Guest Article

DB Plan Meltdowns: Victims of Current Crisis

By Alvin D. Lurie
March 10, 2009

One could easily have mistaken a recent headline in the New York Times as captioning a story on bailing out companies sponsoring qualified retirement plans:

OBAMA PROMISES BID TO OVERHAUL RETIREMENT SPENDING

We had already seen government bailouts for the mortgage insurers (Freddie Mac and Fannie Mae, and for some (e.g., AIG, Merrill Lynch) but not all (Bear Stearns, Lehman Brothers) giant Wall Street financial institutions, and for the major banks by way of direct capital injections and purchases of their subprime mortgage holdings, and then for two of the major American automakers. The queues were already beginning to form for other troubled industries -- even such once-giants of the rust belt as Big Steel -- trying to get on the dole.

But nothing had been heard about one of the largest and most troubled pools of capital in the country, the private defined benefit pension plans, that suffered gargantuan losses during most of 2008, with devastating effects on the finances (and in many instances the very solvency) of their plan sponsors and, of course, on the retirees and other participants whose retirement security is so dependent on the pension trust funds. For months, during the fall of 2008 (one can read that as a reference to more than just the autumn season of the year), while the incredible bailout events were playing out, it was curious that so little attention was being paid to the economic health of the pension sector, that so heavily impacted the Nation's well being at large.

There had been relatively low-key requests for relief from organized pension groups to Treasury and IRS, and to the committees of Congress having jurisdiction, principally for reversal or alleviation some of the more oppressive funding rules of the Pension Protection Act of 2006, as well as other requirements of pension law that were proving troublesome in the down spiraling economy (most notably the unforgiving operation of the required minimum distribution provisions ). But these were met with responses ranging from disinterest to downright apathy from the government offices in the city by the Potomac. Finally, only modest relief was afforded in the clumsily named Worker, Retiree, and Employer Recovery Act enacted in a hastily convened lame duck session of the 110th Congress in the waning days of 2008.

It wasn't that the case couldn't be made that pension plans were in deep distress. The effects of the economic conditions on the private pension system have been direct, immediate and devastating -- formal curtailment, complete freezing of benefits, outright plan termination -- due to massive underfunding resulting from the combination of market losses and diminished contributions (some within permissible bounds under ERISA, but doubtless more the result of impermissible skipping of required plan contributions). These responses were hardly surprising given the competing demands on shrinking business resources to meet payrolls, avert layoffs, pay suppliers, satisfy loan covenants, forestall bankruptcy, or just stay in business.

Against this background persons concerned about survival of the private pension system might have wished the Times headline quoted above had been attached to an article on an Obama commitment to address head-on the looming crisis for this until-then neglected, although critical, sector of the economy. It was no such thing. The "Obama promise" promised by the headline was to curb the problems of the federal government in dealing with the rapidly escalating and unsustainable costs of funding the Medicare and Social Security entitlement programs, soon to be further burdened by the claims of the newly emerging boomer cohort -- obviously a major issue to be confronted by the new Administration, but having no bearing on the equally overarching matter of rescuing the pensions.

The dire financial condition of private pension plans has been widely reported in the trade press. The underfunding of plans of the S&P 500 companies has escalated by over $200 billion in the past year. One of the country's highly respected economists, Peter Orszag (now director of the Office of Management and Budget), has estimated that the total shrinkage of all plan values in the past 18 months is approaching $2 trillion! Hard statistics demonstrating the extent of the devastation in the past year is not likely to be known for a year or more. But the well-regarded Boston College Center for Retirement Research has found that the aggregate funded status of plans has fallen from 100 percent at the start of 2008 to 75 percent in October. Similar indications emerge from studies of leading benefits consulting firms. Both Mercer and Watson Wyatt Worldwide confirm the 75 percent figure. Mercer places the defined benefit pension plan deficits of the S&P Fifteen Hundred companies at $409 billion for 2008, from a surplus of $60 billion the previous year, and projects that the pension expense of that same group of companies will likely mushroom from $10 billion in 2008 to $70 billion this year. It is a certainty that the statistics have become even more dire in the first two months of the new year.

Evidence of the swelling disenchantment with traditional defined benefit plans was readily at hand well before the current financial crisis. A survey by Wyatt several years ago revealed that where 89 of the 100 largest companies offered DB pension plans in 1985, only 50 provided such plans to new hires in 2002, and that number was down to 42 in 2004, and 37 in 2005. In a separate study of the 627 Fortune 1,000 companies sponsoring DB plans in 2006, Wyatt found that 113 had frozen or terminated their plans, or announced that they were, as of April 2006, compared with 71 in all of 2004. An additional 49 sponsors closed their plans to new hires by that time in 2006, up from 25 in 2004.

