Pensions On The Chopping Block
FORECASTS & TRENDS E-LETTER
IN THIS ISSUE:
1. Background: The Basics Of Pension Plans
2. Calculating Plan Contributions Is Complex
3. Causes Of Today’s Pension Problems
4. Baby Boomer Demographics
5. The Federal Government To The Rescue?
The word “pension” usually conjures up thoughts of security and stability; a regular monthly retirement benefit rewarding years of hard work for an employer. It also brings up thoughts of paternalistic corporations who sought to care for their employees by providing one of the most secure methods of retirement income in existence.
Even the government seemed to be very supportive of pension benefits, since it established the Pension Benefit Guaranty Corporation to insure at least some of the promised pension benefit, should an employer go bankrupt or otherwise terminate the plan without fully funding the promised benefits.
Well, that was then, and this is now.
According to many recent articles, pensions are becoming just another corporate cost to be cut, without much regard for the employees who are being affected. The October 31, 2005 issue of Time magazine carried a story entitled, “The Great Retirement Ripoff,” detailing how literally millions of Americans may be at risk of losing promised pension benefits.
More recent articles in the Wall Street Journal, on the Internet and in a multitude of other publications are drawing attention to the fact that what was once considered a secure benefit is now more of an iffy proposition. I would not be surprised if employees stopped seeing their pensions as benefits and started viewing them as targets of aggressive corporate action to contain costs.
The question being asked by most Americans is “How could this be?” Aren’t pensions supposed to be secure? Don’t the rules governing pension plans require regular employer payments in an amount necessary to fund the plan? Didn’t these plans have large surpluses just a few years ago? In short, what’s going on?
In this week’s E-Letter, I’m going to present the first half of my analysis of the pension problem in the US. I’ll discuss some background information about pension plans, how and why the pension problem in the US developed and how it may affect you. In the next few weeks, I’ll present the other half of the story that concentrates on the steps necessary for you to take control of your own retirement security.
There’s a lot to cover, so let’s jump right in.
Pension Plan Basics
I’ll begin by saying that the following discussion will be only a very broad summary of how pension plans work. I do not pretend to know all of the complex mathematical calculations or IRS rules related to pension plans, but the basic concepts are relatively easy to understand.
While many people use the term pension to describe almost any kind of employer retirement arrangement, the actual meaning of the term comes down to an obligation on the employer sponsoring the plan. In a “ pension plan,” the employer is required to contribute sums of money necessary to provide the promised benefit. This is in contrast to a “profit-sharing plan” where the employer has discretion as to whether to make a contribution or not.
The most common type of pension plan is called a “defined benefit” plan, which is one that promises a specific monthly retirement benefit at age 65, or at the end of a specified number of years of service. Benefits are calculated in a number of different ways, but these formulas all end up with a promised monthly retirement benefit for employees. As workers’ salaries and years of service increase, benefits are adjusted accordingly, and the required contributions are increased to fund the additional benefits.
As I noted above, defined benefit plans are also unique in that there is an insurance benefit in the form of the Pension Benefit Guaranty Corporation (PBGC), a quasi-governmental agency funded through employer premium payments on behalf of each participating employee. While the level of benefit guaranteed is not the full amount of the pension (the maximum guaranteed pension benefit in 2006 is $47,659 per year), the PBGC coverage is designed to be a safety net should an employer experience hard times and go out of business or have to discontinue the retirement plan.
As noted above, the PBGC is funded by premiums paid by all of the employers that sponsor a defined benefit plan, but recent pension plan terminations have caused the PBGC to be in the red. Though recent legislation raised the per-participant premium, it may be too little, too late as more and more pension plans are frozen or terminated. In fact, some business groups say that the premium increase itself could cause some employers to think twice about maintaining their defined benefit plans.
How Contributions Are Calculated
This is where the easy part ends. The amount of money required to fund an employee’s benefit is determined by actuarial mathematics based on such factors as mortality, expected future investment returns, future rates of employee turnover, subsequent benefit forfeitures, and so on. The goal is to estimate the earnings and benefits for each employee, and fund an amount equal to what will be needed at retirement to fund this benefit.
Of course, nothing ever happens exactly as predicted. Employees may get higher or lower pay raises than expected, earnings on investments may vary, or even be negative, and there may be more or less employee turnover than expected. The result is that large corporation retirement plans have actuarial calculations that might even boggle the minds of some mathematicians.
It is within the secret and sometimes unfathomable world of actuarial science that some of the most egregious funding problems can occur. Because the employer’s contribution is based on a set of assumptions, a relatively small change in one or two assumptions can result in literally millions of dollars difference in funding requirements.
If earnings assumptions are too aggressive, and actual results are less, a funding deficit could result, which must be made up in future years. There are also other ways that funding deficits can occur, and most are perfectly legal. Take union negotiations for example. Benefits are often the subject of contract negotiations. If a union can successfully negotiate a higher retirement benefit, they mark it as one for the “win” column.
However, what happens if the retirement benefit of a worker who has been employed for 20 years suddenly increases? The employer can’t go back in time and make increased contributions on behalf of the worker. Fortunately, the regulations governing funding of retirement plans allow for such increases to be funded over a period of time. Thus, the employer effectively goes into debt on this benefit increase.
