How much do pensions cost private employers?
December 20, 2021 1:46 AM Subscribe
If a private employer wanted to provide a pension program, how much would that cost them, and what is the legal structure in place to support that?
My understanding is that pensions work via the company paying into a pension fund, which is run by some external pension fund company, and then that pension fund pays out the pension when someone who is covered retires (or whenever the contract says that the pension will kick in, really). I have a few questions about this:
My understanding is that pensions work via the company paying into a pension fund, which is run by some external pension fund company, and then that pension fund pays out the pension when someone who is covered retires (or whenever the contract says that the pension will kick in, really). I have a few questions about this:
- How much does the company have to pay per employee, and what is the payment structure like? Presumably this depends on the amount that will be paid out and the age when the pension kicks in — I'm curious if there are rules of thumb for how this is calculated.
- What are the legal protections in place for if the company providing the pension, or the company running the pension fund goes out of business?
- What are the main companies that run pension funds?
I just happen to have just gotten the end of the year update for my state pension (I know, a little different because it is state supported. Also likely way more employees contributing than your company):
"...the TRS employer contribution rate for the current Fiscal Year 2022 is 19.81%. The employee contribution is 6.00%. Effective July 1, 2022, the TRS Employer Contribution Rate for Fiscal Year 2023 will increase to 19.98%. The employee contribution rate will remain unchanged at 6%."
We have a choice, and some people opt out of the pension in favor of a 401k style program:
"...the 2022 ORP Contribution Rates will remain at 6.00% Employee Contribution and 9.24% Employer Contribution. "
The main differences between the two are, obviously, the difference in employer contributions and whether the outcome is a fixed amount or just whatever you've earned. For our pension system, employees have to contribute at least 10 years to be vested, and then at retirement the payout is based on the number of years worked and highest salary (the formula is 2*number of years*highest salary, so retiring at 40 years pays 80% of highest salary until death). For me, the higher employer contribution and fixed benefits mean the pension is definitely the better deal.
posted by hydropsyche at 4:19 AM on December 20, 2021 [1 favorite]
"...the TRS employer contribution rate for the current Fiscal Year 2022 is 19.81%. The employee contribution is 6.00%. Effective July 1, 2022, the TRS Employer Contribution Rate for Fiscal Year 2023 will increase to 19.98%. The employee contribution rate will remain unchanged at 6%."
We have a choice, and some people opt out of the pension in favor of a 401k style program:
"...the 2022 ORP Contribution Rates will remain at 6.00% Employee Contribution and 9.24% Employer Contribution. "
The main differences between the two are, obviously, the difference in employer contributions and whether the outcome is a fixed amount or just whatever you've earned. For our pension system, employees have to contribute at least 10 years to be vested, and then at retirement the payout is based on the number of years worked and highest salary (the formula is 2*number of years*highest salary, so retiring at 40 years pays 80% of highest salary until death). For me, the higher employer contribution and fixed benefits mean the pension is definitely the better deal.
posted by hydropsyche at 4:19 AM on December 20, 2021 [1 favorite]
Best answer: So I have thankfully forgotten all the mind-numbing details I once learned for my CFA exams as to how pensions are accounted for but the basics of it are as follows:
1) Actuarial calculations are used to determine how much pension future value is being accrued each pay period. So if you have a pension that pays, say, 1/45, of your career average income for each year employed up to a cap of 30/45, then for each month you work they calculate how much money they will need in the fund at your retirement to pay the monthly equivalent. They will also use some assumptions to estimate your likely career average salary based on averages from the company. This is the domain of actuarial science and the rather complex terms in defined benefit pensions make this complex to determine. They need to estimate the distribution of lifetimes for their retired members as well as the lifetimes of spouses (for survivor benefits). This gives an increment to the value that the pension needs to be in the future.
2) Expected rates of return, interest rates, and other factors are used to turn that increment into a present value contribution to the fund which the employer has to make to fund the future payout. If the returns to assets over and above the rate of inflation are high, then compounding makes pension funding cheap
What all the components are called depends on whether you want the IFRS or US GAAP definitions but basically its:
If you want to look at details, and find some useful terms for further research, then these study notes might be helpful.
Defined benefit pensions are locally regulated, it depends on the country but generally there is both regulation of the funding status and an insurance scheme to rescue schemes at risk of failure. Failure of the scheme sponsor (i.e. the employer) shouldn't affect the payment of benefits already accrued *if* the scheme is properly funded.