A previous study by the Center for Retirement Research at Boston College added that in the years 2004-2005 17 large, financially healthy companies -- names like Coca-Cola, IBM and Verizon -- froze their plans for all employees, so no further benefits have accrued for later periods of service. Obviously, thousands upon thousands of other companies, with much less familiar names -- many with healthy balance sheets -- were doing the same thing; and there is no doubt that this past year has seen the abandonment of the bulk of remaining traditional DB plan benefits.

It has been estimated that among the S&P 500, in the decade between 1995 and 2005, 70 percent had converted to cash balance plans (a hybrid version of the traditional defined benefit design but with many of the characteristics of a defined contribution plan), as a way of escaping the otherwise inescapable and unpredictable liabilities with which their DB plans had saddled them. For a time this trend was halted for several years while an onslaught of litigation erupted in courts around the country, in the wake of a lower court decision in 2003 involving the IBM cash balance plan, in which the judge ruled the cash balance design to be inherently and unavoidably age discriminatory. The reversal of that decision three years later by the 7th Circuit in 2006, and the ensuing decisions in three other circuit courts of appeal that followed the 7th Circuit, restored the cash balance plan to favor; but that was before the economic events of 2008, which have doubtless severely tamped enthusiasm for the cash balance design for many of the same reasons already described in regard to traditional defined benefit plans.

Even the 401(k) plan design, which has essentially ousted DB plans as the design of choice for most pension plan sponsors in this country, has not escaped the disenchantment produced by the current recession, but for entirely different reasons than pertain to DBs. According to the prestigious Employee Benefit Research Institute, there were 56,000 401(k) plans in 2007, with 21.8 million participants and $1.425 trillion of assets. If we can assume that those assets have suffered the same 40 to 50 percent depreciation that is generally said to have been the approximate rate of decline in values in the market generally, there are 21.8 million participants and their respective families and dependents who on average have lost almost half their retirement assets (and some significant number of that 21.8 million families have lost all their savings). There is no Pension Benefit Guaranty Corporation back-up for any of that. The PBGC program is only for DB plans (traditional DBs and their hybrid variants, the cash balance and so-called pension equity plans). This vulnerability of the 401(k)-based benefit has provoked a recent chorus of criticism of that vehicle, and some radical proposals for undergirding it with government protections not unlike those provided by Social Security.

It requires no special perspicacity to discern that a radical overhaul of the private pension system, especially the defined benefit branch, will be required if it is to be preserved as a key engine for assuring the retirement security of our workers and their families. Whatever last legs the defined benefit plan design had been balancing on after the "perfect storm" of 2002 have been knocked out from under it with the financial collapse of 2008. What employer of any size -- but certainly if a small business (excepting of course the one- or two-person corporation or family company) -- that has not adopted a DB plan can now be expected to undertake the financial risk underlying a commitment to deliver a defined benefit to the persons in its workforce at an uncertain future time, with no heed to the uncertainties of forces beyond its control. Those steadily shrinking numbers of companies that had in the past adopted such a plan and not yet terminated or frozen it have in recent months been jolted into seriously considering, if not already effectuating, such an action, as they have seen their plans' values cut in half or worse.

The greatest distress in DB circles is due to the funding requirements imposed by the Pension Protection Act. The ostensible purpose of those provisions was to overcome the rampant underfunding of DB plans; but the subtext of the new funding rules -- not acknowledged in public pronouncements explaining the rationale of the legislation -- was to protect the dangerously declining resources of PBGC, a $23 billion deficit in 2005, compared with a $10 billion surplus just four years before that. This led to a sharp increase in the PBGC premium in 2006, when, as part of the PPA, Congress raised the annual, per-participant premium for individual (as distinguished from multiemployer) DB plans from $19 to $30, to ameliorate the imbalance at that time between the dollars flowing out of and into the government insurer of failing DB plans. It cannot be doubted that the imbalance will become much more acute in view of the current state of the economy. Some have projected that the Treasury will now have to pour many billions of dollars into PBGC to enable it to satisfy its obligations to participants of terminated, underfunded DB plans.

It is incumbent on government to do everything it can to bolster the viability of the remaining DB plans. The Worker, Retiree, and Employer Recovery Act of 2008, cited above (with the unpronounceable acronym WRERA), provided some welcome relief, (i) in easing the transition rules for achieving the required 100 percent funding targets introduced by the PPA of 2006 by permitting the targets to be achieved in stages, (ii) by relaxing the required rate of amortization of underfunding, and (iii) by clarifying use of a 2-year "smoothing" method in calculating the plan asset values. as relating to required minimum funding. These new rules will be helpful for diminishing the funding required in some cases, although they would have been more helpful if a so-called 10 percent "corridor" (i.e., above or below the fair market value of plan assets) that was established in PPA had been liberalized. But the extent of the underfunding in 2008 directly attributable to the economic collapse will still leave many plan sponsors with required plan contributions in 2009 that are unmanageable because well beyond their financial means, unless at the same time freezing plan benefits or cutting jobs (or both). So the relief provided by WRERA, if not quite resembling the rearranging of deck chairs to prepare for a storm, leaves many plans without a life preserver.

