1.1 Pension Basics

A pension is a loan which an employee makes to their employer. You work for less today and your employer promises to pay you the amount you gave up, plus interest, when you retire. A simple example: over 30 years, an average worker might give up $154,159 in wages. Their employer might agree to pay this back at 4% interest. Based on this “loan agreement”, in 30-years there should be $500,000 waiting for the employee. The details of how this will be paid (lump sum or monthly payments), along with anything else of importance will be specified in the “loan agreement” between you and your employer, which we call a pension plan.

Each year you work, you loan your employer more money and he grows more indebted. In our example, each year the employee works increases the employer’s debt by $8,915 plus interest. This is the same as purchasing an annuity from an insurance company or amortizing any large loan you might obtain for a large household purchase. Actuaries call this yearly amount “the normal cost”. It’s also called “the service cost”. Both terms mean basically the same thing. These terms are not used in the wider world of finance and their unfamiliarity tends to make pensions less understandable. It’s fine and perfectly correct to think of the normal cost as a yearly loan payment obligation.

Since the employers are basically taking out a loan, your own experience would suggest that the interest rate on the loan would be a hotly debated issue between employers and employee representatives. The borrower always wants the lowest interest rate possible. But in the topsy-turvy world that is pension finance, employers have historically loved high rates. And the higher the better. But we are getting ahead of our story.

You can also think of the normal cost as a yearly deposit made by your employer into a long-term savings account. Financially this is exactly the same as the previous example of the loan payment, but you might find it more intuitive. As with the loan payment, if your employer puts $8,915 a year in a savings account that pays 4% interest, in 30 years the balance will be $500,000.

So far all of these numbers are just entries in an accounting ledger. No actual money has changed hands. It’s what accountants call “notional”, because it’s someone’s “notion” of what someone else should pay. It’s like the charge you see on your credit card statement each month. That’s the bank’s idea of how much you owe them. This notional savings account will prove especially useful because the amount it contains at any instant in time is the employers total accumulated obligation to you at that moment. Actuaries call this “the accrued liability”. When you read about “accrued liability” just think of it as a notional savings account with a history of (notional) deposits.

Hopefully these analogies to loan payments and savings accounts have removed the mystery surrounding the terms “normal cost”, “service cost”, and “accrued liability”. Even people in finance are puzzled by these unusual terms. But as you have seen, they are not complicated ideas that only actuaries can understand. They are just odd names for things you already know a lot about.

In an ideal world, every time the normal cost is added to the accrued liability savings account, real cash will change hands to match the notional accounting entries. In order for employee benefits to be secure, the real-money account built up from these monetary contributions and investment earnings must, at minimum, be equal to the amount of the notional accrued liablity. That’s the function of the accrued liability: it’s our benchmark for the amount of real money a pension fund needs to have on hand at any point in time if they are serious about paying off their debts to the employees.

It’s important to realize that accrued liability is not the same as “total liability”. Accrued liability is how much the employer owes today, while the total liability is the amount the employer will owe you at retirement. It might help to think of it as a (notional) journey across the country. A lot of New Yorkers fantasize about living in California at retirement. At retirement, in 30 years or so, our New Yorker wants to be living in San Francisco. At the start of his working life, he hops in his notional-car and leaves New York, heading for San Francisco. Each stop along the way represents another stage in the accrued liability, but his ultimate destination remains San Francisco. His employer needs to keep filling his notional-car’s gas tank with real gas in order for him to get to San Francisco on time. The employer does that at each stop. If he doesn’t, our New Yorker risks getting stuck in Cleveland. Nobody wants that. The filling will stop when he actually retires, in San Francisco.

If you prefer numbers: 15 years into his career, our 30-year employee will have $178,511 in the notional accrued liability savings account. Hopefully that notional amount has been matched by actual contributions from the employer and real interest payments. None of this changes the total liability at his 15th year which is now $277,632. If his employer wanted to fund his retirement completely today, he would need to make an actual deposit of $277,632 - $178,511 = $99,121 into a savings account paying 4% interest. Or he can continue paying off the total liability, year-over-year.

There’s nothing wrong with funding a pension to the accrued liability but leaving the total liability underfunded. It is unrealistic to expect your employer to give you enough gas in New York City that you would never need to fill your tank again. It will all work out fine as long as he fills it at each stop on the way. But the total liability will always be there, waiting in the wings, ready to be converted bit-by-bit to the yearly normal cost and added to the accrued liablity.

If the employer doesn’t fill your gas tank promptly, then the accrued liability account will have more notional-money in it than the real money account. In this case, the plan is underfunded and your retirement is potentially in jeopardy. As anyone who has missed a credit card payment will know, this situation can get out of control incredibly fast. If our employer misses just one yearly payment for the 15th year of the employees service, next year he will owe $18,186.70. That’s two years of the normal cost ($8,915 + $8,915) plus the missed interest payment of $356.60.

Employers can also underestimate how much gas they need to put in your tank. They keep putting gas in and everything seems fine until suddenly you realize there’s no way you can get to San Francisco in time. This will happen if the accrued liability is being low-balled for some reason. This is particularly serious because it can go on for years without being discovered. This is like accidentally misreading your credit card bill for 10-years and paying much less than the required minimum payment. When you finally realize your mistake you discover you are already in a heap of trouble.

But once again, we are getting ahead of our story.

Hopefully we’ve managed to help you develop an intuitive sense of how pension funds work and some of the problems they can face. In the next section we will talk about exactly how pension funds have gotten themselves into so much trouble.