There are some serious issues with these schemes in many places because returns have been dropping over time which means that previously funded schemes are now underfunded since they are not generating the expected investment returns to turn the original contributions put in at the time the benefits were earned into the required benefits at retirement age.
posted by atrazine at 6:39 AM on December 20, 2021 [5 favorites]
1) Actuarial calculations are used to determine how much pension future value is being accrued each pay period. So if you have a pension that pays, say, 1/45, of your career average income for each year employed up to a cap of 30/45, then for each month you work they calculate how much money they will need in the fund at your retirement to pay the monthly equivalent. They will also use some assumptions to estimate your likely career average salary based on averages from the company. This is the domain of actuarial science and the rather complex terms in defined benefit pensions make this complex to determine. They need to estimate the distribution of lifetimes for their retired members as well as the lifetimes of spouses (for survivor benefits). This gives an increment to the value that the pension needs to be in the future.
2) Expected rates of return, interest rates, and other factors are used to turn that increment into a present value contribution to the fund which the employer has to make to fund the future payout. If the returns to assets over and above the rate of inflation are high, then compounding makes pension funding cheap
What all the components are called depends on whether you want the IFRS or US GAAP definitions but basically its:
If you want to look at details, and find some useful terms for further research, then these study notes might be helpful.
Defined benefit pensions are locally regulated, it depends on the country but generally there is both regulation of the funding status and an insurance scheme to rescue schemes at risk of failure. Failure of the scheme sponsor (i.e. the employer) shouldn't affect the payment of benefits already accrued *if* the scheme is properly funded.
There are some serious issues with these schemes in many places because returns have been dropping over time which means that previously funded schemes are now underfunded since they are not generating the expected investment returns to turn the original contributions put in at the time the benefits were earned into the required benefits at retirement age.
posted by atrazine at 6:39 AM on December 20, 2021 [5 favorites]
For the record, the controlling law in the US is ERISA about which Wikipedia knows more than I do.
If you are desperate enough to want a ball park estimate of your own devising, go to a site that sells annuities. Find out how much you have to contribute now to get a certain level of payments at age 65. For a business, do this for each employee. Add them up.
Be aware though, that the business has a more complicated calculation. The defined payments usually depend on pay in the last years, and that depends on inflation in the future, among other things. The business contributes for employees who leave before vesting too. The only way to keep on track with the uncertainty is to recalculate each year.
posted by SemiSalt at 8:43 AM on December 20, 2021 [1 favorite]
If you are desperate enough to want a ball park estimate of your own devising, go to a site that sells annuities. Find out how much you have to contribute now to get a certain level of payments at age 65. For a business, do this for each employee. Add them up.
Be aware though, that the business has a more complicated calculation. The defined payments usually depend on pay in the last years, and that depends on inflation in the future, among other things. The business contributes for employees who leave before vesting too. The only way to keep on track with the uncertainty is to recalculate each year.
posted by SemiSalt at 8:43 AM on December 20, 2021 [1 favorite]
The vast majority of non-unionized private companies have abandoned the classic "defined benefit" retirement plan, under which the company assumes an obligation to make specific retirement payments in the future, in favor of a "defined contribution" plan, most often a 401(k) plan, under which the employee defers a certain percentage of earnings, usually with a match by the employer, and the ultimate payout to the employee depends on how the investments have done over the years.
Under the DB plan, the company assumes the risk of the investments not doing as well as projected over the years. The DC plan puts that risk on the employee, and the company has no financial risk.
The other benefit to the employee of the DC approach: the money belongs to the employee (subject to vesting requirements as to the employer's match) and he does not have to worry about whether the employer will be in business 20-30 years from now and whether the company will have underfunded the plan during that time.
posted by yclipse at 9:28 AM on December 21, 2021
Under the DB plan, the company assumes the risk of the investments not doing as well as projected over the years. The DC plan puts that risk on the employee, and the company has no financial risk.
The other benefit to the employee of the DC approach: the money belongs to the employee (subject to vesting requirements as to the employer's match) and he does not have to worry about whether the employer will be in business 20-30 years from now and whether the company will have underfunded the plan during that time.
posted by yclipse at 9:28 AM on December 21, 2021
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Payout can be structured in a range of ways, the trajectory over the last couple of decades has been to reduce the payout, but someone with 30-40 services might end up with a pension of 50%-70% of the final-ish salary. Employees might be entitled to some percentage of their (final-ish) salary at retirement for each year of employment. A typical percentage might be somewhere between 1% and 3%. There need to be mechanisms and rules to deal with employees who leave before retirement age.
In the UK, that regulation means that there is some protection through the Pension Protection Fund. Eligible schemes pay a levy and their employees are protected if the company goes bust. I think that if the management company goes bankrupt, the underlying investments may still exist and if so another company can take over management.
The main companies that run where pension funds where I live are life insurance companies, annuity companies and other large financial services funds. They are overseen by the trustees whose duty is to the pension holders.
The fundamental challenge of a pension is that in the ordinary course of things the risk that the investments will not perform as expected sits with the pension fund. It costs money to mitigate this risk, and investment returns are not what they were in the 1980s and 1990s.
posted by plonkee at 2:17 AM on December 20, 2021 [1 favorite]