In recent years, there has been a lot of media coverage about the funding status of pension plans for state employees. In many states, the amount of money invested in employee pension plans is far less than the amount estimated to be needed to pay them the retirement benefits they have been promised. Basically, pension plans work by investing enough money while employees are working so that the money invested, plus the investment income it earns over the years, will be sufficient to pay the workers their retirement incomes once they have retired.
There are many complicated assumptions, estimates, and calculations needed to determine how much money a state should invest in its pension fund each year. One of the most important assumptions is the rate of return the plan's investments will earn in the future. As you have seen in this chapter, the higher the rate of return used to calculate the present value of future cash flows, the lower the present value will be. To determine a pension plan's funded status, actuaries (1) estimate the future cash payments expected to be made to employees, (2) calculate the present value of those cash flows using an assumed rate of return (this present value is the gross liability of the fund), and (3) subtract the amount of money that has been invested from the gross liability calculated in step 2 (this amount is the funded status of the pension plan). Essentially, this is the same as calculating the net present value of an investment. If the plan has less money in its investments than the present value of its estimated future cash flows, it has a net liability and is considered to be underfunded by that amount.
Many states' pension plans have assumed they will earn 8 percent or more on their investments, even though many experts think a more appropriate assumption would be 6.5 percent. As an example, the state of Virginia used an assumed rate of return of 7.5 percent in 2009 but reduced the rate to 7.0 percent in 2011. In 2011, Virginia paid out approximately $3.3 billion in benefits to retirees.
a) Assume Virginia's annual payments will continue to be $3.3 billion, and that retirees will receive benefits for 20 years on average. Using an assumed rate of return of 8 percent, calculate the liability of the state's pension plan. The liability is the present value of the future cash payments. (Be aware that the real-world calculation for a state's pension plan liability involves many more assumptions than just these two.)
b) Assume the annual payments will continue to be $3.3 billion, and that retirees will receive benefits for 20 years on average. Using an assumed rate of return of 6 percent, calculate the liability of the state's pension plan.
c) Reviewing your answers from Requirements a and b, provide an explanation as to why states may wish to assume a higher rate of return on their pension plan's investments than actuaries might recommend.
a) To calculate the liability of the state's pension plan using an assumed rate of return of 8 percent, we need to calculate the present value of the future cash payments.
Step 1: Estimate the future cash payments expected to be made to employees.
The annual payments are given as $3.3 billion.
Step 2: Calculate the present value of those cash flows using an assumed rate of return.
Using an assumed rate of return of 8 percent, we can calculate the present value of the future cash payments. Since the payments are expected to continue for 20 years on average, we can use the formula for the present value of an annuity:
PV = PMT * [1 - (1 + r)^(-n)] / r
Where:
PV = Present value
PMT = Annual payment
r = Assumed rate of return (as a decimal)
n = Number of years
Plugging in the values:
PV = $3.3 billion * [1 - (1 + 0.08)^(-20)] / 0.08
Performing the calculation:
PV = $3.3 billion * [1 - 0.214358] / 0.08
PV = $3.3 billion * 0.785642 / 0.08
PV = $3.224 billion
Therefore, the liability of the state's pension plan, using an assumed rate of return of 8 percent, is approximately $3.224 billion.
b) To calculate the liability of the state's pension plan using an assumed rate of return of 6 percent, we follow the same steps as in part a.
Estimating the future cash payments and using an assumed rate of return of 6 percent, we can calculate the present value of the future cash payments:
PV = $3.3 billion * [1 - (1 + 0.06)^(-20)] / 0.06
Performing the calculation:
PV = $3.3 billion * [1 - 0.312035] / 0.06
PV = $3.3 billion * 0.687965 / 0.06
PV = $3.981 billion
Therefore, the liability of the state's pension plan, using an assumed rate of return of 6 percent, is approximately $3.981 billion.
c) States may wish to assume a higher rate of return on their pension plan's investments than actuaries might recommend for a few reasons:
1. Funding requirements: Assuming a higher rate of return allows the state to contribute less money each year to meet its pension obligations. This can result in significant cost savings for the state budget in the short term.
2. Financial stability: States may choose a higher assumed rate of return to project a more positive funding status for their pension plans. This can help maintain confidence in the state's finances and prevent concerns about underfunded pension plans.
3. Political considerations: Higher assumed rates of return may be politically favorable as they can lead to lower required contributions. Politicians may prefer to allocate funds to other programs and projects rather than making larger contributions to pension plans.
However, assuming a higher rate of return comes with risks. If the actual investment returns fall short of the assumed rate, it can lead to underfunded pension plans and future funding challenges. Therefore, it's important for states to carefully consider the trade-offs and potential long-term consequences when setting their assumed rate of return.