Many retirees living on generous pension benefits look back on the ‘good old days’ and wonder why their younger counterparts only have access to 401(k) plans and IRAs. Likewise, some younger workers wonder why pensions have largely disappeared for all but the government jobs. If you have ever wondered yourself, look no further than North Carolina. The Tar Heel State is a shining example of why pensions are mostly a thing of the past.
North Carolina finds itself in a tenuous financial position. It can only really afford to borrow a total of $11 billion over the next decade. Yet the state is looking at a pension deficit of $42 billion. Their pension obligations are four times the amount they can borrow, and there isn’t enough projected cash to cover pension obligations either.
How the state will meet its obligations is anyone’s guess. It is not going to be easy. North Carolina is like so many other states now watching their pension obligations swallowing up their budgets.
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Defined Benefit vs. Defined Contribution
Understanding the problem begins with understanding the difference between defined benefit and defined contribution retirement plans. Pensions are defined benefit plans. They are so named because they are defined by the benefits they offer. A defined contribution plan is defined by the contributions made to that plan rather than the benefits paid out.
The difference, while seemingly minor, is the very reason private sector pension plans are all but extinct. A defined benefit plan, like a pension, guarantees certain benefits to employees after they retire. Both employee and employer contributions to the plans with the expectation that retirement will result in guaranteed payments to the retiree.
In order to meet those obligations, pension plan administrators invest monies received via contributions from plan members. The goal is to do so in such a way that the returns on those investments cover the difference between contributions and benefits paid. Yet it rarely works out that way.
North Carolina is just the latest example of a state whose pension benefits are outpacing the combination of member contributions and investment returns. Simply put, pension obligations are growing too fast. The problem is exacerbated every time the state brings on a new employee who is then enrolled in the pension program.
Pensions Are Not Sustainable
BenefitMall, a Dallas company that offers payroll and benefits administration services, explains that the private sector came to the realization that pension plans are not sustainable. Back in the late 1980s and early 90s, corporate America began transitioning away from pensions in favour of 401(k) plans. They did so as a matter of survival.
Pension plans tie companies to non-negotiable pension benefits that are guaranteed. By contrast, a 401(k) plan only guarantees that the company will contribute to the plan during a worker’s career. The worker also contributes. At retirement, the worker begins drawing benefits as needed.
How much those benefits are worth depends on how well the worker’s investments performed during his or her working years. As for the employer, there is no further obligation once the worker reaches retirement age. As such, companies are not continually strapped with ever-growing pension obligations that eat up a larger portion of the budget every year.
In short, pensions promise benefits that are not sustainable over the long term. The private sector figured this out decades ago and began phasing out private pensions in favour of 401(k) plans. Government has not done so and is not likely to. As such, expect federal and state governments to continue struggling to meet their pension obligations.