The corporation, on the other hand, may give in to benefit increases more readily because of this “give now, pay later” aspect of retirement plan funding. The amounts of benefits that are not currently funded create an “unfunded liability” on behalf of the employer.
While unfunded liabilities can result from other issues besides benefit increases and too-aggressive earnings assumptions, the bottom line is that whatever the reasons, it is this liability that is causing many of the problems found in pension plans today.
Other Causes Of Pension Problems
You may recall that back in the 1980s, during the days of the “leveraged buy-out” (LBO), over-funded pension plans were a plum to be picked by the acquirer. In some cases, defined benefit plans had been so well funded that they contained huge amounts of money. I noted above how a small change in the actuarial assumptions can affect employer contributions, but such adjustments can also affect the assets required to meet future benefits. If these adjustments made it appear that less money needed to be in the plan to meet future benefits, any excess could be “freed-up” for other uses, and this occurred in a number of LBOs. I also heard about pension plans actually being terminated to get to their huge surpluses.
While the rules allowing employers to use excess pension assets have been changed, corporate greed didn’t die along with the LBO craze back in the 1980s. According to a recent Wall Street Journal article, some of the companies that have chosen to terminate or freeze their pension plan benefits are allowed to reduce future liabilities on its books, resulting in accounting gains that are counted as income. While this is only an accounting entry, it can result in an increase in stock price which, in turn, affects shareholder value and executive pay. Get the picture?
Some causes of pension plan woes have actually been created by their most staunch governmental defenders. As I noted above, an adjustment to a plan’s actuarial assumptions can increase or decrease an employer’s required contribution. To counter the temptation for employers to influence their actuaries to make more beneficial assumptions, the IRS and Department of Labor publish actuarial guidelines and keep close tabs on funding requirements. Compliance with these rules requires hiring an actuary, which can drive up the costs of maintaining a plan.
Plus, even this regulatory oversight can result in incorrect assumptions. One of my staff members used to work for an insurance company that offered defined benefit plans. He tells me that the IRS went on a witch-hunt in the 1980s for small defined benefit plans whose actuarial assumptions were too conservative, resulting in a larger deductible contribution. To be honest, some actuaries were producing huge deductions for older business owners by using questionable actuarial assumptions. However, the benefit plan industry alleged that the IRS decided to go after any plan with an earnings assumption less than 8%.
At a time when prevailing CD rates were in the double digits, this seemed conservative enough. However, an 8% earnings assumption might be considered anything but conservative by today’s standards. This illustrates the difficulty in addressing retirement plan funding. An employer may have to fund a worker’s benefit over a 40-year career. What will interest rates and stock market gains do over the next 40 years? No one knows, so it would seem to make sense that you would be conservative in your assumptions so that employer contributions would support benefit accruals even if earnings on plan assets were low.
Of course, “conservative” to the IRS equals lower tax revenues. The unfortunate result of the 1980s IRS defined benefit plan audit program was that many small employers terminated their plans, and many others did not establish pension plans to avoid ever having to face this kind of IRS scrutiny. The result: far fewer defined benefit plans and far fewer participants. And since premiums are paid to the PBGC for each participant, less funding went to the entity charged with insuring the benefits. I’ll bet the PBGC sure wishes it could have all of those missed contributions now.
Another way the government has actually participated in the pension woes is through something known as the “full funding limitation.” As I noted above, there are limits set on the actuarial assumptions that can be used to establish a plan. However, there are also contribution deductibility limits established by the IRS. Since pension plan contributions reduce corporate income, the IRS doesn’t want employers to contribute extra money during good times, since that would result in lower tax revenues.
In the late 1990s, when corporate profits experienced a huge boost, employers were actually discouraged from contributing extra money to their retirement plans. In fact, I seem to recall articles being written at that time which said some pension plan assets had experienced such impressive returns that employer contributions were not allowed at all.
If a pension plan sponsor does have extra money and wants to make an excess contribution, the contribution is not deductible from income, and the sponsor is actually subject to an excise tax equal to 10% of the excess contribution. Thus, even at a time when employers may have wanted to throw some extra money into their plans, governmental rules would not allow them to do so without onerous penalties.
Considering the number of employees who are now looking at a retirement benefit far less than they had been led to believe, perhaps a few extra contributions during the fat times wouldn’t have been so bad.
A Demographic Problem
While it would be nice to lay all the blame for the pension problem at the feet of greedy corporations and the federal government, such is not the case. Another factor related to the funding of defined benefit pension plans is the issue of Baby Boomer demographics. The younger a person is when benefits are funded, the smaller the required contribution. This is because pension plans use the power of compound interest to fund future benefits.
As employees age, however, there are fewer years between benefit increases and retirement, so compound interest is less of a factor. The employer must fund a larger percentage of the ultimate benefit to keep its promise. The same goes for older employees who may move from one employer to another.
As the Baby Boomers continue to age, the percentage of “expensive” employees covered by retirement plans can increase, resulting in larger and larger funding requirements. You can bet that every large corporation in the US with a defined benefit plan has a team of actuaries trying to calculate what future benefit increases will cost, and I’ll bet they’re not happy with the result.
