A Balanced Look at the Case for Defined Benefit Pensions

A media frenzy has surrounded the pension woes of several airlines and the resultant potential financial hit on the Pension Benefit Guaranty Corporation (PBGC). This, along with the increasing number of large defined benefit (DB) pension sponsors that have either frozen or closed their plans to new hires¹, has led many analysts to conclude that the traditional DB pension system is in a tailspin. But to paraphrase Mark Twain, the rumors of its death may be greatly exaggerated. After taking a second look at the costs and benefits of DB plans, some employers are deciding they're worth keeping.

Trends in Pension Coverage

One of the most striking changes in the composition of household retirement savings over the last 25 years has been the shift from DB to defined contribution (DC) pension plans. While the share of full-time U.S. workers that participated in any pension plan edged down from roughly 55 percent in 1979 to less than 50 percent in 1998, the composition of pension coverage changed much more dramatically (Figure 1). In 1979, two-thirds of workers with pension coverage were covered by a DB plan. By 1998, only one-third of those workers had a DB plan.

At first, DC plans served mainly to supplement DB pensions. Then employers without DB plans and start-up companies began offering 401(k) plans as their only retirement benefit. Many smaller and midsize companies terminated their DB pensions in favor of DC packages. Most large DB plan sponsors still offer dual DB and DC coverage, although as start-up firms with DC-only coverage have grown — and some of the older DB sponsors have gone out of business — firms offering dual coverage have employed an increasingly smaller share of the workforce.

ERISA was enacted in 1974, when DB pensions were the dominant form of employer-sponsored retirement benefit. The law imposed participation, vesting, funding, reporting and disclosure requirements on plan sponsors; created a standards-setting body for actuaries; and established the PBGC to insure accrued benefits against the sponsor's bankruptcy. Many observers have cited the rising costs of regulatory compliance as a key factor in the shift away from DB plans. Because many compliance costs are fixed, they impose a smaller burden on larger employers, which benefit from economies of scale. So the migration away from DB sponsorship has been particularly pronounced among small and midsize companies.

Yet other economic forces have driven the shift as well. Manufacturing has lost considerable ground to the service industry. In manufacturing, company-specific skills are important and DB pensions encourage retention — up to a point — and then encourage retirement. In the service sector, skills are generally more transferable across companies, making retention less valuable and DC-only coverage more attractive to both sponsors and workers. This shift in activity — combined with rapid advances in technology that have increased the importance of non-company-specific skills — has created an increasingly mobile workforce. Since 1983, the median tenure for men in their prime working years (ages 45 to 54) declined from nearly 13 years to about 9-1/2 years — a 25 percent decline (Figure 2). Women entering the labor force en masse in recent decades also may have fueled the demand for more portable benefits.² Women — and dual earners more generally — must make employment choices that accommodate home demands and thus may be less attached to either specific employers or the labor market. Since benefits in traditional DB plans accrue most rapidly just before retirement, these plans provide little savings advantage to workers who change jobs several times over a career.

Another significant trend in pension coverage that reflects changing labor markets has been the conversion of many traditional DB plans to cash balance or other hybrid plans. These conversions became popular in the 1990s, and roughly 25 percent of Fortune 1000 DB sponsors currently have a hybrid plan. Hybrid plans are DB plans legally. However, in contrast to traditional DB plans, benefits accumulate as a hypothetical account balance, which is typically paid as a lump sum when the worker leaves the firm. Benefits in hybrid plans can accrue more evenly over a worker's tenure than they do in traditional pensions, so workers can switch jobs without penalty. Since hybrid pensions are regulated as DB plans, hybrid sponsors do not escape the regulatory burden.

There are other good reasons to adopt hybrid plans. First, their value is much easier to communicate than that of DB plans. Participants often under-appreciate their traditional DB plans until they near retirement. Employers can explain the value of hybrid plans in terms comparable to those used for 401(k) plans — such as account balance — and report annual benefit accruals as well.

