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 are complex and opaque to many participants. This article offers some specific ideas for evaluating the financial health of your plan quickly and easily.
To learn more, read: Analyzing Pension Risk
A Brief History of Pension Plans
Until the advent of 401(k) plans in the 1980s, DB plans were the dominant vehicle through which U.S. employers provided retirement benefits to employees. According to the Pension Benefit Guarantee Corporation (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, leaving 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 the primary goal of protecting workers' rights concerning 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 coverage would continue only for existing participants. However, DB plans still have significant liabilities for future benefit payments along with vast assets. As of the first quarter of 2018, the Investment Company Institute reported that U.S. total retirement funds had $28 trillion in assets and, of that amount, private DB plans had $3.1 trillion. Annuity reserves outside of retirement accounts accounted for $2.2 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 good and bad news.
Collectively, DB pension plans in the United States 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 PBGC, is not in great financial shape either. The PBGC's Multiemployer Insurance Program faces insolvency by the end of fiscal year 2025, according to findings in the FY 2017 Projections Report.
However, the PBGC’s Single-Employer Program, continues to improve and is likely to emerge from deficit sooner than previously anticipated. The program, which covers approximately 28 million participants, could potentially emerge from deficit by fiscal year 2018 and is likely to emerge by fiscal year 2022. Projections for FY 2027 show a possibility that future deficits that be in excess of $100 billion,"but with an average positive FY 2027 net position of $26 billion in future dollars ($20 billion in today’s dollars)." The improvements are a result of better pension plan funding and projected PBGC premiums, which are exceeding projected claims.
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. 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 21 million active participants.
- Private single-employer plans - The vast majority of private plans offered by companies fall in this category, with about 22,000 U.S. plans, 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 2018, there are approximately 1,400 plans representing approximately 10 million participants, according to the PBGC.
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 "Consumer Information on Retirement Plans." The document "Protect Your Pension: A Quick Reference Guide" can alert you to the signs that your pension plan is being misused. The U.S. Department of Labor also provides this document "What You Should Know About Your Retirement Plan." Chapters 3 and 7 are particularly important because they describe what information your plan providers must disclose and outlines their responsibilities.
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.)
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 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.
You can find out if you plan is underfunded by following the guidelines set out by The Pension Rights Center, and you can access summary information on PBGC protection 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 cannot pay pension benefits, participants must look to state statutes for relief. Here, they would find complex 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.
With some research, 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, all well and good. 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 that you can plan an income that will not be disrupted by any downturns or disappointments.