If the present can grow into the future, can the future come backwards to the present? Well, it does in Alice in Wonderland.

What we are talking about here is money concepts; that is, money in hand now versus the right to money (benefits) in a pension plan in the future. The mathematical term for this is more specifically the present value of a dollar versus the future value of a dollar. Oh, oh! Those who always hated maths may be tempted to stop right at this juncture. But, you shouldn't.

Read on to find out what it means when the news media reports that a public company may have an unfunded pension liability, because whether you work for a public company or not, it is important to understand how your personal pension benefits are actually structured.

There are two kinds of pensions - actually there are more - but generally, they fall into two categories: defined contribution plans and defined benefit plans.

Defined Contribution Plans, such as the 2000 Bermuda National Pension Scheme - or a United States 401(k) Plan - cede most of the control, the choice of the investments and the contributions into the plan to the employee, even though the employer may have a mandate to contribute certain percentages each year. Ultimately, it is the employee's responsibility to ensure that the cash contributions withheld from pay cheques, as well as the amounts matched by the employer, are paid into the pension trust for the employees of the company. Ninety-nine percent of employers are extremely conscientious, routinely and ethically meeting their pension obligations in a timely manner; they do not have unfunded liabilities. The one-percent of local firms who do not honour their commitments, and thus are either late or have not paid in the contributions at all, have a liability to you, and to the Bermudian Accountant General and government. You may be able to check to see that your pension payments are current; it is suggested that you inquire of the Pension Commission.

Defined Benefit Plans (DBP) are a different kettle of fish. Years ago some Bermudian companies implemented defined benefit pension plans (for those employees lucky enough to have them), while thousands of United States public (and private) companies still provide this type of pension. They are no longer as popular as defined contributions plans because the employer has the obligation (liability) to pay you, the employee, a certain sum of money in the future for every month of your natural life during retirement. Typically, this annuity income stream is far superior to the defined contribution plan lump sum or annuity at retirement. Why that is, becomes the subject for another article; it is sufficient to say for now that the average investor's track record in handling his/her own investments has been dismal.

In a DBP, the employee has no control over the money (the future benefit), how it is calculated, or how it is invested. How does the company know what to put into their reserves (pension liability) in order to have enough to pay you when the golden watch day arrives? Many variables come into play here, but the four most influential that have to be projected because we cannot see into the future are: Inflation; Level of wage earnings; Mortality; and Average rate of return on earnings.

If you are forty-five now and want to retire at 55 in the year 2012, assumptions are made as to what your last three, usually the best earnings, years will be in the future. From that best three years, an annual retirement pension amount is calculated, perhaps 70% of the average. Let's assume that amount to be $30,000 annually in today's dollars.

What will be your mortality age? A polite way to estimate when you are departing this earth - let's say age 85 (or at least the company is hoping you only live until age 85)! A) In order to keep pace with inflation, what will $30,000 be worth in ten years? B) The inflated value of $30,000 in ten years is projected out for 30 years of glorious retirement to produce a 2012 present value lump sum equal to 30 years of annual pension payments invested at some estimated interest rate and building in for the effects of inflation. C) Are you following me? Don't feel bad if you are not because there are very well compensated actuarial professionals whose entire careers are consumed with the calculations of these probabilities.

Then here is the kicker. The lump sum that you need at the beginning of your retirement - to fund 30 golden years is then brought back to (discounted ) to today's dollars - $ In other words, what does the company need to set aside and invest today at current rates of return to have enough money to provide for your retirement need in the future?

In scenario one, the lump sum needed in 2012 to start your pension is discounted at a 9.5% average rate of return. Unless you never read the papers or watch CNBC, or surf the Internet, or open your financial statements, you know that interest rates are very low right now and have been for more than two years. The investing rate of return is probably subject to the largest swings in calculations because interest rates and investment earnings are sensitive to capital market volatility. The average rate of return has huge implications as to how much of a potential liability the company actually has to its employees at any point in time.

So if a 9.5% rate of return is not theoretically achievable, why isn't a more realistic rate of return of say, 5% used? Scenario two. And the answer is, because the lower the rate of return used to discount the lump sum, the higher the amount that has to be held in reserve and the more cash that has to be set aside. See differences in the chart.

After three years of a bear market, analysts figure that many pension reserves are too low and are publicly stating the fact that many companies' defined benefit plans have unfunded liabilities. Companies will have to contribute additional cash to reduce the liability. To further add to the pain, many company pension portfolios have also lost value; those reserve accruals will have to be increased. All of this negative news tends to depress the market value of the company stock, which very often is itself used to top up pension reserves, thus generating more than one set of losing propositions!

I once had a boss who hated accounting. He often stated he didn't understand all the accruals and reserves, that it really was all "smoke and mirrors." What do you think?"

Martha Harris Myron CPA CFP(tm) is a Bermudian, a Certified Financial Planner(tm)(US license) practitioner and VP and Manager, Personal Financial Services, Bank of Bermuda. She holds a NASD Series 7 license, is a former US tax practitioner, and is the winner 2001-The Bermudian Magazine - Best of Bermuda Gold Award for Investment Advice. Confidential Email can be directed to marthamyron-orthrock.bm

The article expresses the opinion of the author alone, and not necessarily that of Bank of Bermuda.

Under no circumstances is this advice to be taken as a recommendation to buy or sell investment products or as a promotion for financial plans. The Editor of the Royal Gazette has final right of approval over headlines, content, and length/brevity of article.