetric ignorance” may be more accurate than “asymmetric information”, but normally workers are not financially well informed and they may not have access to competent financial advisors. There is a voluntary code of principles for pension exchanges (PIEs as well as other proposals to alter the terms of a pension) but I don’t know how reliable or thorough those might be. Workers or retirees may be easily misled by the prospect of a higher payment today – something like the famous problem “would you rather have ₤1 million today or 1 penny which doubles every day for one month?”

The other side of asymmetric information, though, may work in favor – if that is the word –of the annuitant. If the annuitant knows that he won’t live until the point where the inflation-indexed payment would be higher than the proposed fixed payment he will take the exchange, seeing that for his prospective life he will receive a greater amount.

The third question is obvious now – the terms of the plan can change. Besides all the basic risks and uncertainties that confront the retiree – age, health, outliving financial resources – there is the risk that one can be offered an alteration in one’s retirement plan, an “exchange” that offers a “pension increase”, and be attracted, perhaps even deceived, by the headlines before reading the fine print.

About New York Institute of Finance

With a history dating back more than 90 years, the New York Institute of Finance is a global leader in training for the financial services and related industries with course topics covering investment banking, securities, retirement income planning, insurance, mutual funds, financial planning, finance and accounting, and lending.  The New York Institute of Finance has a faculty of industry leaders and offers a range of program delivery options including self-study, online and in classroom.

For more information on the New York Institute of Finance, visit the homepage or view in-person and online finance courses below: