What Does It Mean When a Pension Plan Is Funded?

January 17, 2014

Accounting rules and disclosures cloud the amount of actual funding that a pension plan has, says Andrew Biggs, a resident scholar at the American Enterprise Institute.

  • Most public employees have defined benefit pension plans, which promise a fixed monthly retirement benefit.
  • These plans have a number of different investments, from stocks and bonds to hedge funds.
  • Where these plans differ from a traditional 401(k)-type plan is in the risk: a public defined benefit plan's risk is borne by governments (and therefore taxpayers).

When people refer to pension funding, the amount of "funding" is comprised of the plan's actual asset value today and its expected earnings in the future.

  • To calculate future funding, plans use an expected return rate (this is usually around 8 percent).
  • That return is not guaranteed, it is only an estimate of what might happen in the future.
  • In fact, a recent survey of eight investment consultants estimated that a typical public plan portfolio would yield only a 6 percent return, rather than 8 percent, over the next 15 years.

Today, riskier investments appear to improve public pension funding. Current accounting rules mean that riskier investments are given higher expected rates of return, so if a plan takes on more risk, it is considered "better funded" than a less risky plan (because that higher return rate yields a higher funding level).

As long as pension assets are considered "funded" based on the expectation of high returns, Americans will not have a true sense of what a "fully funded" plan actually is.

Using a fair market valuation approach would change this practice and would keep plans from being called "fully funded" simply based on risk levels. The approach, which has been endorsed by the Congressional Budget Office and the Federal Reserve, would calculate funding status based on the assumption that the plan invested only in safe assets.

Source: Andrew G. Biggs, "When It Comes to Public Pensions, There's Funding and Then There's 'Funding'," American Enterprise Institute, January 15, 2014.

 

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