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Pension obligations | American civics | US government and civics | Khan Academy - YouTube
Channel: Khan Academy
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Voiceover: Talking about
pensions isn't always
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viewed as the most
interesting thing to do,
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but hopefully this video and the next one
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might convince you that
it is at least worth
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talking about and
understanding because it has
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major implications for
the fiscal situation
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of many, many, many states in the U.S.
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A pension is essentially
a defined benefit plan.
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Defined benefit plan for retirement.
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We can compare that to a
defined contribution plan.
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Defined contribution plan.
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The defined contribution plan, and this is
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more typical in a lot of
private companies right now,
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every year that you work,
let's plot a little graph here.
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This is years that you're working,
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and this is kind of compensation.
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This is compensation right over here.
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In a defined contribution,
every year that you work,
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you're obviously going
to make your salary.
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Let's say you're making $60,000 a year.
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You're obviously going to make
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your salary every year that you work.
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In a defined contribution plan,
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let's say this is when you retire,
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let's say for simplicity, we're assuming
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that you're going to retire at 65.
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At 65, you're no longer going to be
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making your salary anymore.
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You're not working for
that company anymore.
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What the company will
do is set up some plan,
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and a lot of these are 401(k)s, IRAs,
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where some combination of you and
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the company will set some money aside,
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and it's usually done
in a tax-deferred way,
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so you don't have to pay
taxes on it in that year.
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Every year, you're going
to set some money aside,
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and I'll do that in green.
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You're going to set maybe
10% of your income aside
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in every year, so these are every year.
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Actually, the years are
going to be much smaller
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than that, if we're thinking
this is about 30 years.
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Over the 30 years,
you're setting some level
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of money aside, and you're investing it:
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you're putting it in the
stock market; you're buying
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bonds with it; you're buying mutual funds.
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Who knows what you might be doing with it?
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You're setting this money
aside, so that when you
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retire, it will hopefully have grown.
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Well, one, it's there,
and you've invested it.
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Hopefully, if you've invested
it well and the stock
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market didn't do anything
crazy, it will have grown,
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and it will be just a
big lump sum of money.
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Let's say that you set aside $6,000 a year
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on average for 30 years,
so you set aside $180,000.
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Let's say you invested it
pretty well, and now that has
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grown to, I don't know,
let's say it's grown
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to $1 million, because
it was invested well.
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We could do the math to figure out what
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it could grow based on
different growth rates.
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You have this huge lump sum of money now.
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I'm not even drawing it to scale.
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You have this huge lump sum of money,
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$1 million, assuming it was invested well.
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If it was invested badly,
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maybe that $180,000 is still $180,000.
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In theory, maybe if it
was invested really badly,
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it could be even less than $180,000.
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Whatever that number is,
whether it's $1 million
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or whether it's $200,000, or whether it's
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something smaller, that's
essentially the money
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that you have to live
on for your retirement.
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Regardless of how long you live,
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regardless of what the
cost of living might be,
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regardless of what your needs might be,
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regardless of how expensive
your healthcare might be,
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this is going to be the money
that you have to live on.
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It might be more than enough money, if you
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invest it well and you
put enough money aside;
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it might be a lot less than you need,
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in which case you're
going to be in trouble.
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A defined benefit plan,
and this is typical;
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a lot of state employees
have defined benefit plan,
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a lot of more traditional industries
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oftentimes that are unionized.
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You also have a defined
benefit plan or a pension,
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and the situation is a little different.
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Just like any organization,
you will get your salary
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every year that you
work; and let's just say
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that this is over the course of 30 years.
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Once again, you retire at age 65.
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In defined benefit plan,
the employer is going to
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set aside some money, and sometimes
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the employee sets some
money aside as well,
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so some money is set aside.
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Once again, the money is set aside,
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and it is invested,
hopefully in a safe way.
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But regardless of what that
money and regardless of
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what that turns into
through an investment,
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you are guaranteed a
certain degree of benefits.
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In this case, you are
guaranteed; let's say that
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if you'd done more than
20 years of service here,
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you get 60% of your
last five years' salary.
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There's different ways of
defining that defined benefit.
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It could be like that, it
could be you get $100 per month
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for every year that you
worked at the organization.
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You get $100 per month
extra when you retire.
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But they tend to be for life,
for the rest of your life.
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So from 65 until you pass away,
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you are guaranteed this defined benefit.
