Why Are So Many Retirement Programs Underfunded?

The Pension Benefit Guarantee Corporation announced yesterday that it is, surprise, underfunded. Who isn't these days? Social Security, Medicare, Medicaid, the PBGC and any number of other organizations may not have the funds necessary to meet future obligations. But it's not quite as bad as it sounds.

During a big economic contraction, it's common for many financial institutions to come under strain for the funding of their future obligations. Why? Because the funding calculation is based on certain assumptions about the health of the economy, investment rates of return and how many potential liabilities they may need to pay. When both the economy and market returns decline, the figures change quickly and you can get some pretty ugly outcomes.

This is a highly simplified example (and not representative of the PBGC numbers), but it will give you a sense of how the numbers might work in a pension situation:

• Assume you have a $100 million pension obligation that is due in 15 years and you have $50 million in your fund. Let's say you make a conservative assumption that your $50 million will grow at five percent per year for the next 15 years. At that pace, it would be worth about $100 million in 15 years, and you look to be fully funded for those future obligations.
• Now throw in a big recession, and assume your $50 million, which was invested in the markets, falls to $35 million. Well, assuming five percent growth on the $35 million means you'll only have about $73 million in 15 years. And now you look underfunded by $27 million.
• But that's not the end of it. Because of the bad economy, your $100 million obligation looks like it will be $110 million as more people may make claims against your pension guarantees over the next 15 years. Ouch, now you're $37 million underfunded from just one bad recession.

The reason these organizations are always evaluating where they stand is so that they can make adjustments along the way and don't get surprised down the road with a big liability they can't handle.

For instance, in doing a google search on the PBGC, I found the funding report from March 29, 2000 -- which, by the way, was issued at the all time peak of the stock market's value. And guess what -- at that point, the PBGC had a surplus. Yet in that report they mentioned the need to be vigilant because they knew conditions could change quickly.

Bottom line: Underfunding is something to be concerned about, but you have to put the numbers in perspective. As long as institutions are reacting to the underfunding, then the numbers shouldn't concern you much. But if an institution fails to react to the underfunding, then you've got something to worry about. I'll talk about who is and who isn't reacting in future posts.