By Blaine A. Mineman
Forty-four million Americans participate in private pension plans, down from over 50 million a decade ago as companies have steadily migrated to the cost certainty of defined contribution plans. Now there are calls for radical changes in pension regulations, accounting standards and investment approaches. But we should pause before making changes that will further discourage companies from providing pension benefits. The private pension system is much like America itself — it isn't perfect, but it's the best system around.
Among the voices for change, proponents of asset-liability management now argue that minimizing the risk of a decrease in funded status should be our primary objective, pointing to the sharp decrease in funded status in the past three years as justification. They argue that bonds should be used to effectively immunize liabilities to reduce volatility in funded status.
Certainly, asset-liability interplay is an important consideration for a plan's investment strategy and there must be a balance between moderating risk and maximizing returns.
But ERISA encourages plan sponsors to take a long-term view with regard to pension investments, which resulted in increased equity ownership by pension plans. For 30 years, pension plans have been managed to maximize return at an acceptable level of risk. ERISA also permits some deferred funding and smoothed asset returns over time, allowing companies to have a long-term perspective and, consequently, to use capital market returns to offset much of the cost of the benefit.
Pension plans must be able to continue to maximize long-term returns at acceptable levels of risk to keep these benefits affordable to the sponsoring companies. The private pension system is voluntary. Employers are not obligated to provide a defined benefit pension plan and will only continue to do so if the cost is reasonable.
From a behavioral perspective, people tend to think recent conditions will continue indefinitely. This was evident in the 1990s as the market bubble formed and forecasters typically straight-lined this into the future. Conversely, the consensus became unduly pessimistic as the market sold off for three straight years. Now in reaction to the 2000-'02 market downturn, many want to change the rules to discourage equity ownership for pension funds. Because a pension plan sponsored by a going concern is essentially a perpetuity, pension funds should continue to take a long-term view. And as long as the equity premium is expected to be positive long-term, it is appropriate for pension funds to invest in equities.
In addition, the accounting rules need to continue to allow some smoothing of asset returns. In the United Kingdom, the Accounting Standards Board promulgated Financial Reporting Standard 17, which requires companies to add the net pension surplus or deficit to the balance sheet and no longer permits the smoothing of asset returns over a number of years. Early results in the U.K. show many companies have closed their pension plans to new members (including Marks and Spencer, Lloyd's and Sainsbury's). A 2002 poll reflected that 77% of more than 800 of the U.K.'s major employers believe that FRS 17 makes it less attractive to offer a pension plan. The Financial Accounting Standards Board should learn from the U.K. example and understand that tightening the accounting rules will come at a significant price — many companies will freeze pension benefits following such a change.
Companies also need to be part of the solution. Companies can help themselves by re-examining the benefits that have been promised and eliminate provisions that significantly increase cost for extraneous benefits. For example, early retirement subsidies and temporary supplements should be discontinued prior to at least 60 years of age. The cost to the company is doubled when retiree medical benefits are included with an early retirement. In addition, lump-sum payments should be discontinued because they significantly accelerate the cash outflow from the trust, decreasing the compounding benefit that companies enjoy from annuity-type payments. While very popular, these benefits significantly increase the cost of offering a pension plan.
So, what changes to pension regulations are appropriate?
A corporate bond index rate should replace the 30-year Treasury for determining the discount rate for funding purposes. The Treasury Department's elimination of new issuance of long bonds has resulted in a supply-demand imbalance that artificially decreases the yield on outstanding issues, which increases the present value of liabilities.
Companies should be required to fund normal cost every year (until at least 120% funded), and receive a tax deduction for doing so. Funding normal cost each year would be a healthy discipline for plan sponsors. Further, if the tax rules were more accommodating, some companies would have funded more during good years, which would help in downturns.
The required amortization amount for deficit reduction contributions should be smaller, perhaps 15% or 20% instead of the current 30%. The current rules result in extreme funding requirements (a "falling-off-the-cliff" scenario). Since a permanent legislative solution to this problem is very unlikely this year, Congress should provide a waiver for deficit reduction contributions until this problem is fixed.
Plan sponsors and investment professionals need to speak up to move the debate on pension reform in a rational direction. Despite its current problems, America has a great private pension system — a system that has improved its funded status in the 30 years since ERISA while continuing to cover a significant portion of workers. Let's work to improve the pension system, not dismantle it.
Blaine A. Mineman is director-pensions of Ispat Inland Inc., East Chicago, Ind.