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If the money is set
aside, if it was set aside
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and invested well and
happen to be a lot more
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money than necessary,
that's great, but all
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the employee would get is
this kind of guarantee.
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If the money is less than necessary,
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then the company is still promising that
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they are going to pay this benefit.
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They'll probably have to
put more, or the state,
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or whoever is doing
this, would have to put
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more money in in order
to pay this compensation.
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Now, what are the things
that you would have to
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estimate if you are the
person setting aside
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this money, to figure out
what you have to set aside
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in order to give this defined benefit?
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You're going to have to hire
a bunch of statisticians,
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essentially actuaries,
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to say how long are people going to live.
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You're going to have to
care about life span.
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Obviously, you can't predict
any one person's life span,
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but if you're doing this for hundreds
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of thousands of employees, maybe you can
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figure out what a likely life span is.
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You're going to have to
figure out cost of living.
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Inflation is a measure of cost of living,
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but it might be more
specific to the region, or it
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might be negotiated in
some ways with the union.
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You're going to have cost of living.
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This is a cost of living adjustment.
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When people talk about COLAs,
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if they're not talking about soda,
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they're talking about cost
of living adjustments.
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You're going to have to think about
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this money that you set aside.
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What is the assumed growth rate?
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What is the assumed growth rate?
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If you make very optimistic
estimates of how well your
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investments will do, you
can set aside less money.
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If you think that your
money isn't going to
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do well investment-wise, you're going to
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have to set aside even more money.
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This is one of the cruxes of the issue,
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because you could imagine,
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let's say that we're
talking at a state level,
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and people are, right now let's say that
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your current actuaries or
statisticians are saying,
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"Look, for this person,
in order to guarantee them
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60% of their salary when they retire,"
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so that's $36,000, "In
order to guarantee that,
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we have to put aside ..." and I'm just
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estimating these number right over here.
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Let's say we have to
set aside $6,000 a year,
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especially when we're 30 years in advance.
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Actually, let me do a
little more than that.
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Let's say $10,000 per year.
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Let's say that the person in charge,
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the state official, goes
to those actuaries and say,
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"What are you assuming
about how much we're
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going to get on our investments here?"
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The actuaries are saying,
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"We're going to assume
a fairly conservative.
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"We're going to assume that
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we're going to get 3%
return on our money."
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But then the state official says,
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ideally, they would want some of this
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$10,000 per year to spend on other things,
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and so they would like this to be lower.
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They say, "That seems very conservative.
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"In the last 10 years in the stock market,
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"we've gotten 10% return," or, "I know an
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"endowment that's
recently gotten 6% return.
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"Why don't we assume a higher return here?
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"If we assume a higher return,
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"why don't we assume a 5% return?"
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All of a sudden, if we're
assuming a 5% return,
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then we'll have to set
aside less money that year.
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$8,000 a year.
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Sometimes, it's not even this,
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it's not even this playing
with the assumptions,
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making more optimistic
assumptions that allow you
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to spend less money in that current year,
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sometimes you might know
that you have to spend
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$10,000 a year to kind of be able to
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properly fund these
pensions in the future.
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You do have some type
of unfunded pensions;
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but, in theory, a
responsible party should try
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to fund these as much as possible.
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You might know that you
have to fund $10,000 a year
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in order to credibly
give this defined benefit
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for this employee 30 years in the future.
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But 30 years in the future is a long time.
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You have present difficuties;
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you have present shortfalls
in your budget, and say,
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"I recognize that I have
to put $10,000 a year,"
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but you still don't do that,
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so you underfund the pension.
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Even if you recognize this,
or if you recognize this,
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you still only put $5,000 a year.
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Really just kind of kicking
the can down the road,
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hoping that the next guy or
gal who's in your position
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is going to figure out
something; or maybe you'll just
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be very optimistic that
the growth will turn out,
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or that the state will
eventually work things out.
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What we'll see over the next video,
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this notion of underfunding
pensions is a big, big,
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big, big problem because we've had decades
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of underfunded pensions, and it's been
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especially pronounced
in particular states.
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Because of that, those
states, in order to fund
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the pension obligations
that are hitting now,
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those expenses for
employees that are retired
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are starting to grow beyond their budgets
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for the employees that
are working right now.
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It's a tough issue.
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You can't cut these things very easily.
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People expected these.
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These are retirees.
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These are people who've been working
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their whole life based on this assumption.
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But, at the same time, they're starting to
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squeeze out key services
that the state is doing.
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It turns into a major, major hairy issue.
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