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“History, Issues and Trends of Defined Benefit and Defined Contribution Plans andHow to Combat the Effort to Change From DB to DC”. 10/2009
- HoleHistory of pension plans-
The first US government pension plan was started by the militia. The first privatedefined benefit corporate pension plan in the U.S. was started by American Express in1875. In 1911 Massachusetts formed the first state pension plan. In 1948, unions wonthe legal right to include pensions on the collective bargaining agenda and tried to force
company’s to set aside money to fund future obligations. The number of DB plans grew.
 At that time, pension funds were invested mostly in bonds. In 1950, US Steel was one of the first plan sponsors to utilize equities to fund pension pr
omises. In the late 1960’s andearly 1970’s, trust banks lost control of conservative investing to pension funds and
money managers who now had the academic theories of the Markowitz and SharpeModern Portfolio Theory and federal legislation. A portion o
f the 1970’s was a time of 
low or negative returns due to high inflations. People began to move from job to job.In 1974 the Employee Retirement Income Security Act (ERISA) was passed, largely inpart because of the collapse of Studebaker. This act set standards to protect members of private DB plans. This first comprehensive pension reform law passed during a large-capitalization bear market, thus further helping money managers. ERISA requiredcompanies to fund ongoing pension costs and close unfunded liabilities; established atough fiduciary standard; directed plans to diversify their portfolios, and allowed pensiontrustees to delegate fiduciary responsibility to money managers that registered with theSecurities and Exchange Commission (SEC). Laws were passed which reduced oreliminated incentives and made it more expensive for the private sector to offer DBplans.
In the 1980’s, corporate profits were down and the high interest rates reduced the present
value of pension obligations, creating surpluses that companies could use forrestructuring or acquisitions simply by shutting down the pension plans and paying outthe benefits. Corporate raiders used over funded plan surpluses to pay off debt associatedwith their leveraged buyouts. In 1990 Congress ended this practice by imposing a 50percent excise tax on reclaimed surpluses.
DB plans took another hit in the 1980’s, the recognizing of the defined contribution or 
401(k) plan by the Internal Revenue Service. Union membership numbers weredecreasing, and workers were moving in mass from job to job. The DC plan filled theneeds. Companies had to think about costs as health insurance was becoming morecostly, and global competition was cutting into profits. The new DC concept seemedcheaper to administer, but the bulk of the financing and the liability of investment risk now fell on the uneducated worker.
In addition, the bull market began to rage in the 1980’s, and mutual funds became more
attractive. From 1985-2000, the number of corporate defined benefit plans fell from
 
2170,000 to 49,000. In that same time period, the number of 401(k) plans jumped from30,000 to 348,000. The bull market continued until 1996. DC folks were happy.High assumed rates of returns were assigned. Many times, employers were notcontributing as they should have (contribution holidays). Corporations usually made theminimum contributions. Multi-employers usually funded higher amounts due to contractobligations. This not only stabilized funding and minimized volatility of employercontributions, plans were able to increase benefits. Corporations on the other hand wouldmake benefit adjustments annually.In 2000-2002 the US stock market tanked. Not only did the stock prices plunge, theFederal Reserve Board deeply cut interest rates. As a result, pension liabilities soaredand many corporations had to pump in large amounts of cash to fund their pension plans.In 2002 and 2003 the amounts went as high as three times the annual average contributedover the previous 20-year average.Plans went from being well funded to being under funded. Companies went from notneeding to make a contribution for many years to having to make a balloon payment, asthey had not continuously contributed. Employers saw a way to cut costs and liabilitiesor obligations. Many small corporations and some governments changed from DB to DCplans. Some corporations closed or froze their pension plans because it seemed likeeveryone else was doing it.In 2006, good market returns and a rise in interest rates improved the financial health of many corporate DB plans. Plans were again fully funded, but plan freezing continued.20-25% of the nations 2.3 trillion dollars in corporate DB plans had been frozen by theend of 2006. In years past this was only done in troubled businesses, but now it camefrom financially stable companies.Part of the cause was due to the reform of the Pension Protection Act of 2006, a law thatwas intended to strengthen DB plans. Tighter funding rules required sponsors to valuetheir pension assets and liability more frequently, beginning in 2008. Full funding had tobe phased in over the next seven years.The 2006 the Pension Protection Act called for the valuing of assets and liabilities morefrequently, and said they must be funded. Corporate benefits were discounted usingcorporate bond interest, which therefore increased corporate liability. Soothing wastightened and therefore more conservative investing took place producing lowerreturns. On the other hand, multi-employer benefits were discounted using interestassumption on expected returns, and they had to go to a 15-year amortization periodinstead of 30 years. Funding status zones were created.As a result of the passage of the PPA of 2006 and FASB guidelines, many companiesshut down their plans rather than face new funding requirements, additional costs andrisks. Within a year of passage of the PPA, the Pension Benefit Guarantee Corporation,
 
3which is the government entity established by ERISA to take over pension plans fromtroubled companies, had 5,000 pension plan terminations. As a result, the PPA requiredcompanies to pay a higher premium to the PBGC to assist with the bailouts.The Financial Accounting Standards Board (FASB), has passed new rules that addedpressure such as no longer allowing the net funded status on their balance-sheetfootnotes, and no longer allowing smoothing values and liabilities over a variable periodof 10-15 years, but rather 24 months. Now current market values of assets and liabilitieshad to be used and must be posted on the balance sheet. This could reduce the
company’s net worth considerably. In the following three years, FASB (if they are still
around due to lack of funding) was expected to extend the mark-to-market pension
accounting to the income statement, resulting in even more volatile earnings. This “FASPhase Two” initiative spiked the number of plans being frozen in the UK.
 
These and other measures, both accounting and political, forced more conversions fromDB plans to DC plans.The real estate market bubble burst in 2007 and the financial world unraveled in 2008.
The trouble is that…
 
States and local governments have 14 million employees, 10% of the US workforce.In 2000, 90% of those folks had a DB plan. One forth of those folks are not in SocialSecurity.The number of government and private DB plans is falling rapidly. 437,000 individual401 plans account for 65 million participants and 3 trillion dollars.If you take away the DB benefits, some still have Social Security benefits to supplementtheir retirement (Nebraska, District of Columbia, Michigan, and West Virginiateachers), but how about those not under Social Security like Alaska? Otherstates that are not under Social Security are: Louisiana, Colorado, Maine,Massachusetts, Nevada and Ohio.Some states like Florida, South Carolina, Colorado, North Dakota, Vermont, Washington,and some plans in Ohio and Montana, a DC plan is optional.Some states went from DB to DC and back to DB (West Virginia, and plans inNebraska).Some states went to hybrids (Indiana, Washington, Nebraska, Oregon, and some plans inTexas and Ohio).Retirees are living longer, therefore the need for retirement funds is increasing. In 80
years, a three year “down market” has only occurred once. Are employers using the
economic downturn just to strip benefits from plans that may not have been funded
 properly during the “good years”?
 
DC participant issues and concerns: What they should be asking themselves.
1) Have members had to buy disability insurance or life insurance (side accounts)because of lack of disability and survivor benefits that a DB plan has? (Disabilityrisk, survivor risk and mortality risk). If the DC plan does offer these benefits, theyare usually based on the account employee must pay for coverage.
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