Your pension promise.

• Author: Smith, Rodger F.
• Position: Includes related article - Pension Fund Management

Are you making the right promise to your employees for their retirement? One two-letter word makes all the difference. Take a look at the statistics.

What pension promises has your company made to its employees? Most firms promise to provide a given income replacement ratio, usually targeting 65 to 75 percent, on retirement. But is that the right promise to make? Or should the promise be to provide a given standard of living in retirement?

Of course, the difference in these two small words, on and in, is a bigger and more powerful word called inflation. Look at it this way: At age 63, which is the typical actuarial retirement age that companies have adopted for their workers today, the average life expectancy is around 18 years. Over those 18 years, inflation will take place. During that period, a 4-percent inflation rate, for example, will cut a retiree's purchasing power in half to 49 cents on the dollar if you've paid on retirement. A 6-percent inflation rate will cut your promise from $1 to 35 cents. And an 8-percent rate will cut it to 25 cents.

For Corporate America as a whole, the average pension plan participant is 40-1/2 years old. Over the past two years, that average age has been stable. The workforce isn't getting older; it isn't getting younger. And that average participant has worked for his or her company for 11.8 years. That is up very modestly but is essentially stable.

If you assume this average participant will work another 18.8 years until he or she is eligible to retire--the remaining active service life assumption--and you add 18.8 to 40.5, you come up with only 59.3 years. But your retirement age assumption is 63. What happens in those four intervening years?

In the aggregate, 66 percent of the workforce now has a vested benefit. Two years ago, only 59 percent did. So, even though the average working life hasn't extended, you've improved the vesting.

The other characteristic of the workforce is there are both retired and active components. Of the total workforce, 21.6 percent are currently retired. These retirees are already drawing on the pension promise. That's also been relatively stable over the past two years.

But what about investments? A year ago, the average corporation was expecting its investments to earn 9.4 percent long term. And almost one-quarter of companies expected their investments to earn more than 10 percent. But interest rates have fallen dramatically in the last 12 months. Companies will have a hard time earning 9.4 percent if long-term bonds are under 7.5 today and equities are sporting high P/E multiples.

The typical company assumes inflation at 5.7 percent. (That's the 6 percent I mentioned earlier that makes a dollar today worth 35 cents for your participants near the end of their retirement.) Firms discount their liabilities at 8.7 percent and their plans are overfunded--so overfunded, in fact, that the cash flow of defined benefit plans is becoming increasingly negative. In 1990, for instance, there was $20 billion negative net cash flow; in 1991, that grew to $30 billion. That's almost 4.5 percent of assets for the average fund.

Turning to retirees, the benefits that firms pay to all participants average $520 a month. In the past two years, that hasn't changed. However, companies are giving new employees more--as much as $815 dollars a month, up 5 percent over the past two...