Pension plans are created with the intention of making payments to employees after they retire. Often, plan assets grow after inception and for a long period of time because the number of employees paying into the system is much higher than the number of retirees receiving pensions. When the number of employees and retirees equalizes, a plan is nearing or already has achieved a mature state.
The goal of a pension is to allow people to retire. Most pensions are formed with contributions from both the employer and employee into a fund. The fund's money is invested in various place and grows. Each paycheck, these contributions are paying in advance for the future payments. This is called accumulation. As the fund accumulates, the employee has ownership of the fund and is active in its growth. Finally, when the time comes to retire or begin receiving from the fund, an employee who has previously been adding to the fund becomes the receiver. As more and more employees reach that point, maturity of the fund inches closer.
Upon maturity, the number of contributors to the fund is reduced, and the number of pensioners grows. This ratio reaches or even tips past a point of equality. At this point, the fund must change. A fund that is growing or that does not have any immediate liabilities, such as the payout of benefits, can invest for the long term. Money can be invested heavily in higher-risk, higher-return assets that should provide long-term growth even if the markets turn lower in the short term. However, when the fund matures, more of the fund is relied upon to pay benefits. This proportion of funds must be protected from risk and placed in a lower-return, lower-risk asset. At maturity, this slows the investment return and asset growth of a fund.
The reduction of contributions from employees, the rise in benefit payouts to retirees and the reduction in asset investment income because of the shift toward lower risk investments all combine to put stress on a pension fund. This stress can take the form of rising liabilities and falling asset values. The funding ratio of a plan is the ratio of these two numbers. The lower the funding ratio, the more stress on the pension fund. Funding ratios in government pensions tend to be in the 60 percent to 80 percent range, while those in private pensions should be closer to 100 percent or higher. If ratios fall below these ranges, only serious measures will save the fund.
Prepare for Maturity
Pension plans and their sponsoring entities can prepare for maturity. Pension maturity is partially a function of employee demographics. Employment practices and pension participation rates can help defer or reverse the effects of maturity. Actuarial analysis also helps a plan prepare for maturity, and often getting the right projections will lead to having sufficient investments to maintain funding ratios. If pension maturity has set in, the tried and true method for sustaining a pension is raising contributions or lowering benefits for future retirees, or both.
Based in Round Rock, Texas, Steve Crone has been writing a variety of pieces since 2001. His articles have appeared in various blog outlets and longer pieces have been produced for specific agencies. Crone holds a Bachelors of Arts in economics from the University of Texas at Austin.