The pitfalls (?) of defined benefit plans; commentary about recent art

[Dave Baker]

In an article called "The pitfalls of defined benefit schemes" at

http://www.townhall.com/columnists/bruceba...b20011123.shtml

the author says a "new study suggests that defined-benefit pension plans were a key culprit in the stock market bubble of recent years. As the value of such plans were inflated by stock market gains, companies were able to withdraw excess pension assets, which went directly into corporate profits, further buoying stock prices. This is yet another reason for shifting workers away from defined benefit (DB) plans to defined contribution (DC) plans."

The article was included in the list of linked articles in the November 26 issue of the BenefitsLink Newsletter, Retirement Plans Edition.

A reader, Eric Hansen, has the following comments about the article, which he asked me to use to start a message thread:

The above article appears to be a poorly veiled attempt at convincing us we should abandon traditional pension plans in favor of defined contribution plans.

First, the author suggests pension plan sponsors have withdrawn "vast sums" from their pension plans and that these withdrawals were "a key culprit in the stock market bubble of recent years." He goes on to suggest "shifting workers away from defined benefit plans to defined contribution plans" will solve this problem. Nonsense. In my experience, since the excise tax on "reversions" was generally increased to 50% (effective October 1, 1990), the number of pension plan sponsors taking reversions has decreased dramatically. And he neglects to mentions the vast sums being withdrawn (and spent) from defined contribution plans by participants who change jobs. Who is going to pick up the tab for these folks when they retire?

Next, the author suggests the back-loaded nature of traditional pension accruals is bad. What makes a back-loaded accrual worse than a front loaded accrual? These patterns are simply a function of the ERISA requirement that retirement plans not discriminate in (pick one) contributions or benefits.

The author also says participants "cannot withdraw their assets before retirement without paying a hefty penalty" and suggests defined contribution dollars are more likely to be available at retirement. Again, this is nonsense. The hefty penalty is just a fraction of the reversion penalty. In fact, as employees quit or change jobs, there is a ton of money pouring out of defined contribution plans.

I'm not suggesting traditional pension plans are superior to defined contribution plans. Rather, they have different characteristics and are more appropriate in some circumstances than others. But to suggest we should shift workers away from defined benefit plans to defined contribution plans regardless of circumstances is naive.

[MGB]

The article is completely based on false information.

The entire discussion is predicated on employers "removing vast sums" from DB plans in recent years according to a separate report he is supposedly commenting from. That is completely bogus. The separate report is discussing FAS 87 income to the bottom line. This author interprets that to mean this money is being withdrawn by the companies when it is not.

The facts are wrong, the conclusions are baseless and the article should have never been published.

[david rigby]

Good comments.

Another issue is how the Financial Accounting Standards Board wrote Statement Number 87, generally effective in 1986 or 1987. This required standardization in the accounting for pension costs (that is, how and what the plan sponsor recorded in its financial statements).

In many ways, this was a very positive step. However, in my opinion (and this is not necessarily shared throughout my actuarial profession), it did create one very undesirable aspect. When plan assets grew dramatically as they did during most of the 1990s, the sponsor might have a negative pension cost. Another term for "negative pension cost" is pension income; thus, the pension plan actually became a profit center for many companies. I believe that is a very undesirable result, for reasons too lengthy to discuss here. Simply put, a pension (or profit-sharing) plan, by its nature, costs money. To let short term fluctuations distort that leads to financial decisions that do not allow for the fluctuations.

The quoted article suggests that defined benefit plans are the "culprit" in stock market bubble. I suggest that it is exactly the opposite: the dramatic equity growth of the 90s is (part of) the culprit in how pension plans have affected the corporate bottom line.

OK, while I'm at it, here is another complaint.

Many DB plans reached the "full funding" limitations of the Internal Revenue Code. The result was that the plan sponsor could not make any deductible contributions. And now, when the market has fallen, along with other negative economic signs, full funding limitations no longer apply. Now the sponsor is required to make a contribution, just when its business environment may not readily generate enough cash. Wouldn't it be better to have allowed deductible contributions a few years ago, when the cash was there?

[mwyatt]

E-mailed the following to Mr. Bartlett:

Dear Mr. Bartlett:

Three comments are in order concerning your analysis of the impact of Defined Benefit plans on equity markets:

1) Companies actually never received "real" income from these pension plans (the only way that a company could actually have assets revert to the employer would be for the plan to terminate, which these plans did not do). I think that you are confusing "pension income" showing on the books due to FAS-87 calculations with physical income received by a company. Rather than hiding this problem, several major actuarial firms have been pointing out the impact of this phantom income on major corporations' bottom lines in the past few years (see Mercer and Watson-Wyatts' websites - also go back to Barron's over the last year). Note that this is only an issue for major, long-established firms. I wouldn't say that DB plans are the culprit here, though. This "pension income" under FAS-87 (which in a way is phantom as the money is still under trust and can only eventually go back to the company after payment of significant excise taxes) largely arose due to favorable investment gains in equity markets (which came first, the chicken or the egg?). Rather, I would tend to focus on the gimmicks inadvertantly provided by the implementation of FAS-87 (why do you think Cash Balance plans came into being anyway?).

2) While there was an impact on the DOW index companies, I would venture that DB plans had little or no impact on the large majority of NASDAQ companies who don't even sponsor such plans. And I think I can state with certainty that DB plans had NO impact on the stock prices of the large majority of Internet/Telco/Tech companies (do you really think that DB plans were the reason that the Amazon.coms of the world were trading at the ridiculous levels of 1999-2000?).

3) To tell you the truth, the impact of DB plans on corporate earnings really won't be felt until the next few months. I would dare to say, though, that rather than casting out DB plans, I would work to eliminate the crediting of "income" from DB plans on corporate balance sheets as it is a misleading (and nonexistent) source of revenue due to the fact that pension assets belong to the Trust, and not the company.

I am an enrolled actuary with about 18 years of experience working with small qualified plans. After seeing the experiences of a few clients in the past year ("masters of the universe" managing their own assets to spectacular losses), I would venture that the safety net provided by defined benefit plans, coupled with experienced and prudent investment guidance (rather than having a "Stuart" daytrade funds to oblivion), may be in participants' better interests than the 401(k) plan. This pentup rush to defined contribution plans looks great during a bull market; however, having seen losses in the past year under 401(k) plans from 20% to 86% (yes not a typo), defined benefit plans don't look so bad after all.

Respectfully,

Michael S. Wyatt

Enrolled Actuary

Norwell, MA