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Special Report

Credit easing, regulation put plans on critical list

Attempts to help economy and protect workers backfire for corporate funds

Gordon Clark
Quantitative easing has “exploded the value of liabilities,” said Gordon Clark, director and professor at University of Oxford Smith School of Enterprise and the Environment.

U.S. corporate defined benefit plans have been closing and freezing benefit accruals for decades, with a number of industry experts pointing to the very regulations meant to protect them as a top contributing factor.

But the flood of cheap money unleashed by central banks' quantitative easing efforts to combat the global financial crisis has only added to the pressures that corporate, as well as public, plan sponsors face, experts said.

Quantitative easing has “exploded the value of liabilities,” said Gordon Clark, director and professor at University of Oxford Smith School of Enterprise and the Environment.

“It is the realization really, what it is, five years, six years of quantitative easing have made the affordability of defined benefit plans almost around the world actually fundamentally at risk,” Mr. Clark said.

According to data from the Washington-based Employee Benefit Research Institute, 28% of all U.S. private-sector workers had a defined benefit plan in 1979, while 10% had a combination of a defined benefit and defined contribution plan.

By 2013, the percentage of U.S. private-sector workers who were covered only by a defined benefit plan fell to 2%, while 11% were covered by both a DB and DC plan. Thirty-three percent were covered only by a DC plan.

The decline in participation in DB plans hasn't been a surprise. Ten years ago, Pensions & Investments partnered with Oxford University to survey 1,605 global pension experts about the fate of DB plans. A little more than half of the respondents agreed that open private-sector DB plans would continue to exist by 2027.

Even before that survey was conducted, corporations had been closing and then freezing the benefit accruals in their DB plans. Since the survey, that activity has accelerated and a number of large plans have even transferred their assets and liabilities to third parties.

To be sure, DB plans, both public and private in the U.S., continue to hold the dominant share of plan assets, with the P&I 1,000 survey of top U.S. retirement plans finding that DB assets of the 200-largest plans accounted for 71% of total plan assets of $6.792 trillion, compared with 29% in DC plans.

In place of a traditional DB plan, private-sector employers have adopted defined contribution plans that shift the risk to participants. Some sponsors also are incorporating some of the best features of defined benefit plans into their DC plans.

Regulatory repercussions

In the 2007 P&I/Oxford survey, respondents blamed regulations for what they called defined benefit plans' “drag on corporate competitiveness.”

The first culprit was the Employee Retirement Income Security Act of 1974, specifically Part 4 of Title 1, which named plan sponsors as fiduciaries, required to discharge their duties solely in the interest of plan participants and beneficiaries.

Joshua Gotbaum, guest scholar in the Economics Studies Program at the Brookings Institution and a former executive director of the Pension Benefit Guaranty Corp., the federal agency created by ERISA, said in a telephone interview that the flight from defined benefit plans is the result of companies ultimately rejecting the regulatory responsibility of being the fiduciaries of those plans.

“It's pretty clear ERISA itself caused the death of ERISA defined benefit plans,” said Mr. Gotbaum.

Some of the largest corporations in the U.S. that launched after ERISA became law in 1974, such as Amazon.com Inc., Apple Inc., and Microsoft Corp., never had a defined benefit plan. And those companies incorporated after 1974 that did have defined benefit plans, such as Verizon Communications Inc., often simply carried legacy defined benefit plans from predecessor companies.

But even those companies that carried legacy defined benefit plans, like Verizon and General Motors Co., have transferred billions of dollars of liabilities to insurance companies to significantly reduce the sizes of those plans.

The movement of U.S. corporations away from offering defined benefit plans is far from recent. Following the passage of the Tax Reform Act of 1986, which overhauled vesting, integration and coverage rules for defined benefit plans, which motivated many newer employers to gravitate toward 401(k) plans, P&I ran an editorial in the Oct. 13, 1986, edition: “Defined benefit plans slowly dying.”

Pressures continued to mount with the Pension Protection Act of 2006.

The law took actions that included the speeding up of the time over which companies had to amortize deficits to their DB plans, adding the requirement of additional contributions by “at-risk” plans and encouraging automatic enrollment in 401(k) plans.

While the PPA contributed to corporations moving away from DB plans, the effect of the 2007-2009 financial crisis accelerated that flight.

One expert said she believes the alarm that many have raised over the decline of the defined benefit plan is a result of “a lot of misplaced nostalgia for the old traditional defined benefit plan.”

“Defined benefit plans worked for a subset of the labor force, primarily in manufacturing, railroads and airlines,'' said Olivia Mitchell, professor of insurance and risk management at The Wharton School, University of Pennsylvania, Philadelphia, and executive director of the Pension Research Council, in a telephone interview. “They never worked for the rest of the economy at all.”

