In the world of public defined benefit plans, negative net cash flow could have implications on the future health of a plan. Net cash flow refers to the balance of contributions less benefits and expenses:
Net Cash Flow = Contributions – Benefits – Expenses
If benefits and expenses are greater than contributions in a given year, the net cash flow is negative; if the contributions are greater than the benefits and expenses, then the net cash flow is positive. It is important to note here that investment returns do not factor into the equation for net cash flow. As such, while net cash flow can be an important indicator, it does not provide a comprehensive assessment of a given plan.
In this paper, we will discuss the implications and insights that negative net cash flow can provide for a prototypical public defined benefit plan. From there, we will suggest generalized levers that plan sponsors can use to help increase the health of their plan and minimize any challenges caused by negative net cash flow.
The funding status of public pension plans has been a frequent topic in the news in recent years. Looking at the actuarial funded ratio for state and local pension plans, the funded status of these plans have significantly declined over the last 15 years despite equities attaining all-time highs in recent periods.
Though some of the reduction can be attributed to the impact of having two major market downturns during this period, we have seen that some plan sponsors have not been willing or able to contribute up to their actuarial requirements, which could help to bridge the gap during stressful market environments.
Some headlines in recent years have captured how underfunded pensions can contribute to credit downgrades or even bankruptcies in states or municipalities. While the pension funding status is typically only a contributing factor in these events, the funding status nevertheless can have very real consequences.
Changes in plan demographics have also been a concern as public plans have become more mature over time. Plans become more mature as participants age, retire, and start to collect payments from the plan. Public plans generally peg employer and employee contributions to the active population, meaning you will often see pension contribution requirements expressed as a percent of payroll.
As more participants move from active to retiree status, combined with potentially larger underfunding, cash requirements as a percent of active employee payroll could increase significantly in order to fund these larger distributions.
Contact your PNC representative for more information.