But what can you say when your clients ask whether their DB pensions will pay 100 cents on the promised dollar? How can you help?

In this article, I'll offer a few ideas and I'd like to hear yours, too. Here's my key point: It doesn't help to gloss over the question by being optimistic. For reasons I'll cover, many DB pensions probably won't pay 100 cents on the dollar. You can discount future benefit projections in increments that vary by type of plan and each client's risk tolerance. This exercise will draw clients' attention to the issue, so other retirement planning decisions can be made in context.

Next: Reading the signs

Reading the signs

Let's start by reading the signs that explain why many DB pensions probably won't pay 100 cents on the dollar. It's significant that these signs are global in nature and keep popping up more frequently. To interpret them, it helps to understand that there are three sectors of the U.S. DB pension system and all three are weakening, although in different ways and at different rates. They are:

• Public  – The Pew Center on the States has estimated that the pension funding deficit now totals $757 billion for all state plans and $99 billion for 61 large city plans. You can review Pew's data on cities (and check your city's funded ratio).

• Multiemployer  – These plans, created through collective bargaining, cover about 10 million Americans, with a backstop of Pension Benefit Guaranty Corp. insurance.  In March, the Government Accounting Office warned that insolvencies in these plans are threatening the PBGC fund. PBGC has raised the 10-year projection of its present value liabilities from these plans from $1.8 billion to $7.0 billion.

• Private single-employer  – Private pension expenses and unfunded liabilities keep rising, despite healthy investment returns. Wilshire Associates reported in April that private DB plan earned an 11.8 percent return in 2012, on average. Yet, the median funded ratio of plans represented by S&P 500 companies fell from 77.7 percent in 2011 to 76.9 percent in 2012, even as total contributions made by these plans increased $3.4 billion. Towers Watson separately reported that total funding deficits of the 100 largest U.S. private plans increased 17 percent (to $295.2 billion) at year-end 2012 compared to the year earlier.

• State law pension protections – The Chapter 9 case of Stockton, Calif., the largest U.S. city ever to declare bankruptcy, has become a test case of whether federal bankruptcy courts can override state laws that forbid cuts in public pensions. The case eventually could reach the Supreme Court and have far-reaching consequences.  In bankruptcy, Stockton has stopped making interest payments on the "pension bonds" it has used to borrow money from private investors, to meet obligations to the state pension system, CALPERS.

• COLAs – How reliable are the cost of living adjustments (COLAs) promised by some pensions? Apparently, not very.  For example, Rhode Island has "modified" the 3 percent annual increase it promised participants in its state retirement system, making it contingent on the system's achieving an annual investment performance target. Legislatures in Illinois and Oregon are considering cuts to pension COLAs.

• Government bailouts  – As Greece has shown, pensioners can be expected to play a role in bailing out troubled governments. After several rounds of cuts to pensions, some public sector workers retiring today in Greece will receive about 50 percent of the income promised to a worker who retired a few years ago. Can it happen here? In 2012, the Rhode Island town of Central Falls emerged from bankruptcy after cutting the pensions of some workers by up to 55 percent.  The town's bankruptcy did not protect pensioners from devastating cuts in retirement income.

• Owning troubled debt – The Social Security Reserve Fund of Spain has reported that 97 percent of its assets are now invested in Spanish sovereign bonds, which doubly exposes pensioners to any future default in government debt. Meanwhile, this fund has moved into deficit status, paying out more in benefits than it takes in.

• Owning the company – In April, Kodak announced that it planned to emerge from bankruptcy by selling its largest remaining operating unit for $2.8 billion to satisfy claims of its pension plan in the U.K. Thus, these pensioners' retirements may well depend on whatever they can extract from the business itself. In the U.S., Kodak's DB plans cover 63,000 people, according to the PBGC, which is expected to share the plans' costs for decades.

• Ratings – Moody's recently announced it is reviewing ratings of 29 local governments over pension funding concerns. The ratings agency said it believed pension liabilities were being under-reported. Any downgrades will make the governments' borrowing more expensive, further weakening their ability to adequately fund pension promises.

