Defined Benefit Plans--Still a Good Idea?
By: Source: AARP.org Date Posted: 2004-11-30 00:00:00-05:00
Defined Benefit Plans-Still a Good Idea?
By Anna M. Rappaport, F.S.A. and Don Fuerst, F.S.A.
Defined benefit (DB) pension plans face severe challenges. Contribution requirements are escalating sharply. Accounting costs suddenly are high and volatile, while looming accounting changes threaten greater volatility. Executives question plans with insufficient assets and poorly defined risks. Are pension plans still a good solution? Despite serious challenges, a well-designed and well-communicated DB plan actually creates substantial value for both employer and employee, and can be a source of competitive advantage for the employer.
Background: A changing landscape
Most mature pension plans were designed to provide retirement income to long-term employees on a tax-effective basis. They help organizations retain employees, provide workers a graceful transition to retirement, and help keep direct compensation and taxes lower. The retirement plan options available to employers changed dramatically when it became possible for U.S. employees to save pre-tax dollars in 401(k) plans, starting in 1981. Employers quickly added matching to their savings plans and this benefit pattern spread to different countries. During the bull market of the 1990s, many employees began to believe their defined contribution (DC) plans would make them rich and allow early retirement, while financial executives became accustomed to holidays from contributions for traditional pension plans. The bear market early in this decade quickly changed these perceptions. Employees face working longer to afford a comfortable retirement, and executives confront sharply higher contributions and expense for defined benefit plans.
During the bull market of the 1990s, many employees began to believe their defined contribution (DC) plans would make them rich and allow early retirement...
Meeting changing needs
Citizens in industrialized countries expect to retire earlier, live longer, and use more medical care than any previous generation. Traditional pension plans have declined and responsibility for retirement security has shifted to employees. Savings rates vary greatly by country, but Americans' savings far fall short of what is needed to meet their retirement expectations even though a variety of opportunities for tax sheltered savings are available. Practice differs but traditional plans usually pay benefits as monthly income in many countries. It's time to remember that employer-sponsored pension plans can create significant value for both the employee and the employer by addressing the shortcomings of DC plans.
Value creation: Tapping the potential
An employer-sponsored benefit plan creates value if it provides either the same benefit for a lower cost than could otherwise be obtained or a greater benefit for the same cost. For example, employer-sponsored insurance plans create value by pooling risk and purchasing power. Benefits are provided to all employees at a cost less than for which individuals could purchase the insurance. Pension plans have similar characteristics, but they are often overlooked because of the deferred nature of the benefits. Pension plans create value by pooling both longevity and investment risk and by reducing expenses.
How long will you live?
Pooling longevity risk creates value in two ways, one rather easy to recognize and one quite subtle, but both significant. First, consider how long an individual will need retirement income. If your retirement fund is adequate to last the average life expectancy, you stand a 50:50 chance of outliving your assets. Not the odds most would choose for such a critical issue. But how much more is really enough? If you are satisfied with 2:1 odds that you will not outlive your assets, you will need approximately 11 percent more assets. With 4:1 odds, you would need about 20 percent more, and with 10:1 odds, at least 26 percent more.
On the other hand, an employer-sponsored pension plan that covers thousands of employees can pool the longevity risk and fund for the average life expectancy with a high level of confidence that the funds will be sufficient. The value created ranges from 10 percent to 25 percent.
An employer-
sponsored benefit plan creates value if it provides either the same benefit for a lower cost than could otherwise be obtained or a greater benefit for the same cost.
The second aspect is subtler. Pooling longevity risk in a pension plan allows a plan to fund benefits more effectively even for a specific number of years. A pension plan will have some participants who die well before the average life expectancy and some who die much later. The benefits saved (not paid) to those who die early are invested and earn income that is used to pay the benefits to participants who live past their life expectancies. The two longevity factors (blending longevity plus blending resources among a group) create value of 15 percent to 35 percent.
Investment management
Investment pooling also creates significant value by offering liquidity, professional management, asset allocation, and expense reduction.
An investor needing a monthly income must keep some funds in liquid form thus lowering investment income. An employer-sponsored pension plan needs a much smaller percentage of liquid funds due to the mix of active and retired participants and inflow of ongoing employer contributions.
Most defined contribution plans rely on the individual to make investment decisions. Employer-sponsored pension plans generally have a team of investment professionals who are investing millions, often billions of dollars compared to the thousands of dollars that individuals invest. Both transaction costs and investment management costs are significantly lower for employer plans. Consider these factors together and it is easy to understand why the typical pension plan return exceeds the typical DC return by 100-200 basis points and sometimes much more. This could easily capitalize at a cost saving of around 20 percent.
The pension plan also creates value directly for the employer. Pensions encourage continued employment, thus lowering turnover costs and helping to retain intellectual capital. Contributions are allocated primarily to those employees who stay with the organization-little is allocated to those employees who leave after a few years or long before retirement age.
Pension plans deliver more consistent benefits to employees. The benefit level does not depend on the individual's investment skills or luck. DC plans produce large dispersion of benefits based on the investment choices of the individual. Participants who lack the knowledge, the skill, or simply the luck to be good investors are not disadvantaged in a pension plan and can expect a level of retirement income less exposed to the vagaries of the investment markets than self-managed funds would generate.
Support is needed for DB benefit plans
DB pension plans can create value and help employees attain economically secure retirement. They are highly desirable socially. But the deferred nature of the benefit, the employer risks associated with the plans, and the complex regulations, accounting rules, and funding requirements in the U.S., and other countries have all contributed to the steady decline of employer participation in these plans. Help is badly needed in two areas: creating a stable, favorable legislative climate and focusing the public on the value of defined benefit plans paying regular income.
Conclusion: The best type of plan
In today's competitive labor market, most if not all employers will want to sponsor a competitive savings plan. However, relying on a DC plan as the sole retirement vehicle will be expensive and inefficient for employers who want to encourage lower turnover, facilitate retirement of older workers, and create value for their employees. From the employee perspective, a DB plan should give clear advantages for all except young employees who will not stay long with a company where DC plans (or cash balance DB plans) may well be better value. Employers who offer a good balance will see lower overall employment costs and a more productive workforce. Well-designed and well-communicated defined benefit pension plans can create value and minimize employment costs.
Anna Rappaport, a worldwide partner and Principal in the Chicago office of Mercer Human Resource Consulting, is an actuary and futurist with 40 years' experience.
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