The defined benefit plan system has received some recent encouraging news.
Gov. Arnold Schwarzenegger shelved, at least temporarily, his pension initiative to replace public defined benefit plans in California with defined contribution plans after reaching an understanding with legislators to work with him to reform the system.
West Virginia legislators, in contrast to the California governor's original effort, are considering reopening a defined benefit for state teachers plan that was closed in 1991 while closing the defined contribution plan that was started to replace it. The West Virginia rationale, as unlikely as it sounds: to save money.
A number of consultant reports show improved funding of both corporate and public DB plans.
A study by Wilshire Associates Inc., Santa Monica, Calif., for instance, found the funding ratio — that is, pension assets to pension liabilities — of 64 state retirement systems improved to 83% in 2004 from 77% for the same plans in 2003.
FPL Group Inc., Juno Beach, Fla., among individual companies, won't be required to make contributions to its pension plan "in the near future," according to a company filing with the Securities and Exchange Commission. The plan had $2.9 billion in assets and a surplus of $1.3 billion, as of last Sept. 30.
The news reinvigorates efforts to maintain defined benefit plans as having a solid place in providing retirement income. But with that effort should come recognition of what maintaining DB plans means. Above all else, sponsors have an obligation to properly fund the plans.
The key to the success of DB plans — and one of the reasons for the failing of the Social Security system — is investing assets to achieve a return commensurate with the risk that should be taken. But returns alone cannot drive defined benefit funding. Sponsors must commit to properly funding their plans. Skipping contributions robs the fund of the enormous power of compounding.
With the huge opportunity cost of shortchanging contributions, DB systems become even more costly.
Too often, for instance, state legislators renege on funding obligations for political expediency. In some fashion, statutory if necessary, a discipline has to be imposed to ensure proper funding. Union plans, whether corporate or Taft-Hartley, face a similar problem, based on the nature of tax limitations to contributions and labor leaders' willingness to compromise.
Moving to DC systems is not necessarily a panacea. An actuary for the West Virginia State Teachers' Defined Contribution Plan noted that it has a higher cost to employers than that of the defined benefit plan. A switch back to the DB plan for teachers could save the state 3% of payroll a year. That's one reason the West Virginia House of Delegates passed a bill for the switch, legislation that now goes to the state Senate.
At the corporate level, DB systems won't regain the dominance they had, despite the recent promising outlook. Companies like General Motors Corp., Detroit, can't compete funding a DB system with huge legacy costs, in the face of downsizing its work force and growing competitors who produce vehicles without such cost burdens.
GM keeps its DB program in part because of strong union pressure. But International Business Machines Corp. a few months ago announced an end to its DB program, in part because of competitive pressures in its industry.
DB plans were created in an era before DC plans, which have risen in popularity in part because they haven't been around long enough to see if they do control sponsor cost while providing reasonable retirement benefits.
Whether DB plans continue to exist in the private sector will depend on the willingness of senior corporate executives to fund them properly, and to accept contribution and earnings volatility as a result. The willingness remains in doubt. Whether they continue to exist in the public sector depends on the tolerance of taxpayers for the taxes necessary to properly fund the promised pension benefits, benefits greater than most in the private sector receive.
For now, DC plans clearly are winning in the private sector, and may yet gain ground in the public sector.