A self-described fan of defined contribution plans, Ms. Mitchell said that even fewer numbers of employees could even take advantage of the benefits of a traditional defined benefit plan since they rarely stayed with an employer long enough to vest, and even then, it could take up to 30 years to achieve the full possible benefit.

Mr. Clark said younger employees prefer defined contribution plans, specifically that account balance to which they have access.

“Many private employers ... actually ask new employees which they would prefer,” Mr. Clark said. “If there is a choice, oftentimes younger employees pick defined contribution over defined benefit. They do so partly because they expect any account balance in a defined contribution plan will be transferrable when they move onto another employer.”

Not doomsday

To those who fear that the decline in DB plans spells a retirement income security doomsday, Keith P. Ambachtsheer, director emeritus, Rotman International Centre for Pension Management, University of Toronto, and president of KPA Advisory Services, noted that “what people forget is Social Security.”

“The basic idea is if you're a middle-income worker, it's going to replace 40% of your income. Well, that's not bad,” Mr. Ambachtsheer said.

He also added that the general rule of thumb has been that a retiree requires 70% of their income in order to maintain his or her standard of living.

“For a lot of people that's too much. It's more like 60 (percent). You need to go from 40 to 60 to maintain your standard of living, as long as you have a good retirement savings plan.”

Mr. Clark said, “For lower-paid workers eligible for Social Security, for example, in the U.S., Social Security is a very important component of their long-term retirement income, which is not the same actually to middle- and higher-paid employees in the private sector in the U.S.”

“It's much more important how they save themselves other than Social Security, so you have to balance that,” Mr. Clark said. “You have to be aware that in some countries the entitlements available to lower-income workers are sufficient to underpin a low contribution rate on the defined contribution side. Those same levels of benefits aren't nearly as lucrative to middle- and higher-income workers.”

What's next?

The question, however, remains: Will U.S. private-sector workers be covered by defined benefit plans in the future?

J. Mark Iwry, until Jan. 20 the senior adviser to the secretary of the Treasury and the Treasury Department's deputy assistant secretary for retirement and health policy, said some companies continue to work on preserving some kind of a defined benefit plan.

“Creative efforts are underway to design pension plans that share some of the financial risks — longevity, investment, inflation — between employers and employees, but in appropriate ways that take account of individuals' reasonable expectations and their relative disadvantages in bearing certain kinds of risk.”

One example Mr. Iwry cited is the variable annuity pension plan, in which the employer tells participants what guaranteed benefit they can expect upon retirement, which could hypothetically be higher if investment returns reach a certain level.

“We absolutely believe DB plans have a future,” said Brian McDonnell, global head of pensions at Cambridge Associates LLC, Boston, in an email. “While the freezing of benefits may garner the most headlines, there are many plan participants that will be continuing to accrue new benefits in (the) private sector as well as Taft-Hartley and public defined benefit plans going forward.”

“We believe forward-thinking employers will continue to assess the elements of DB plans that make them well-suited to their intended purpose (a secure retirement) while improving on the limitations that funded status volatility imposes on the sponsors,” Mr. McDonnell said.

Others aren't as confident.

“DB plan sponsors in the U.S. have been freezing DB plans and terminating them for over a decade,'' Ms. Mitchell said. “Based on trends around the world as well as low capital market returns, I believe that the few remaining plans will follow suit within the next few years.”

Kevin Hanney, director of non-U.S. pensions and savings plans at United Technologies Corp., Hartford, Conn., said it is unlikely that traditional corporate defined benefit plans will be revived.

“It is hard to find much in the current economic environment that could facilitate a resurgence of traditional corporate defined benefit plans. Low interest rates, rising PBGC premiums and changing accounting standards are just a few of the headwinds that buffeted corporate plan sponsors in recent years,” Mr. Hanney said. “It's a big part of why we've seen so many high profile companies in the U.S. adopt mark-to-market accounting or other non-traditional reporting methods, as well as pursue pension derisking activities.”

UTC had $30.6 billion in global defined benefit plan assets as of Dec. 31, according to its most recent 10-K filing, and $20.7 billion in defined contribution plan assets as of Sept. 30, according to Pensions & Investments data.

“UTC remains committed to preserving the security of our traditional pension benefits, but we made a strategic decision when we closed the defined benefit plan to look ahead and consider how we might best address the retirement needs of our current and future employees,” said Mr. Hanney.

That included enhancing the company's 401(k) plan with a lifetime income annuity option, a default option for new employees

“The Lifetime Income Strategy launched 4 years ago, and already serves nearly 27,000 employees who have dedicated over $900 million of their retirement savings to it,” Mr. Hanney said.

This article originally appeared in the February 20, 2017 print issue as, "Credit easing, regulation put plans on critical list".