VOICES FROM THE INDUSTRY: Are traditional pension plans an endangered species?

Defined benefit plans, or pension plans as they are more commonly known, were a core component of the benefits provided by blue chip employers until the 1980s. About 40 percent of all American workers were covered by these plans.

Under such plans, employees are guar
anteed monthly retirement checks for life
based upon their compensation, years of service and other factors. Recently, however, the use of pension plans has dropped dramatically. In 2003, only 20 percent of the work force was covered by these plans.

Traditional pension plans have fallen sharply out of favor with employers for two primary reasons. First, in recent years these plans have become extremely expensive to maintain. Second, the cost of the plans has been volatile and unpredictable.

Federal law requires employers to make “minimum funding” contributions to pension plans each year so that assets will be available to pay the promised benefits. An
actuary calculates the amount the employer must contribute. If the contributions to the plan turn out to be insufficient to pay the promised benefits, whether because of downturns in the market or errors in the actuary’s assumptions, the employer must contribute more money. The employer bears all of the investment and financing risk.

In addition, minimum funding obligations have been very volatile since 2000 because of the downturn in the markets between 2000 and 2002, and because of changes in the assumptions used to calculate the minimum contributions. When the stock market is down, plan assets that are
used to pay benefits decrease and the required employer contributions rise. When interest rates decline, pension liabilities increase, and again the required contributions go up. The combined effect of a decline in plan assets and an increase in plan liabilities puts an extraordinary burden on employers.

In spite of the minimum funding requirements, the government estimates that the nation’s pension plans are currently underfunded by $450 billion. The Pension Benefit Guaranty Corp., a government organization that pays minimum monthly benefits to retirees if their employer goes bankrupt, has gone from a $7.7 billion surplus in assets in 2001 to a $23.3 billion deficit in 2004 because of bankruptcies in the airline and steel industries.

In 2002, to provide some relief, the government temporarily changed the way required contributions are calculated. This fix expires, however, at the end of 2005.

Pension plans are now facing two additional threats-a change in how they are reported on financial statements and the Bush administration’s decision to increase the minimum funding requirements. Today many employers are able to report lower plan liabilities in their financial statements than they report to their employees. Right now, this disparate reporting is perfectly legal. However, the non-governmental body that sets the accounting rules is preparing a proposal that would require many large corporations to give a more consistent picture of their pension liabilities.

If this news is not bad enough, the Bush administration in January announced that it is going to submit a proposal to Congress to require companies with credit ratings below investment grade to make greater minimum funding contributions.

There are some actions an employer with a pension plan can take to reduce the burden. Minimum funding contributions are calculated based on assumptions about future market performance and interest rates, as well as future wage rates and retiree life expectancies. A small change in the assumptions used can have a large effect on the minimum funding obligations. Alternative assumptions are permitted, and an actuary can determine if an employer is using the most favorable assumptions permitted by law.

An employer facing a short-term financial crisis can apply for a waiver of its minimum funding contribution. Employers can also carefully preserve in their written and oral statements to employees their right to amend the plan, change the eligibility rules, close the plan to new participants, freeze the benefits or, in some cases reduce the benefits.

An employer can also terminate their pension plan, but only if there are sufficient assets in the plan to pay all benefits. If there aren’t sufficient assets, the plan can be terminated only if the employer and all related companies are in bankruptcy.

In stable or bull markets, the assets in pension plans tend to keep up with the benefit liabilities. Both employers and employees should hope for a healthy economy that bolsters the market.