Defined Benefit Plans Become Significantly More Valuable

As interest rates have declined over the past five years, sponsoring defined benefit pension plans has become increasingly expensive — as plan sponsors are well aware. Plan participants, on the other hand, often do not fully understand or appreciate how much their defined benefit plans are worth. For most workers who participate in a typical pension plan, the value of their pension benefits has grown at a significantly faster clip than their 401(k) account balances over the past five years.

What is the cash value of a monthly benefit provided by a defined benefit pension plan? That depends on the monthly benefit, the time value of money and the participant's life expectancy. The following analyses use the annuity rates developed by the Pension Benefit Guaranty Corporation (PBGC) to assign a cash value to immediate and deferred annuities.

Figure 1 shows the rise in value between August 2000 and August 2005 of a $1,000/month lifetime annuity beginning at age 65. Values are shown only for male participants. But values for female participants are even higher — due to their longer life spans — and increases to their pension values have been comparable to those for men over the past five years. In August 2000, an immediate lifetime annuity paying $1,000/month to a 65-year-old male cost roughly $110,000. Today, it costs about $145,000 — roughly 32 percent more.

Since the funding horizon is longer for younger participants than for older ones, funding costs (and therefore pension values) have risen more sharply for younger participants than for older ones during the past five years (Figure 2). Thus, the 32 percent increase in cash value observed over the last five years for 65-year-old men rises to about 82 percent for 55-year-old participants. And the rising pension values in Figure 2 reflect only the decline in interest rates — they do not reflect the increasing pension value associated with participants' aging.

Figure 3 shows the increase in the value of a $1,000/month life annuity payable at age 65 over the past five years, reflecting both declining interest rates and participant aging. In August 2000, a deferred annuity for a 60-year-old man that would start paying out $1,000/month at age 65 cost about $74,000. Buying the same annuity today would cost about $145,000 — roughly 97 percent more. The increase was even steeper for younger participants.

Figures 1 through 3 understate the growth in pension value for a typical participant, because none reflects increasing benefit accruals during the five-year period. These figures essentially assume that benefits under the defined benefit plan have been frozen.

Swapping a Higher 401(k) Match for a Defined Benefit Plan

Suppose that a hypothetical plan sponsor decided to freeze its defined benefit plan and to contribute more to employees' 401(k) plans in August 2000, as many plan sponsors have done recently due to rising costs, funding volatility and other reasons. Assume it was a typical defined benefit plan, paying out a lifetime annuity at age 65 equal to 1 percent of the participant's final average compensation for each year of service. Employees could also participate in a 401(k) plan, and the employer matched $.25 for each $1 the employee contributed up to a maximum of 6 percent of pay (the maximum employer contribution was 1.25 percent of pay).

On August 1, 2000, the hypothetical employer froze the defined benefit plan and increased the match to the 401(k) plan. Assuming employees contributed the maximum of 6 percent, how much more would the employer need to contribute to give employees the same total retirement value they would have received from their old, pre-frozen retirement program?

Figure 4 shows the contributions that would be required to keep hypothetical employees with different age/service combinations whole from 2000 to 2005. To determine these contribution levels, we assumed that annual 401(k) investment returns would equal 70 percent of the annual return on the S&P 500 and 30 percent on annual 30-year Treasury yields. We also assumed that employee pay increased according to the national average wage index (which averaged about 3 percent per year for the past five years).

For a 35-year-old with five years of service, the employer matching contribution would have to jump from $.25 per dollar under the old plan to about $.90 per dollar to make up for five years' worth of lost defined benefit accruals. If the sponsor offered to roll over the value of the frozen plan into the 401(k) plan in August 2000, and the participant elected that option, the employer match would have to be roughly dollar-for-dollar to make the 35-year-old participant whole.

For a 55-year-old with 20 years of service, the employer would have to match about $1.32 per dollar up to 6 percent of pay if the benefit were frozen. The employer would have to pay about $1.70 per dollar if the lump sum value of the August 2000 defined benefit were rolled over to the 401(k) account. Either scenario would entail a very steep increase. Moreover, since only about 70 percent of eligible participants contribute to a 401(k) plan (and most participants do not contribute the maximum), the average employee would need even larger matches to be made whole. For this and other reasons, many sponsors allow employees over a certain age or certain age and service combination to continue participating in the defined benefit plan and freeze benefit accruals only for new hires or for younger workers.

Defined Benefit Plans Are Hard to Replace

From 2000 to 2005, workers who participated in defined benefit plans generally did better than workers who participated in defined contribution plans. Granted, investment returns during this period were relatively weak and interest rates fell continuously. In other five-year periods, the results of the analysis might have favored 401(k) plans. When the financial markets are booming, defined contribution-type vehicles can help employees accumulate wealth. But defined benefit plans provide participants with a more stable source of retirement income in all market conditions.