Tuesday, August 25, 1998

Pensions. No one talks about them. No one cares about them.

"Throwbacks", they say, "Ancient history."

Or, "It wont do much for me."

Not so.

Defined benefit pensions are one of the least discussed and least understood benefits available to American workers at all levels of income. Not all companies have them, and not all workers will work long enough at a single company to receive one, but pensions will still be major resources for millions of people. A recent Bureau of Labor Statistics study showed that 56 percent of private sector employees and 91 percent of public employees were covered by defined benefit pensions. For many people, a defined benefit pension plan will be their most valuable asset.

"Asset?"

Yes, asset.

You and I live in a world of promises. The promises take different forms but all arrangements of income, in the end, are promises.

Lets start with what a defined benefit pension is. It is a promise, from a corporation or government entity, to provide a lifetime income when you retire. The size of the pension is determined by years of service and your final salary. A typical plan may pay 1.25 percent of salary per year of service. As a result, a twenty year career will provide a pension that will replace about 25 percent of final salary (20x1.25%). A forty year career will provide a pension that will replace about 50 percent of final salary.

For the 94 percent of all employees who earn less than the Social Security wage base maximum ($68,400 for 1998) the combination of Social Security and a single employer with a defined benefit pension can provide a good retirement. Add home ownership and it can be a generous retirement.

Where is the asset?

Its in the promise of income. It has value. It may not be money in the bank (another kind of promise) or securities in a 401k account (still another kind of promise), but it has value.

You can understand this by comparing two different assets, a bond and a pension. If you own a bond what you have is a promise. In exchange for lending your money, the borrower promises to pay you interest until the bond matures. When the bond matures, your original principal is returned. Suppose, for instance, you bought a twenty-year bond with a face value of $100,000 that paid 6 percent a year in monthly payments of $500. You would receive 240 monthly payments of $500 and a check for $100,000 at the end of the period.

The value of that last check, today, is only $31,180. The value of the monthly checks, today, is $68,820. In other words, if money costs 6 percent, a buyer would pay $68,820 for the right to receive the income payments and $31,180 for the right to receive the original principal in twenty years. The total is $100,000.

Whats important here is that most of the value in the promise— nearly 70 percent in a 20 year obligation— is in the payments, not the principal.

In a pension, there is no principal. All you have is the promise of income, paid monthly. If you have a pension of $1,000 a month, you would need to have nearly $218,000 in investments to produce the income. The promise of monthly income is worth less than $218,000 because you dont have the principal and never will. It also isnt certain how long you will live and receive the payments.

Let me give you a big number example.

Not long ago, an executive mentioned that he was worried about the stock market, where all his money was, and was thinking about shifting some money to tax-exempt mutual funds. Did I have any suggestions?

I mentioned several funds. Then I asked if he had considered how much he owned in de facto bonds.

"What are de facto bonds?", he asked.

"Its what you have in promises of future income."

It turned out that his corporation had a defined benefit pension. It also had a long-term security agreement for top executives. The combination would provide him with over $200,000 a year when he retired.

I told him: "With bonds yielding 5.5 percent, youd need to have $3.6 million in fixed income securities to produce that income. That means youd need to have $3.6 million in equities to have an effective portfolio mix of 50/50 and $10.8 million in equities to have a more aggressive 75/25 mix of equities/fixed income. You might not be so over-committed to equities after all."

The numbers are smaller, but the same principles work for you and me. If you work for a company with a defined benefit pension plan, dont ignore it. Ask about it. See if you can get a projected retirement income. Factor it into your saving and investment plans. If you are fortunate enough to have a defined benefit pension, your "portfolio" is probably a lot less risky than you think.

That can be a big comfort in markets like this.