Wednesday, January 2, 2013

Some quick NHL pensions math

Lots of talk today about a pensions issue that is holding up NHL-NHLPA CBA negotiations. To many on twitter, it seems like this sounds like small pototaoes. It's not. Here's why:

Let's say you run a business with 700 employees. As part of their compensation, you've agreed to set up a pension plan for them.

For the sake of keeping things simple, let's assume the following:

Every single employee will earn $45,000/year in pension starting at age 65.
Every one of those employees will collect that pension until he dies, which will magically be age 80 for all of them.

The contributions to fund the plan come out of the employee's salary until age 35 - so there's a 30 year gap between his 'stop-funding' date and his age 65 pension payout date.

The money paid in until age 35 will grow, thanks to compound interest, such that there is enough money to pay the full pension benefit when the employee is 65.

How much will it grow? It depends on the interest rate the pension plan gets on its investments. Let's say the plan earns a steady interest rate of 5% for the 30 years between ages 35 and 65.

(1.05)^30 = 4.32

So the money paid in will quadruple in that time. If the total paid out per employee is $45k/year * 15 years (again, i'm really fudging numbers here, and cutting actuarial corners for sake of simplicity), the fund will need to pay out $675,000 per employee. A fund worth about $500,000 per employee at age 65 will grow enough in the retirement years (again, at 5%) to meet those obligations.

Here's the problem: what if the plan doesn't grow at 5%? What if it grows at 4%?

(1.04)^30 = 3.24

So with the same initial contribution, you don't have $500k in the plan per employee; you have $375k per employee. Your plan is short by $125,000 per employee - that's $87.5 million for the 700 total employees.

You can see the big risks created by the uncertainty of interest rates. What if the economy continues to stagnate? What if the pension plan makes some bad investments?

Pension plans run into this sort of trouble with alarming frequency. In good scenarios, such failures are backstopped by the company behind the plan (which may be what the NHLPA is asking the NHL to do). In other scenarios, the plan is protected by a large insurer or by purchase of derivatives, but this can be very expensive to cover for such distant future events...or, the plan members suck it up and get 75 cents on the dollar, or whatever it is they end up with.

Who are we to say, though, where the NHL will be in 30 years? Maybe interest in the sport will fade, or a rival league will take over, or the sport will become less profitable, and so on. Maybe massive concussion lawsuits from former players will destroy the league...who knows.

The players, earlier in negotiations, agreed to put up $50 million of the make-whole money towards the pension-shortfall backstop - but that doesn't cover all potential risks. The $87.5m figure I quoted above is from just a 1% shortfall; what if it's 2 or 3%? I only counted 700 pension plan members - granted, all of those 700 will be receiving full pension under my model (in reality, I believe NHLers with short careers get a fraction of the full pension), but what if it's a 10-year CBA and hundreds more players are affected by a shortfall? The potential liabilities are huge.

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