Defined-benefit (DB) plans were the cornerstone of employer-provided retirement benefits for many years. These plans are often referred to as "pensions." Although they are still fairly common in the public sector, such as the government, these plans have largely disappeared from the private sector.
DB plans are complex and opaque, even to their many participants. Recently, the financial solvency of these plans has placed in question the benefits of the defined-benefit plans that still exist.
Here's a look at the history of DB pension plans and ways to evaluate their financial health.
- Until the 1980s, defined benefit (DB) plans were the dominant vehicle through which U.S. employers provided retirement benefits to employees.
- U.S. DB pension plans are not in sound financial shape.
- Private DB plans that are significantly underfunded must meet special requirements for accelerated funding and disclosing shortfalls.
A Brief History of Pension Plans
Until the emergence of 401(k) retirement plans in the 1980s, DB plans were the dominant vehicle U.S. employers used to provide retirement benefits to employees. During the 1960s, several large DB plans collapsed, leaving thousands of workers without promised pensions. In the late 1980s, the number of DB plans peaked. As a result, Congress passed the Employee Retirement Income Security Act of 1974 (ERISA) with the primary goal of protecting workers' rights concerning workplace retirement plan benefits. The same act created the Pension Benefit Guaranty Corporation (PBGC) as an independent federal agency to secure DB plan benefits in the private sector.
During the 1990s, 401(k)s began to dominate the workplace landscape, thousands of DB plans disappeared, and many others were frozen (meaning that coverage continued only for existing participants).
DB plans still have significant liabilities for future benefit payments, along with vast assets. As of the first quarter of 2019, the National Association of Plan Advisors reported that U.S. total retirement funds had $29.1 trillion in assets—an increase of $1.1 trillion from the same quarter a year earlier—and, of that amount, private DB plans had $3.2 trillion.
A Mixed Picture of Health for DB Plans
For those counting on a DB pension plan for part of their financial security in retirement, there's good news and bad news.
Collectively, DB pension plans in the United States are not in sound financial shape. Some of these plans will not be able to fulfill their promised benefits to retiring workers. The PBGC, which guarantees benefits in most private DB plans, is not in great financial shape either. The PBGC's Multiemployer Insurance Program faces insolvency by the end of fiscal 2026, according to findings in the FY 2018 Projections Report.
The PBGC’s Single-Employer Program, on the other hand, continues to improve and is likely to regain a solid financial footing sooner than previously anticipated. The program, which covers approximately 28 million participants, emerged from deficit in FY 2018 faster than expected.
Projections by PBGC simulations show improvements in the program’s net position over the next 10 years. However, high levels of underfunding of plans is a considerable problem. Fundamentally, the system is vulnerable to any unexpected downturn in the economy. The 2018 report shows a mean projected present value net position of $26.7 billion for FY 2028 for the Single-Employer Program, an increase of $6.6 billion from the prior report, and a mean projected net position in FY 2028 of $36.7 billion in nominal terms. There is significant variation around this mean outcome. The overall trend is consistent with that seen in the past several reports but reflects the program’s earlier emergence from deficit.
Out of 5,000 simulations, none project that PBGC’s Single-Employer Program will run out of money within the next 10 years. The improvements are due to PBGC’s net position over the 10-year period and improving plan solvency in single-employer plans and projected PBGC premiums exceeding projected claims.
On the bright side, if problems loom in a plan, a potentially affected future retiree now has more ability to learn the truth and plan for shortfalls. Also, those who participate in a private DB plan offered by a company enjoy increased odds of the full pension payout thanks to provisions of the Pension Protection Act of 2006 (PPA).
Types of DB Plans and Their Promises
Here are the four main types of DB plans in the United States:
- Federal government plans—These 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 instruments) and the taxing power of the U.S. government. These are considered the safest DB plans in the United States.
- 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 15 million active participants.
- Private single-employer plans—Most private plans still offered by companies are in this category, with just under 45,000 U.S. plans (in 2019), of which about 23,400 are currently insured by the PBGC. Three layers of security support the benefit promises of these plans: current assets and investment results; contributions that employers are required to make to keep plans funded; and guarantees provided by the PBGC in case these plans are not able to meet obligations.
- Private multiemployer plans—These are negotiated by unions on behalf of workers at multiple companies. They have been steadily declining and, as of 2019, there were approximately 1,400 plans representing some 10 million participants, according to the PBGC.
Understanding a DB Plan's Funding
A DB plan is considered adequately funded if its assets equal or exceed the discounted value of its future liabilities—the benefits it must pay. 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.
Perhaps the most important variable in a plan's liabilities is the cost of money or discount rate. Before 2006, DB plans were required to use the yield on 30-year U.S. Treasury bonds. The PPA clarified that both short- 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.
How to Tell If a Private Plan Is Underfunded
Under the 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 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 had underfunded plans. Any significant downturn in the stock market could lead to even more plan failures.
It is important to know the following information about a plan:
- Its current funding ratio (plan assets divided by the benefits it must pay)—the higher, the better
- The sponsor's plans for making up any shortfall in this ratio with additional contributions
- The portion of plan assets exposed to stock market volatility
If a DB plan is significantly underfunded, the question is whether the company is financially strong enough to make the extra contributions required by the PPA to bring it up to 100%. If the company is not financially strong, and the stock market goes down significantly, the next step may be to rely on the PBGC as a guarantor of benefits.
Perhaps the best place to check into a private DB plan's health is the basic information the plan is required to provide. The PPA requires that anyone covered by a DB plan receive a pension funding notice annually to give workers an idea of their plan's level of funding.
If you do not receive a funding notice, follow the guidelines from the Pension Rights Center, which directs you to examine your company pension plan's Form 5500, a financial report that private pension plans must file with the federal government each year. You can request a copy from the plan administrator.
State and Local Program Guarantees
State/local-sponsored DB plans have no uniform guarantor like the PBGC. If a town or county goes broke and cannot pay pension benefits, participants must look to state statutes for relief—and may find mostly legalese.
In a few states, the law is clearly favorable for pensioners, stating in boilerplate language: "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 requires the state to use its taxing power to make good on any pension benefits.
At the opposite extreme are the states that treat pension rights as gratuities, meaning workers have no contractual rights when arguing against the state. Between these two are the states that provide no constitutional or statutory protections but have strong histories of case law protecting public pensions.
The NCPERS provides a useful summary of provisions in all states.
The Bottom Line
Research can help determine how much retirement funding a DB plan is likely to provide. If you work for a strong and growing company in a healthy industry and a plan is near or above a 100% funding ratio, good for you. If an employer is in danger of going broke, workers may be forced to fall back on the PBGC for private plans or on state guarantees for state/local plans. In either case, participants and prospective retirees should know the status of backstop programs.