Wednesday, January 22, 2014

Sharing Retirement Risks and the Future of Nonprofit Pensions

The story of the Minnesota Orchestra is perhaps one of the most watched disputes between an arts organization and its employees in recent memory, but certainly not the only one. As reported in the Nonprofit Quarterly, this 15-month long lockout has finally reached an end. One interesting tidbit in the agreement to end the lockout is a deal to share revenues -- not ticket revenues, but endowment income. This interesting agreement makes one wonder whether we will see more of this in the future, particularly since many nonprofits have both (a) relatively large permanent endowments and (b) underfunded pensions that are placing a strain on finances.

Consider the issue of underfunded pensions and retirement risks more broadly. At its core, retirement saving entails two key risks:
(1) investment risk: uncertainty about the amount of wealth to be accumulated by an employee's retirement; and
(2) mortality risk: uncertainty about how long that wealth will need to last.

While mortality risk can be diversified by sharing it across employees, either by an employer or by an annuity contract with an insurance company, investment risk is more tricky. Investment performance for any given time period is unknown and not all such risks cannot be diversified across employees or investment opportunities (systemic risk looms). For this reason, a fundamental decision faces most employees/organizations about who will bear this risk. For-profits have largely abandoned defined-benefit pensions, opting for defined-contribution plans that place investment risk entirely on the shoulders of individual employees. Nonprofits have been more reluctant to do this, leaving investment risk with the organizations (often also relying on unrealistic assumptions about investment returns, but that's another issue all together). Perhaps not surprisingly, when investment performance has been poor, the underfunded pensions become a big financial problem for these nonprofits.

What I find interesting about the Minnesota Orchestra agreement is that it embodies a middle-ground of sorts. By sharing endowment returns with employees (while also cutting base pay), the organization has effectively pushed some of its investment return risk on employees but not gone so far as to place it all. Time will tell, but such efforts to share investment risk may be the future if organizations want their defined-benefit pensions to survive.

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