Pay As You Go Pension Plan

finance a la shmoop. what are pension liabilities? okay so if you haven't seen

our James Cameron directed and shmoop academy award-winning video called

what is a pension, we'll watch that first. before you continue. okay hi welcome back. [link to pension video]

a pension liability is not that different from a liability owed by any

corporation or even an individual. the corporations and governments both

provide pensions for their employees. very roughly an employee making say 75

grand a year might get 10% of a salary a year in pension contributions from the

employer. while pensions are divided into two

flavors. there are defined contribution pensions - one flavor of a 401k plan. in a

defined contribution plan the employee contributes say 10% of their salary and [defined contribution pension defined]

in this case that would be 7,500 bucks. and the employer might match it. that is

the employer takes 7,500 bucks off of their total salary that is calculated

for taxes so the employee instead of being taxed on 75 grand a year gets

taxed on sixty seven thousand five hundred they then defer the 7,500 bucks

they put into their 401k plan and well they'll still pay taxes on it eventually [equations on screen]

when they take it out but presumably when they're old and retired and poor

and thus likely to pay lower tax rates than they would in their heavy working

high tax hike tax rate era at the peak of their careers. so the employee saves

seventy five hundred bucks there or at least puts it away, and the employer

matches that 75 with seventy five hundred of its own. so from the employers

perspective that employee does not just get a seventy-five thousand dollar [equations on screen]

salary they cost the employer 75 grand plus another seventy five hundred bucks

of 401k pension matching expenses or eighty two thousand five hundred dollars.

and the employer pays it grumbling and wondering when the next version of robot

comes out so they can replace this worker ,well what happens to those

savings. well, employers usually provide employees with a menu of investment

choices they can hold all cash, they can invest in high-growth relatively risky [list of investment options shown]

funds, they can invest in balanced growth and income funds and so on and so on.

well the employee gets to choose from a supermarket of investment fund choices

or even buy individual stocks in their pension. the key takeaway at the

end of however many years or decades of working the employee is able to take out

from their pension whatever value that pension has accrued to be worth over

that time period. easy. in a defined contribution fund there is essentially [flow chart]

no pension liability. no pension liability to the corporation other than

each year doing the matching thing on that salary. okay?

the employee bears the stock market risk just like everyone else. the big

controversies you read about in the press revolve around the benefit flavor

of a pension, 2nd flavor here, called a defined benefit plan. in a defined

benefit situation a number of irresponsible financial dealings take [types of pensions listed]

place where taxpayer money is often just given away with no thought of fiduciary

duty or obligation to ,you know being respectful of the taxpayers hard-earned

money. a given government worker works for the state for 30 years eventually

making a hundred grand a year at the end having received pension contributions

all along the way just as in the defined contribution system that corporations [equation on screen]

use as outlined above .only in a government defined benefit program the

employee is guaranteed a minimum rate of return in many situations. that is the

employee is guaranteed say 10% a year in investment returns even if the stock

market is flat or down or bad for 7 ,10 15 ,years whatever. that happens all the

time, yet the taxpayers on the hook to give

them that guaranteed 10 percent a year compound rate. well at a 10 percent of [flow chart]

your compound rate after seven years well let's say the actual stock market

return was only 7 percent and the employee lagged 3 percent a year each

year compounded well that would be a lot that the state would then owe them so

that's one flavor of pension liability that could likely bankrupt California

and Illinois at some point not too far away because the pension liabilities [California and Illinois pictured.]

there are enormous. and it gets worse there are other irresponsible things the

states have done like guarantee retirement return minimums or investing

pension money in dead stock beanie babies. it was a really bad investment by

CalPERS there huh. so yeah pension liabilities are a

totally simple easy to understand uncontroversial thing and while they

can't possibly have an adverse effect on the world around us right? sorry hard to

keep a straight face there. [man talks out the side of his mouth]