Underfunded Pensions: 5 Big Questions Revealing Why Everyone Should Care

Millions of workers and retirees in the United States currently pay into or are paid by dramatically underfunded defined-benefit pension plans. The frequently troubled plans take multiple forms, but the crux of their plights can usually be boiled down to structural instability, with more money flowing out than going in.

Darden Professor James Naughton, who has testified before the U.S. Congress on the issue, calls the situation facing multiemployer pensions — plans in which workers from various employers pay into a single plan — a particularly acute disaster, largely due to a combination of inadequate funding and risky investing.

The precarious state of pensions — which has grown even shakier in the wake of the economic tumult brought about by the coronavirus pandemic — should be of interest to all taxpayers, Naughton says, as failed pension systems are typically bailed out by the U.S. government, typically at the expense of billions of dollars. Naughton recently spoke about how the systems got so bad and what could be done to arrest the decline.

Why are defined-benefit pension plans under so much stress across the country? Are they uniformly under stress?

It’s not uniform and, depending on the sector you look at, there is variation.

With defined benefits, promises have been made and those promises are fixed dollar obligations in the future. Some plans have set that money aside and invested conservatively; others have not set the money aside or set aside part of it and invested aggressively. Those choices are really what determines the level of stress.

Look at the state of Illinois’ public sector pension plan. The reason their plans are so poorly funded is because they just don't put sufficient money in. It's very simple. They keep making promises, and they don't fund them. There's been a pattern over time in states where they have the most leeway in which they just haven’t contributed.

There are some states that have mandatory contributions and there is typically a formula that says you have to put in X amount, and they tend to be in better shape. Often not great shape, but manageable.

And then in the private sector, there are typically two groups of plans. There are those run by individual employers — the IBM pension plan or the General Motors pension plan — and, for the most part, they tend to be in good shape because they have relatively stringent funding rules.

Then there are what is called multiemployer pension plans, and those are in serious trouble. Generally speaking, multiemployer plans are managed by unions, not employers, and contributions are determined by collective bargaining agreements. Those plans are chronically underfunded. Some are only 30 or 40 percent funded.

The reason they're in such bad shape is, in part, because they didn't collect enough, but also because they invested aggressively and they really had no way to make up for poor performance.

And if you go into an environment like we have right now, there are two things that happen. One is interest rates go down, and lower interest rates mean those fixed-dollar promises are now more costly.
And then on the asset side, they invest a great deal in the stock market, which they shouldn't be doing. When the stock market goes down, now you have the combination of higher promises and less money to pay those promises.

What are the societal implications for underfunded, or unfunded, pensions?

If you look at multiemployer plans, those people worked in coal mines, driving trucks, in bakeries — typically physical, difficult jobs, and they certainly earned the pension they were promised by their union. Now, some of them are 70-years-old and in retirement and have the terrible prospect of having their pension cut.

There’s a government backstop for private pensions, but the government backstop for multiemployer plans is very modest, and that’s because the unions argued for that and said they didn’t need a backstop, because their plans were safer, which was completely incorrect.

Once the government backstop runs out of money, there is basically nothing. There are literally pensioners right now who have a respectable pension, $30,000 a year or thereabouts, and that’s going to be cut to a few hundred a year in five years if the government doesn’t bail them out.

Does the COVID-19 crisis exacerbate these societal implications, particularly as states face budget struggles?

Fiscal crises always do the same thing. They always reduce revenue and increase costs. For the most part, when you look at the way the states are organized, they don’t really have a way to set aside additional funds when times are good. The incentives for government are to spend a little bit more than they collect. So when you hit these crises, it does pose a significant crisis.

Look at a state like Illinois. I would be very surprised if they had enough money to contribute to their pension plans in the next couple of years. At some point, the public pension funds are going to run out of money and then pension promises are going to need to be paid out of tax revenue. That can lead to a reinforcing downward spiral, where increasing taxes are needed to pay for past pension promises. It is hard to see how such a spiral can be alleviated without the involvement of the federal government.

Do you see evidence of big plans that are invested in the stock market making riskier bets to try to make up lost ground?

It shouldn’t happen but you do see cases. It is such a frustrating thing to see. Riskier investments have higher expected returns, but they also have higher volatility, which can be very damaging to pension systems that have promised fixed-benefit amounts.

If a pension fund can’t bear high levels of investment risk, then it should do what insurance companies do with their annuity portfolios. Insurance companies have trillions of dollars in annuities and they're unaffected by what's happened in the last six months because the promises are fixed and the money is invested mostly in bonds, which are also fixed. Those annuity promises are no different than defined-benefit plans, and they're all in great shape.

What's happened in the other sectors is there's the belief you can generate arbitrage, where you can take money and invest in something riskier and earn an extra return. In theory, there is nothing wrong with that. And in theory, there should be a premium for taking on risk, but you can’t guarantee higher returns and sometimes you have lower returns.

A key indicator of whether a fund can bear investment risk is its ability to adjust contributions following adverse experience.

With company sponsored pension plans, on average, they respond to negative investment returns with increased contributions. When a multiemployer plan has adverse returns, it still has these fixed contracts where contributions are defined for the length of the collective bargaining agreement. So when things go badly, it can’t collect any more money. Those plans are designed in a way where taking high levels of investment risk is a very bad idea. And yet they do.

You’ve testified before congress on this issue before. What’s your message?

People have habits and often rely on past practices. Those are natural human traits. However, a problem arises when certain investment strategies are justified because that’s what was done in the past. The part of my testimony on multiemployer plans that was unique was explaining the idea that, if you are going to promise a fixed-dollar amount and you really have no way to respond to adverse investment performance under the structure of your plan, then you really shouldn’t be taking investing risk. This view contrasts with the typical practice of these plans in which more than 50 percent of the assets are invested in equity securities.

For a lot of these plans, the way in which they are funded, there’s this belief that we just take investment risk and it's not really risk, it's just higher returns and they don't really see the downside.

As an academic, I think I have a very different perspective on that. And I have a view that is different from all the practitioners who, for the most part, if they seek to determine whether you're taking too much risk or not, they tend to look at what other plans are doing.

Collectively, pretty much all those plans are taking risk. On the academic side, people are pointing out that these risks are pretty substantial and you really shouldn't be taking them, given how these plans are structured and what’s at stake.

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About the Expert

James Naughton

Associate Professor of Business Administration

An expert in pensions, disclosure, financial regulation and government accounting, Naughton examines how financial, legal and regulatory institutions shape financial disclosure and economic choices. His research has delved into defined benefit pension plans and the financial reporting and economic risks associated with them.

Prior to joining the Darden faculty, he taught at Northwestern University’s Kellogg School of Management, where he received a number of awards for his impact and teaching. Before receiving his doctorate in business administration and J.D. from Harvard, he was an actuary at employee benefits consulting firm Hewitt Associates, working on the design and administration of employee benefit plans and executive compensation agreements.

B.S., Worcester Polytechnic Institute; DBA, Harvard Business School; J.D., Harvard Law School