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Retirement Income: Guarantees Vs. Realities

25 July, 2013

The 1995 movie “Tommy Boy,” starring Chris Farley and David Spade, is one of those low-brow comedies that becomes a “classic” because it gets regular rotation on cable TV stations. Farley is Tommy Boy, an immature and dimwitted heir to an auto parts factory, who attempts to keep the business alive when his father, the owner, dies suddenly. Going on the road to meet the company’s customers, Tommy encounters skeptical buyers looking for written guarantees, now that his father is no longer in charge. At one sales call, the following conversation takes place:

Tommy: Let's think about this for a sec, Ted. Why would somebody put a guarantee on a box? Hmmm, very interesting.

Ted Nelson, Customer: Go on, I'm listening.

Tommy: Here's the way I see it, Ted. Guy puts a fancy guarantee on a box 'cause he wants you to feel all warm and toasty inside.

Ted Nelson, Customer: Yeah, makes a man feel good.

Tommy: 'Course it does. Why shouldn't it? Ya figure you put that little box under your pillow at night, the Guarantee Fairy might come by and leave a quarter, am I right, Ted?

As the dialog continues, Tommy makes a convoluted analogy that closes the sale (if you want details, Google “guarantee tommy boy”). The essence of his pitch: it’s not the guarantee on the outside on the box, but the quality of the product inside that matters.

The dictionary defines a guarantee “as a formal promise or assurance (typically in writing) that certain conditions will be fulfilled.” Just like Tommy says, a guarantee is intended to make you feel “all warm and toasty inside.” It’s an additional inducement to buy a product or service, and trust someone.

But even the best guarantees cannot provide absolute assurance. Formal promises, even in writing, cannot make the impossible possible. For guarantees to be credible, they must be based on realistic assumptions. When people rely on implausible (or impossible) guarantees, disappointment will likely follow. This can especially be true with financial guarantees.

Detroit and Illinois: Guarantees erased by realities

On December 4, 2013, two stories ran side-by-side in the Wall Street Journal. The first reported the decision by US Bankruptcy Judge Steven Rhodes to allow the city ofDetroit to reorganize under bankruptcy law. If it occurs,Detroit would be the largest-ever municipal bankruptcy inUS history. The determination that Detroit is broke and can no longer expect to meet its obligations has significant financial ramifications for over 30,000 past and present city employees. As Matthew Dolan reports:

“In the most watched part of the case…the judge said Detroit’s public pension holders aren’t entitled to special protection from potential cuts – despite a Michigan state constitutional provision aimed at shielding pensions.”

Unions and pension funds contend the retirement plans are guaranteed under state law, but the judge disagreed. John Pottow, a law professor at theUniversityofMichigan, said the judge’s decision means “Unions and pension funds no longer have the magic bullet of the state constitution to protect them.” In other words, the guarantee is void, even if it is written into the state constitution.

The second WSJ report was a similar unwinding of retirement income guarantees, this time inIllinois. On December 3, 2013, state legislators passed an overhaul of the state public-employee retirement system, “cutting benefits for workers and retirees…including reducing the annual cost-of-living increases for retirees and raising the retirement age for younger workers.”

This action was precipitated by faltering state finances; Illinois has the lowest credit rating among the 50 states, and the funding gap in its pension plan is estimated at $100 billion. Unions representing the state employees have asserted that government workers shouldn’t be punished for mismanagement by state officials. But in the event of a legal challenge, the state will likely “argue that certain benefits aren’t protected, particularly in light of the state’s fiscal problems.”  As House Speaker Michael Madigan puts it, “We’re here today because the cost of our present state systems are simply too rich for the resources available.” Realities trump guarantees.

The Final Fade-out for Pensions

The circumstances in Detroit and Illinois are perhaps the final act of a generation-long trend away from retirement pensions. The primary problem? Pension funds couldn’t keep their promises. For a combination of reasons, their guarantees weren’t sustainable. The business was no longer profitable, the number of retirees was too high, the investment returns were too low, and/or the funding was insufficient.

In the place of pensions, most employers have instituted defined-contribution retirement plans, such as 401(k)s, which allow an employee to accumulate a retirement fund, but do not guarantee a monthly income. Instead, the individual has the responsibility of deriving a stream of retirement payments from interest, dividends, or systematic liquidations.

Because interest, dividend rates and asset valuations fluctuate, the income may also vary. In extreme cases, there is the possibility that assets may be exhausted and income stops. This uncertainty may compel some retirees to consider financial products, such as annuities, that promise a guaranteed lifetime income, regardless of the performance of the underlying financial assets. Given the recent events involving the inability of pensions to uphold promises, can consumers rely on guarantees from an insurance company? To revisit “Tommy Boy,” the quality of the guarantee is very much connected to what’s “in the box.”

Individual Annuities and Pensions are not the same

Even though both an annuity and pension fund can promise a lifetime stream of income, the processes by which income is calculated and funded are different. And these differences impact the integrity of the guarantees.

The income guarantees for an annuity typically apply to one person (or two, if the annuitant selects a survivor option). In contrast, a pension plan attempts to provide income guarantees for a large and changing group of people, all retiring at different times.

The funding for an annuity is provided by the purchaser from existing funds; the agreement is fully funded at onset. A pension plan is never fully funded; it constantly reassesses current performance, estimates future obligations, and evaluates whether additional funding is necessary.

The determination of additional funding required for a pension is partially dependent on the estimated investment return a pension’s managers believe can be achieved by the plan’s portfolio. Because higher projected rates of return mean lower funding requirements, there is often a financial incentive to be optimistic when projecting future returns. In fact, several studies have characterized pension assumptions as “overly optimistic,” and the subsequent under-performance only makes a funding gap worse. By comparison, insurance company assumptions may border on the pessimistic, both in regard to guaranteed payments, and how well the insurance company’s investments will perform. With no recourse to additional funds at a later date, each annuity contract must stand on its own. This reality, along with stringent regulation, compels actuaries to be cautious in their guarantee calculations.

And as recent events demonstrate, pension complexity has made it challenging for plans to meet their guarantees. A dollar-for-dollar analysis might determine that pensions project higher returns in retirement income than individual annuities. But one could also assert that annuities offer more realistic guarantees; historically, insurance companies have a strong track record of keeping their retirement income promises to individual annuity holders.

A Silver Lining for Retirees?

In the “old days” of lifetime employment followed by a lifetime pension, retirees didn’t need to do much more than sign a form and collect a check. They didn’t contribute to the plan, and didn’t really “own” their benefits – even if they were vested, they couldn’t demand a lump-sum payment in lieu of a monthly payment. For those who now find themselves wondering if the check will be there because the plan’s guarantees cannot be met, there aren’t many alternatives; they are stuck with whatever a judge decides and the pension can afford.

Going forward, individuals have much more responsibility to accumulate their own retirement, but they also have more guaranteed options for receiving retirement income. Other vehicles may offer the prospect of higher returns, but when it comes to meeting their guaranteed commitments, insurance companies have the underlying financial integrity to back their promises.

As the first generation of defined-contribution retirement plan participants transitions to retirement, many may be looking for “warm and toasty” income guarantees they can rely on. In the long run, the variety of individual income contracts backed by insurance companies may provide more options and guarantees than employee-sponsored pensions.