By following these trends and keeping clients informed, you will better understand each client's DB plan risk tolerance. Clients with a high risk tolerance may decide to ignore the potential impact. But some conservatively-minded clients will think: "If it can happen in Greece, Spain or Stockton, it can happen to me."

Next: Developing a rationale

Developing a rationale

Let's develop a rationale for projecting client's future pension benefits. We'll begin by making a few assumptions:

• Conservative retirement planning should assume most pensions will not pay out 100 percent on the promised dollar. This gives clients a cushion of assurance. It also may help to determine when they can afford to retire and the lifestyle they can afford in retirement.

• The longer clients live and the farther pensions stretch, the more likely it is that their pensions will pay less than 100 cents on the promised dollar.

• The "safest pensions" are in the private sector, where plan liabilities are measured using a historic average of bond yields. Benefits are less secure in public plans, which are given broad latitude to choose discount rates based on investment return assumptions. The higher the discount rate used, the less realistic projected liabilities (and funding ratios) may be.

• In the private sector, the security of DB payouts depends mainly on:

1. The company's stability and growth; and
2. The plan's current funded ratio. Although Kodak's U.S. DB plans have a relatively high funded ratio (estimated at about 85 percent), the company's lack of growth has made its participants vulnerable and dependent on the PBGC's dwindling resources.

• The most vulnerable DB plans are multiemployer. Union employees have steadily lost their ability to bargain for protection of promised benefits. The PBGC's multiemployer insurance program can't be relied on long term.

The table below shows a pension benefit discounting projection over 30 years for two pension streams:

1. A fixed (flat) promised benefit of $1,000 per month; and
2. A starting benefit of $1,000 per month with a 3 percent annual COLA. At the end of 30 years, the COLA increases the benefit to $2,427.

The projection uses a "neutral" benefit discounting method that an advisor might apply to an average DB plan by assuming:

1. Promised benefits are discounted by 1 percent per year compounded – i.e., in the fixed pension, each year's benefits are 1 percent lower than the last;
2. The annual COLA assumption is reduced from 3 percent to 2 percent.

Next: Project results

Projected results

• The projected flat monthly benefit shrinks from $1,000 per month to $740 when discounted at 1 percent over 30 years. This is actual dollars in the retiree's pocket, not inflation-adjusted purchasing power. If we also assume 3 percent annual inflation over this period, the purchasing power of the discounted pension benefit ($740) shrinks to $297 by the 30th year.

• With the COLA assumption cut from 3 percent to 2 percent, the COLA-adjusted benefit shrinks from $2,427 to $1,811 in the 30th year – a 25 percent reduction. If the COLA-adjusted benefit is further discounted by 1 percent annually, the benefit in the 30th year falls to $1,340.

You may find these assumptions useful as a baseline for a client who is about 60 years old and five years or less away from starting a pension payout. For clients who are older or already drawing pensions, the uncertainty of future income may be somewhat less. For younger clients, it probably is greater. When faced with funding crises, most DB plans have found it easier to cut promises to younger workers than to the already-retired.

Why Do This?

The ultimate goal of a retirement income analysis is to help the client make decisions that will avoid depleting assets in old age. For the millions of Americans who have earned (or are now earning) pension benefits, the security of promised benefits is one of the most critical retirement variables – and the trend isn't looking good.

Actually, the biggest trend in DB pensions may be divergence – the growing gap between strong plans and the rest. In each of the three DB sectors, there are well managed plans with adequate contributions, high funding ratios, and a tailwind of growth. This tailwind is important for clients to consider in projecting benefits from both private and public plans. It's why pension benefits are somewhat more secure in high population growth states such as Florida and Texas, and less-secure in low-growth states such as Rhode Island, Illinois, Michigan and Pennsylvania.  

On the other hand, the discount assumptions used in the example above may not be conservative enough for pensioners in multiemployer plans, private plans of weak companies, and public pensions of financially-stressed cities such as Detroit, Philadelphia, New Orleans and Chicago.

This is one way to call clients' attention to the differences between their real retirement assets and the promises. Remind them that one of their most valuable real assets is the ability to make smart decisions supported by sound professional advice.