Pressures mount on sponsors of both types of plans
WASHINGTON, D.C., October 13, 2008 — The financial crisis starkly highlights the relative pros and cons of defined benefit pensions and 401(k) plans, according to experts at Watson Wyatt, a leading global consulting firm.
Broadly speaking, the predictable, mainly guaranteed income of pensions (including so-called hybrid plans like cash balance plans) contrasts sharply with the day-to-day fluctuation of 401(k) account values, which are wreaking havoc on planned retirements.
“We are in uncharted territory. The 401(k) plan has been around for less than 30 years, and we’ve not yet had a generation of workers retire on all or mostly 401(k) assets,” said Alan Glickstein, a senior retirement consultant at Watson Wyatt. “What happens when market volatility makes 401(k) investment returns and retirement income anything but predictable?”
With a 401(k) plan, employees invest assets as individuals. As they near retirement, employees need to construct individual “glide paths” to reduce risk in their 401(k) accounts and to provide some measure of predictable income in retirement. Increasingly, employers are helping with this process, as they are beginning to offer employees target-date retirement funds and, to a far lesser degree, annuity options in their 401(k) plans.
With pensions, sponsoring companies invest assets as one large pool and with a longer time horizon than individual employees. They can thus more easily ride out market downturns. In addition, pension plan assets are guaranteed by the sponsoring company and, in a second layer of security, by an agency of the federal government for most benefits.
Individuals bear investment risk in 401(k) plans, while companies take on the risk – and the opportunity to provide more efficient benefits – with pensions.
“The current environment underscores some latent employer risks with 401(k) plans,” says Glickstein. “For example, they make it harder for companies to predict who will retire and when. Employees who mostly rely on 401(k)s are also more likely to worry about their financial security, creating an additional drain on morale and productivity during turbulent times.”
On the pension side, employers are dealing with new funding rules that became effective in 2008. Companies must fund their pensions based on the value of plan assets relative to liabilities (the present value of projected retirement payouts based on accrued benefits). Under old funding rules, pension sponsors could smooth their asset values based on market returns over a five-year period. Under new rules, companies can only average returns over a two-year period, and the averaged assets cannot exceed current market value by more than 10 percent.
The new rules are much closer to the so-called mark-to-market rules that have been implemented in corporate accounting with respect to the balance sheet. Assets are “marked” or valued at what the market will pay for them on a given day, rather than smoothed over time.
“The federal bailout of the credit markets is an acknowledgment that in extreme cases, the mark-to-market principle does not work,” said Kevin Wagner, a senior retirement consultant at Watson Wyatt. “This crisis should increase pressure generally to revisit mark-to-market principles. Without some relief, a sustained downturn in asset values will noticeably increase required contributions to pension plans starting next year, when plan sponsors will also be facing significant business pressure.”
This pressure, especially with respect to accounting, will be offset to some degree by the effects of higher corporate bond rates on pensions. As high-quality corporate bond rates rise, which they have been doing, the present value of future retirement payouts (or plan liabilities) goes down.
In addition to dealing with the workforce management risks mentioned earlier, 401(k) sponsors should be stepping up the oversight and governance of their plans, said Robyn Credico, national director of Watson Wyatt’s defined contribution practice. “We are in a very litigious environment, and the sharp market downturn will only fuel matters.”
Credico warns against hasty action: “Now is not the time to switch 401(k) vendors or change investment choices unless absolutely necessary. The market is too fluid.”
About Watson Wyatt
Watson Wyatt (NYSE, NASDAQ: WW) is the trusted business partner to the world’s leading organizations on people and financial issues. The firm’s global services include: managing the cost and effectiveness of employee benefit programs; developing attraction, retention and reward strategies; advising pension plan sponsors and other institutions on optimal investment strategies; providing strategic and financial advice to insurance and financial services companies; and delivering related technology, outsourcing and data services. Watson Wyatt has 7,200 associates in 32 countries and is located on the Web at http://www.watsonwyatt.com.