Defined Contribution Plans Gaining

December 31, 2003
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GRAND RAPIDS — Traditional corporate pensions — or “defined benefit” pensions — promise workers a monthly benefit at retirement, with the amount of the benefit known in advance and usually tied to an employee’s age, earnings and years of service.

Such plans require substantial contributions by the sponsoring companies, either through cash contributions or investment returns. But are defined benefit pension plans still viable for both employers and employees today?

Defined benefit pension plans tend to be concentrated in the long-standing U.S. industries with older workers — such as the steel and auto industries — and are designed to reward long-time employees.

They’re also still common in the public sector, said John Schneider, president and shareholder/director of Law Weathers & Richardson law firm.

In 1980, more than 80 percent of workers were covered by defined benefit plans, according to the Pension Benefit Guaranty Corp. (PBGC), the federal agency that insures private sector defined benefit pension plans.

In the mid-1980s there was a shift away from defined benefit plans toward defined contribution plans, such as 401(k) plans, that allow employees to save for their own retirement and choose how to invest their own money. In 1985 PBGC was insuring the defined benefit plans of a record 114,000 private companies.

The agency now insures about 32,500 private sector defined benefit plans that collectively guarantee about 44 million American workers and retirees a pension for life.

Defined benefit plans are still viable for some companies, particularly for employers that are highly confident about their future revenue and profits, Schneider said.

Under certain circumstances, defined benefit plans are attractive because they allow employers to put away more dollars per year for the benefit of their employees than defined contribution plans allow, he explained. 

But generally, Schneider said, most employers still prefer — and in the future are going to prefer — the defined contribution plan.  

“Defined benefit plans require actuarially calculated contributions every year, based on what the future benefits are,” he explained.

“If the stock market drops or if interest rates change dramatically, the contribution has to be made regardless of the financial situation of the employer.

“The difference between the employer’s required contribution commitment and the employer’s financial situation is sometimes rather dramatic,” he added.

“That’s a risk that many employers have decided they literally can’t afford to take.”  

A defined benefit plan is also more complicated and expensive to operate on the administrative side, Schneider pointed out.

The financial risks have caused many employers to either abandon or never start defined benefit pension plans, he added.

Employees, too, helped drive the shift to defined contribution plans in the 1980s and 1990s. From the employee’s perspective, there were really high returns on the stock market in the 1990s and the double-digit returns were a boon to defined contribution plan participants, Schneider observed. 

Defined benefit plan participants, on the other hand, did not benefit from the stock market’s exceptionally high returns.  

“So the potential upside for employees is not the same with the defined benefit plan as with the defined contribution plan,” he said. 

Although defined contribution plans have greater potential for really high growth in one’s retirement account, he added, the downside is that a stock market decline can have a devastating effect on funding of plans that are invested heavily in stocks.

Today, however, many young people just launching careers are likely to have several different employers over their lifetime, rather than a single employer for 30 to 35 years.   

“From the employee’s perspective, there has been increased interest in what’s called ‘portability’ — which means you take your benefits with you when you go from one job to another,” Schneider explained.

“That’s much easier to do with defined contribution plans than with defined benefit plans.”

Furthermore, defined plans don’t allow participants to make decisions about market investments. Young people, Schneider noted, are more sophisticated in terms of making their own investment decisions today than people were even 15 years ago, because there is so much information available.

“It’s their money and their retirement and they would like to have something to say about it.”

There has been a sharp deterioration in the funded status of defined pension plans, according to PBGC.

The agency’s executive director, Steven A. Kandarian, informed the U.S. Senate’s Special Committee on Aging last October that the PBGC is assuming higher loses as unhealthy companies terminate under-funded pension plans or file for bankruptcy.

The system is currently under-funded by $350 billion.

“Demographic trends are another structural factor adversely affecting defined benefit plans,” Kandarian testified. “Many defined benefit plans are in our oldest and most capital intensive industries. These industries face growing pension and health care costs due to an increasing number of older and retired workers.”

He said demographic trends also have made defined benefit plans more expensive because Americans are living longer in retirement as a result of earlier retirement and longer life spans.

The average American male worker, he pointed out, spends 18.1 years in retirement, compared to 11.5 years in 1950.

Schneider said the $350 billion is likely the cost of PBGC’s obligations if all of the under-funded plans in existence terminated right now.

“That’s not going to happen,” he predicted. “Obviously, when the stock market goes up like it has this year, even if plans are under-funded, they’re not as under-funded as they used to be because they’re probably invested in markets that have appreciated in value.” 

For many companies, an economic slowdown stunts revenue growth, making contributions to pension plans more difficult and increasing the risk that undefended plans will terminate, according to a U.S. General Accounting Office report released Oct. 29, 2003. 

Economic weakness also raises the likelihood that companies sponsoring pension plans will go bankrupt, the report states.

Schneider has seen more evidence of companies freezing defined benefit plans rather than terminating them. 

The problem with termination, he said, is that once the plan terminates, all those promises to pay in the future become promises that have to be paid now, so employers have to calculate what’s called the “present value of future benefits.”

“If the market value of the plan assets is low — which it has been because of the stock market depreciation — and interest rates are really low, the present value of calculations produce very high numbers,” Schneider explained.

“So it’s been very difficult for anyone in the last three years to voluntarily terminate their defined benefit plan without writing a big check, and people have been disinclined to do that.”           

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