Moreover, even freezing a plan does not foreclose funding problems under the PPA, since benefits accrued before the freeze must continue to be funded if they are at that time partially unfunded; so the plan sponsor may still be left with unmanageable pension costs. Substantial layoffs, apart from their effect on the laid-off participants and even on the participants initially spared who work in the shadow of the next layoff -- to say nothing of the cumulative effect on the nation's unemployment rate -- also might lead to undesirable consequences for the plan, under the so-called partial termination rule under which a significant level of job terminations (often pegged at 20 percent of participants among the pension cognoscenti) is treated as tantamount to a plan termination for purposes of satisfying the qualification requirements of the Internal Revenue Code, with corollary increased plan funding implications.

The well-regarded American Benefits Council, which lobbies the tax and labor arms of government on behalf of plan sponsors, is widely respected by government technicians for its thoughtful, understated and rigorously analyzed positions. It is not given to the pursuit of radical changes in the existing pension rules. It typically is content to achieve incremental changes causing as little disturbance as possible to the relevant body of law (and even less disturbance to the government designers and administrators of that law). It is therefore notable that, while the ABC acknowledges that WRERA provided assistance for the classes of stakeholders named in the title of the statute, in coping with the pension funding crisis brought on by the current severe economic downturn, the Council, in its paper entitled Legislation Needed To Addresses Funding Crisis (January 2, 2009), minces no words in writing, "more relief is desperately needed."

One could go further. This is a rare opportunity to make major changes to the regulation of private (and perhaps pubic) pension plans. The funding issue is of course paramount for DB plans. But it is almost 35 years since ERISA established the DB/DC classification scheme. In the intervening period many hybrid variants of both designs have evolved which fit uncomfortably within the discrete rules of either category, so the system has strained to operate within that rigid binary divide. We have seen the traditional defined benefit design, which once was the sole foundation for delivery of pensions in this country, and which many today still regard as the safest and most beneficial platform for workers generally, give way to what Professor Edward Zelinsky has perceptively called "the defined contribution paradigm (that) changed America." It is necessary to reexamine how best to provide retirement security for the Americans of the 21st century. It would be presumptuous to lay out the blueprint here for achieving that goal. This is a task best pursued by a bipartisan, high-level Presidential commission. The challenges threatening survival of the existing instrumentalities of pension delivery -- not least the greatly expanding body of government regulation, whose effects are now compounded by the present economic crisis -- give new urgency to the project.

Given the difficulty and enormity of the issues needing research, deliberation and resolution, this would have to be seen as a multi-year project; but discrete pieces of it, such as the funding issue, need not await completion of the entire reform agenda, and could be assigned deadlines to assure their timely completion. Also, a mechanism should be established for keeping Congress apprised of the work product, so that it does not become susceptible to Congressional dismantling once the Commission is discharged.

Such a project could be designed to also yield not just a bailout of the DB plan, but a much overdue simplification of the entire pension regulatory structure, and a stripping out of the excesses and contradictions of the rule-making that have poured out of the principal agencies of oversight -- Treasury, IRS, Labor and PBGC -- over the past third of a century, admittedly much of it in response to continuous legislative accretions to the law since the original enactment of ERISA.

The complexity of the project is not to be minimized; but it is far less so than other more radical changes suggested in recent years that have gained support, e.g., privatization of Social Security and replacement of the income tax with a national sales tax. It is a big task, and it obviously won't be Job #1 of the new Administration. But hopefully it will find its way on to the priority list. Pensions are no less a part of our infrastructure in need of repair than the bridges, and roads and energy grids that are to become a feature of the economic revival program of the new Administration.

Perhaps one coda is appropriate to end this piece: DB plans should not too hastily be discarded as a relic of an earlier, simpler time. After the frightening shredding of pensioners' individual account values that has occurred in the past couple of years, there will be a yearning among workers coming into the workforce in the years ahead for that old-time security that was the bedrock of the defined benefit design that spawned its enormous growth in much of the second half of the last century. The architects of the new pension paradigm that will come of the project of retrofit that I propose in the preceding paragraphs should be in no haste to throw the baby out with the bath water.

Copyright 2009 Alvin D. Lurie

Alvin D. Lurie is a practicing pension attorney. He was appointed as the first person to administer the ERISA program in the IRS National Office in Washington. Mr. Lurie is the first recipient of the Lifetime Employee Benefits Achievement Award sponsored by the Employee Benefits Committee of the American Bar Association Tax Section. He can be contacted at Alvin D. Lurie, P.C. in Larchmont, New York, at (914) 834-6725 or via email: allurie@verizon.net.

BenefitsLink is an independent national employee benefits information provider, not formally affiliated with the firms and companies who kindly provide much of the content and advertisements published on this Web site, including the article shown above.