Defined-benefit (DB) pension plans were the cornerstone of employer retirement benefits for many years. Recently, however, issues of financial solvency have put the availability of these benefits in question.
DB plans have always seemed complex and opaque to many participants, so in this article we'll offer some specific ideas for evaluating the financial health of your plan. Surprisingly, you can implement these ideas fairly quickly and easily.
A Quick History Lesson
Until the advent of 401(k) plans in the 1980s, defined-benefit plans were the dominant vehicle through which U.S. employers provided retirement benefits to employees. According to the PBGC, the number of DB plans peaked in the late 1980s at more than 112,000.
However, during the 1960s, several large DB plans collapsed, stranding thousands of workers without promised pensions. When the Studebaker Corporation closed its automobile manufacturing plants in 1963, 7,000 workers lost virtually all of their retirement benefits. After extensive analysis, Congress passed the Employee Retirement Income Security Act of 1974 (ERISA) with a primary goal of protecting workers' rights in DB plans. The same act created the PBGC as an independent agency of the U.S. government, to insure DB plan benefits in the private sector.
During the 1990s, as 401(k) plans became dominant, thousands of defined-benefit plans disappeared and many others were "frozen" - meaning that they continued coverage only for existing participants. However, DB plans still have significant liabilities to pay future benefits, along with vast assets. As of the fourth quarter of 2011, the Investment Company Institute reported that federal, state, and local government pension plans had $4.5 trillion in assets and private DB plans had $2.4 trillion. Annuity reserves outside of retirement accounts accounted for another $1.6 trillion.
Good News and Bad News
If you are counting on a defined-benefit pension plan for part of your retirement financial security, be aware of some bad and good news.
Collectively, DB pension plans in the U.S. are not in sound financial shape, and some of these plans will not be able to fulfill promised benefits to retiring workers. The agency that guarantees benefits in most private DB plans, the Pension Benefit Guaranty Corporation (PBGC), isn't in great financial shape either. For fiscal year 2011, the PBGC increased its annual deficit to $26 billion from $23 billion reported in 2010. This is the largest deficit in the corporation's 37-year history.
On the bright side, if problems are looming in a plan that promises your benefits, you now have more ability than in the past to learn the truth and plan for any shortfalls. Also, if you participate in a private DB plan offered by a company, provisions of the Pension Protection Act of 2006 (PPA) should increase your odds of receiving the full pension payout promised by requiring increased contributions by the company sponsoring the plan.
Types of Plans and Their Promises
There are actually four main types of DB plans in the U.S.:
- Federal government plans - These plans cover civil service employees, retired military personnel and some retired railroad workers. The promised benefits are backed by secure funding (largely U.S. Treasury debt) and the taxing power of the U.S. government. Because these are considered to be the safest DB plans in the U.S., they will not be mentioned further in this article.
- State and local government plans - These plans cover state and local government employees, teachers, police, firefighters and sanitation workers. The largest trade group of these plans, the National Conference on Public Employee Retirement Systems (NCPERS) includes 500 public funds with more than 14 million active participants.
- Private single-employer plans - The vast majority of "private" plans offered by companies fall in this category, with about 26,000 U.S. plans covering more than 30 million participants, according to the PBGC. Three layers of security support benefit promises of these plans:
- current assets and investment results
- contributions that employers are required to make to keep plans funded
- guarantees provided by the PBGC in case these plans are not able to meet obligations
- Private multiemployer plans - These plans are negotiated by unions on behalf of workers at multiple companies. They have been steadily declining and as of 2010 insures about 1,460, representing approximately 10 million participants, according to the PBGC. As of 2008, the multiemployer program's net position declined by $396 million increasing the program's deficit to $869 million. They have the same three-legged support as private single-employer plans, except contributions are made by more than one employer.
Basic Information Rights
The best place to begin checking into your plan's health is the basic information the plan is required to provide.
The U.S. Department of Labor provides a free online guide called What You Should Know About Your Retirement Plan. The most important information is in Tables 5 and 6, describing key information your plan administrator must provide automatically (Table 5) and upon written request (Table 6). Documents such as the Summary Plan Description (SPD), Summary Annual Report (SAR) and Individual Benefit Statement explain matters such as when and how your benefits become vested and when you qualify to begin receiving payouts. For the purpose of evaluating your plan's health, the most important document is the Annual Report (Form 5500). ERISA requires that this document be filed by all private plans within seven months after the end of the plan year, and it must be provided to participants within 30 days of the participant providing a written request for a copy.
Understanding Your Plan's Funding
A defined-benefit plan is considered adequately funded if its assets equal or exceed the discounted value of its future liabilities. Most assets can be valued accurately, but the valuation of liabilities is far more complex. Performed by a qualified actuary, liability valuation must include an estimate of how many participants will qualify for benefits and how long those participants may live. But perhaps the most important variable in determining a plan's liabilities is the cost of money or "discount rate". Before 2004, DB plans were required to use the yield on the 30-year U.S. Treasury bonds. The PPA clarified that both short-term and long-term discount rates must be blended, based on the maturity of a plan's participant demographics.
