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< page 9 of 44 > |
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Ongoing challenges
Teachers’ fundamental challenge is that the plan is continuing to mature. Within this challenge, the cost of future benefits is increasing as pensioners live longer than expected, and the current low interest rate environment limits prospects for investment returns, thereby driving up projected pension liabilities. Nearly all defined benefit pension plans worldwide face these concerns and are having to make the difficult decisions needed to balance assets and pension liabilities.
Plan maturity
There are currently 1.6 working teachers for each retiree. This ratio is projected to fall to as low as 1.2:1 in 10 years. As a result, a declining proportion of the membership carries increased responsibility for meeting the plan’s funding requirements. Meanwhile, new life expectancy data shows that retirees will receive payments for a longer period of time than before. With the ability to retire as early as age 50, plus increased longevity, the average teacher who retired in 2007 will have worked 26 years and is expected to receive a pension for 31 years, with five additional years of pension expected to be paid to a survivor. We expect the average pension entitlement will run nearly 10 years longer than the average contribution period.
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| | 1970 | 1990 |
2008 |
|---|
| Active members per retiree |
10:1 |
4:1 |
1.6:1 |
| Expected years on pension |
20 |
25 |
31 |
| Value of contributions as a percentage of assets1 |
93% |
42% |
26% |
| Increase in contribution rate for 10% decline in asset values |
0.56% |
1.9% |
4.4% |
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1Assuming the plan is fully funded.
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Today, contributions comprise a much smaller percentage of the plan’s assets. Consequently, the required contribution rate increase to cover a 10% decline in asset values would be more than double what it was in 1990. For example, a 10% decline would result in a contribution rate increase to 15.5% from 11.1%. |
In addition to the retirement period exceeding a teacher’s working life, the plan is also experiencing negative cash flow as benefits exceed contributions on an annual basis. In 2007, benefits paid out exceeded contributions coming in by $1.9 billion. This has been the trend for many years and is expected to continue in the future. As a result, investment returns play an increasingly critical role in enabling the plan to meet its obligations.
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Benefits paid exceeded contributions from members and the government by $1.9 billion in 2007.
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Another key measure of the plan’s maturity is the ability of contributions to absorb funding shortfalls and keep the plan fully funded. This capacity has changed dramatically over the past 17 years. In 1990, future contributions represented 42% of the plan’s assets. If the plan had experienced a shortfall, contributions could have been increased to close the gap. Future contributions represent only 26% of total assets. This percentage is expected to continue to fall in coming years. Consequently, the low ratio of working teachers to pensioners and the small percentage of contributions to total assets make it increasingly difficult to overcome funding deficiencies using contribution rate increases alone.
Low interest rate environment
Real interest rates – the return above inflation – substantially affect the amount of money required now to fund future pensions. Securing a typical $40,000 pension requires 30% more money when real interest rates are at 2% – approximately the current level – than at 4%. Though rising slightly since 2005, real interest rates remain low compared to the 1990s, but close to the historical average.
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Real Interest Rate |
Amount Required1 |
|---|
| 2.0% |
$855,000 |
| 3.0% |
$745,000 |
| 4.0% |
$660,000 |
| 5.0% |
$585,000 |
1For retirement at age 58.
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When real interest rates are low, bond yields are low. As a result, the cost of future pensions is higher because the pension plan needs more money today to earn the value of pensions to be paid in the future.
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Declining interest rates do benefit the fund by increasing the value of bonds, real estate and other income-oriented assets already owned. Over the long run, however, these gains are offset as any future investments must be made at the lower prevailing yields and consequently are likely to generate lower income.
Impact on investment program
Teachers’ investment program faces a formidable two-fold challenge in managing plan assets in relation to the liabilities. The portfolio must generate relatively high returns to support the inflation-indexed pensions that have been promised. The desire for stable contribution rates and the low ratio of working teachers to pensioners restrict the ability of plan managers to increase returns by taking on more risk. If financial markets were to fall significantly, it would be difficult, if not impossible, for higher contributions to make up any investment loss that might arise.
Teachers’ investment managers address these competing concerns by operating within an asset mix that is more conservative than other large pension funds, while skillfully exploiting opportunities and using innovation to maximize returns within that mix. |
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