Pension Challenges Due to the Virus Crisis

Tuesday, April 28, 2020

By: Neal Stoughton, Professor of Finance, School of Accounting and Finance

Among the many significant impacts of the recent crisis is the effect on individual pensions. Retirees are heavily dependent on other pension funds or savings as the average social security benefit is only $1500 per month. Pensions can come in many forms such as 401(k), IRA, Roth IRA, defined benefit, and defined contribution. We discuss important considerations facing individuals in view of recent developments and changes in pension policy.

Defined Contribution Plans

In recent decades there has been a gradual trend away from defined benefit toward defined contribution plans. Defined benefit plans are at the discretion of the employer and may be threatened by underfunding. By contrast, defined contribution plans are “fully funded” by definition. But all the risk is essentially borne by the employee or retiree. Optimal asset allocation policies are usually governed by a rule whereby the mix between risky stocks and bonds shifts towards bonds as the employee approaches retirement. Due to the market crash, it is very likely that the allocation to equities has declined already. Therefore, many employees may find they are “underweight” equities. Do not exacerbate this by selling equities and moving more funds into bonds or cash. First, lessons of financial history show that there are long run mean reversion tendencies in the stock market. Risky investment opportunities are better now than before the crisis. Second, long term bonds are returning a nominal return near zero, which means that even small amounts of inflation may decimate real bond returns in the future. Especially if there are more than 10 years to retirement, if the equity/bond percentage is below the classical 60/40 split, a reallocation towards stocks will probably pay off handsomely in the long run.

401(k) Plans

These are a form of defined contribution plans sponsored by the employer, so the above considerations apply. Examine the current value split between equities and bonds (cash) in relation to the 60/40 classical ratio. Keep an eye on the types of funds in your portfolio, however. There has been a big difference in industry impacts in the recent crisis. Some industries, like travel have been very hard hit. Their prices have declined enormously. But because government bailouts come with strings attached, current shareholders may have their stakes diluted by government warrants. This is what happened in the last financial crisis, GM and Chrysler being an example. By contrast many Tech companies are in relatively better shape going forward despite the fact their prices have declined less.

One important change in regulations concerns Required Minimum Distributions (RMDs). Under current law retirees do not have to withdraw RMDs until age 72. Due to the virus there is a one-year moratorium on RMDs. This means that retirees can save on current taxes if they do not need the money for consumption purposes. But be careful. The massive increase in federal deficits and Fed balance sheet growth has consequences. Tax increases especially for wealthy retirees are likely. You may be trading off saving taxes now but paying much more in a few years when that money must be withdrawn anyway.

Roth IRA Conversions

An IRA is another example of a defined contribution plan, but one where the individual has more authority over the options for investing. These plans are not employer specific. Now might be a good time to consider a Roth IRA conversion, i.e., paying the tax in 2020 and shifting funds to a non-taxable Roth IRA account. Again, this might be a good idea because of the likelihood of higher future tax rates. Also, Roth IRAs are not subject to RMDs.

The Virus Crisis has forced us all to reexamine our lives. Even if we can stay healthy, we should take this opportunity to reexamine the pension situation as well. In the immortal words of Benjamin Franklin, we should aspire to be healthy, wealthy, and wise.