In a normal yield curve, long-term rates are higher than short-term - and the lower the discount rate a plan uses, the more its future liabilities will be worth. So, the PPA's requirement to use short-term rates to discount short-term liabilities could result in an increase in reported liabilities for some plans. That, in turn, could cause these plans to fall short of adequate funding. (To read more about yield curves and their uses, see our Bond Basics Tutorial.)
A DB "funding ratio" measures assets divided by liabilities. At the peak of the bull stock market in 2000, all PBGC-insured single-employer plans had a combined funding ratio of 144%. In total, their assets exceeded their liabilities by $565 billion. However, these plans were hit hard by the bear market of 2000-2002, and their combined funding ratio dipped to 81% in 2009. They were a cumulative $352 billion in the red as of 2009, according to the PBGC.
For all insured multiemployer plans, the PBGC reported in 2009 that the funding ratio was just 48%, representing a shortfall in assets of $354 billion. A conservative estimate, therefore, would be that all PBGC-backed plans currently have about $400 billion more in liabilities than assets.
Is Your Plan Underfunded?
Under PPA, private DB plans that are significantly underfunded must meet special requirements for accelerated funding and disclosing shortfalls to the PBGC. By 2011, all private DB plans pursued full (100%) funding by amortizing any shortfalls over seven years and increasing plan contributions accordingly. This requirement was most difficult for cash-strapped, unprofitable companies that already have under-funded plans. Any significant downturn in the stock market could lead to even more plan failures. Therefore, the important information you want to know about your plan is:
- its current funding ratio
- the sponsor's plans for making up any shortfall in this ratio with additional contributions
- the portion of plan assets that are exposed to stock market volatility
If your plan is significantly underfunded, you should evaluate whether your company is financially strong enough to make the extra contributions required by the PPA to bring it up to 100%. If your plan is significantly underfunded, your company is not financially strong and the stock market turns down, your next stop may be to rely upon the PBGC as guarantor of your benefits.
The State Of The PBGC
"The PBGC is responsible for the pensions of 1.3 million Americans, but we don't currently have the resources to keep all of our future commitments." In February of 2003, PBGC Director Charles E.F. Millard made that stunningly frank statement in introducing a major change in the way his agency invests its $55 billion in assets. Given such a vulnerable state, you might think Director Millard was announcing a plan to decrease the exposure of PBGC assets to financial market volatility. The Millard introduced a strategy that aimed to take a far larger bet on the stock market and "alternative investments" (mainly hedge funds and commodities). The new strategy will increase the PBGC's allocations to these classes from 28% in 2007 to 45% in equities and 10% in alternatives (55% in total) over time. With twice as much of the PBGC's assets ultimately exposed to risky asset classes, individuals who are counting on PBGC protection for retirement security should hope these classes perform well in the future.
Not quite. The PBGC provides benefits for about 3,800 DB plans that it has taken over. Thus, it functions like a big DB plan itself. At the end of fiscal year 2011, the PBGC's own funding ratio was just 77.2%, which meant it owed about $20 billion more in liabilities than it had in assets. To fill this shortfall, Even in the best case, participants should know that the PBGC does not protect all benefits of failed DB plans. For 2011, the maximum amount the agency guarantees in single-employer plans is a single life annuity of $4,500 per month ($54,000 annually) beginning at age 65. Maximum benefits paid over two lives or beginning before 65 are scaled down. In multiemployer plans, the maximum is $35.75 per month multiplied by the years of credited service ($35.75 x 30 years = $1,072 per month).
The PBGC is clearly vulnerable to a severe recession in the U.S. economy that would cause many private DB plans to fail. The PBGC is also vulnerable to structural difficulties in specific industries with histories of failures and low plan-funding ratios. Historically, two industries - air transportation and primary metals - have accounted for 75% of the PBGC's single-employer claims. The automobile industry may be its next big Achilles' heel.
You can access summary information about the number of plans and workers the PBGC protects in your state on the PBGC website.
Checking State/Local Program Guarantees
In state/local-sponsored DB plans, there is no uniform guarantor like the PBGC standing behind promises to pay benefits. If a town or county goes broke and can't pay pension benefits, participants must look to state statutes for relief. Here, they would find a maze of legalese.
In a few states, the law is clearly favorable for pensioners by stating: "Membership in employee retirement systems of the State or its political subdivisions shall constitute a contractual relationship. Accrued benefits of these systems shall not be diminished or impaired." This language requires the state to use its taxing power to make good any pension benefits, if necessary. On the opposite extreme are states that treat pension rights as gratuities - meaning workers have no contractual right against the state. In between are states that provide no constitutional or statutory protections but do have strong histories of case law protecting public pensions. The NCPERS provides a useful summary of provisions in all 50 states.
By doing a little homework, you can decide how much of your "retirement ranch" you want to bet on DB plan promises. If you work for a strong and growing company in a healthy industry and your plan is near or above a 100% funding ratio, don't worry too much. If your employer is in danger of going broke, then you may be forced to fall back on the PBGC for private plans or state guarantees for state/local plans. In either case, it pays to know the status of these backstop programs before you reach retirement, so you can plan an income that won't be disrupted by any downturns or disappointments.