One solution is obvious: don’t hire older workers and fire the ones you have. Of course, I say this tongue-in-cheek because doing so would subject these employers to age discrimination lawsuits ad naseum. However, I wouldn’t be surprised if there are not some “unofficial” hiring policies at play in some corporations with under-funded defined benefit plans.
The Federal Government To The Rescue?
As usual, wherever there is a problem, there are scores of members of Congress ready to take it on. Some pension plan participants take heart in the fact that, since some government rules are at least partially responsible for this mess, the government is the perfect place to fix the problem. However, I think the government’s record on fixing problems that involve its own ability to take in tax revenue is far less spectacular than on other issues. You have to look no further than its ability to address the Alternative Minimum Tax and permanent repeal of the estate tax to figure this out.
Even so, there may be more of a chance to get a governmental fix than to fix the corporate greed or demographic issues. The problem is, the complexity of pension plan funding does not lend itself to being easily addressed with legislation.
Of course, that’s unlikely to deter politicians, as evidenced by a search of the House of Representatives website showing that 204 bills have been introduced in the 109th Congress alone containing the word “pension.” One of the better known of these bills is the Pension Protection Act (HR2830) introduced in 2005 by the newly elected House Majority Leader, John Boener.
This bill addresses many issues related to not only defined benefit plans, but also other types of retirement plans including “cash balance plans” and 401(k)s. The provisions related to defined benefit plans include requiring certain funding levels to be maintained at all times, restricting benefit increases and accruals if plans become seriously under-funded, and providing guidance on acceptable actuarial assumptions. The bill also allows employers to make deductible contributions of up to 150% of the regular required contribution in good times, and raises premiums paid to the PBGC by employers. You can click on the following link to see a Fact Sheet on all of HR2830’s provisions:
As you might suspect, unions have come out against this legislation, saying that it would eliminate their ability to negotiate for increases in pension benefits. In all fairness, they’re right, but only to the extent that these negotiations involve an employer whose pension plan is already severely under-funded. The sponsors of HR2830 say if a pension plan is “already in a hole, it should stop digging.” Thus, if an employer’s plan is already in the red, the employer and union cannot increase pension benefits with a promise to pay for them at a later date.
This bill is currently in committee at the Senate, so it remains to be seen whether or not these changes will become reality. What I find most interesting about this bill, however, is that the same steps they are going to require of corporate employers could also be used to put Social Security back on a secure footing. Where were all of these well-meaning sponsors and co-sponsors when Social Security Reform was dying on the vine? Where were they when the Medicare Prescription Drug bill was being debated?
Wouldn’t it make sense for the federal government to stop adding new benefits and increasing current benefits in an entitlement program that is already severely under-funded? I guess it’s a matter of decades of “do as I say, not as I do” on the part of Congress and various presidential administrations.
The logical conclusions from this week’s pension plan discussion appear to be pretty bleak. It is very unlikely that new funding rules will reduce the number of plans being frozen and terminated by cash-strapped employers. Already we have seen large employers such as IBM, Verizon Communications and Sears Holdings freeze their defined benefit plans, while others such as Bethlehem Steel, U.S. Airways, and United Airlines have terminated their plans and turned them over to the under-funded PBGC.
The PBGC released a report in December of 2005 supposedly painting a better picture for pension plans. The report stated that only 9.4% of all pension plans have frozen benefit plan accruals. Using this statistic, the PBGC argues that the hype about mass employer defections from defined benefit plans is an overstatement. However, the 2005 report used data only through 2003, which did not include any of the more recent actions by large employers to either terminate or freeze their plans since that time.
Most experts agree that there is very little you can do if your employer chooses to freeze or terminate your retirement plan. If you are represented by a union, however, you may have more bargaining power, but there is still no guarantee that you will receive the benefits you have been promised under your employer’s retirement plan. This is true even if you work for a state or local government, since some of these plans are among the most seriously under-funded plans in existence, and they are NOT covered by PBGC insurance.
Since unions and employees still value defined benefit pension plans, some employers may want to continue to maintain their plans, either to live up to union contracts, or to be able to attract the best talent. However, in light of many corporations increasingly going to multi-national labor and concentrating on corporate costs and stock prices, it is unlikely that defined benefit pension plans will remain as prominent as they once were.
What does this mean for you if you are covered by a defined benefit plan? First, you should be informed as to the funding status of your plan, especially if you are in a troubled industry. Each year, your plan sponsor is required to give you a Summary Annual Report showing the financial status of the plan. You also have the right to review certain plan documents and records upon written request to do so. If you are concerned about the condition of your employer’s retirement plan, study these items closely, or have a local CPA do so on your behalf, so you can be aware of any potential funding problems.
Even if a plan is well funded now, there is no guarantee that your employer will continue to maintain the plan, especially if business prospects and profits dim in the future. Thus, you must assume responsibility for your own retirement security. In the next few weeks, I’m going to publish the second half of this story to tell you exactly how you can do just that.
Wishing you all a Happy Valentine’s Day,
Gary D. Halbert
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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.