Workforce aging is another impetus for hybrid conversions. Most traditional DB plans offer early retirement subsidies that encourage older workers to retire. As labor market growth slows, however, employers increasingly need to retain experienced workers. Most hybrid conversions eliminate early retirement subsidies, and many include features such as accruals that increase with tenure, which encourage work at any age. Finally, hybrid plans offer more predictable funding. The Omnibus Budget Reconciliation Act of 1987 limited the ability of firms to prefund benefits, making it difficult for them to manage the backloaded pension accruals typical in traditional DB plans.³

The Current Environment

The decline in DB coverage slowed in the late 1990s, perhaps owing to new plan designs that enabled DB sponsors to meet their workforce management needs, as well as to favorable financial markets. While the number of small plans continued to decline, the number of large plans actually increased.⁴ Since 2000, however, plan sponsors have faced challenges that threaten to further weaken the DB pension system. The first is often referred to as the "perfect storm" — the combination of falling equity prices that dealt a blow to pension asset values and falling interest rates that pushed up current value measures of liabilities. These adverse conditions drove funding ratios down from a peak average of 122 percent in 1999 to a trough of 76 percent in 2002. Since then, firms have regained some lost ground, with the average funding ratio climbing to 83 percent by the end of fiscal year 2004. In the late 1990s, many sponsors ran up against IRS contribution limits and had to stop contributing to their plans. But in recent years, many of these same firms found themselves in double jeopardy: facing both pension shortfalls and challenges in their core business at the same time.

And the regulatory future is still uncertain for hybrids. Cash balance plans have been at issue in a number of high-profile age discrimination cases, and the rulings have left these plan designs in legal limbo. Congress has yet to clarify the legality of the cash balance plan design. And the recent collapse of several large plan sponsors in the steel and airline industries has left the PBGC facing the largest funding shortfall in its history. Current legislative proposals would impose stricter funding requirements and higher PBGC premiums on all plan sponsors. The number of large DB sponsors with a frozen or terminated plan rose last year, and several companies have closed their DB plans to new hires and adopted a DC-only structure for retirement benefits going forward.⁵

Yet firms with DC-only pensions increasingly face their own problems. The overwhelming majority of DC plan designs require employees to contribute before the employer matches contributions, and participation rates in DC plans have generally been disappointing. Roughly 75 percent of all eligible workers participate in 401(k) plans, but participation rates are much lower among lower-income and younger workers. ⁶ It also appears that many 401(k) participants make suboptimal investment choices, and some withdraw their funds before retirement when they change jobs. Taken together, it is not clear that DC-only pension coverage leads workers to efficiently secure their retirement.

Defined Benefit Versus Defined Contribution: What Are the Real Differences?

With hybrid DB plans offering portability and more front-loaded benefit accrual, differences between the DB and DC retirement models have become less pronounced. Yet fundamental distinctions remain. In DB plans — unlike DC pensions — the employer decides who participates, how much to contribute and where to invest the money. This control enables employers to set savings targets for their employees that are not affected by inertia and procrastination.

In DB plans, employers bear the investment risk. This may lower the long-term cost of the plan if their investments flourish, but it can also increase the volatility of costs. While long-term plan expenses can be forecast fairly accurately, year-to-year volatility may threaten a firm's ability to manage its core operations through business cycles. Consequently, ERISA gives plan sponsors funding flexibility to help them manage the volatility and ride out economic fluctuations. Theoretically, employers can contribute more when economic times are good and less when times are tough. But this flexibility has limits. Employers are restricted in their ability to overfund their plans by tax law. One consequence is that between 2000 and 2002 — an extreme down market — employers had to come up with large cash infusions.

In firms with DC-only plans, employees bear the risks of market volatility. And asset values often move up and down along with business conditions. In the last market downturn, many employees in DC-only firms suffered a double whammy as stock values fell and their employers cut back or suspended their 401(k) match owing to weak revenues at the firm level. Such situations can become particularly difficult to manage if an employer needs to reduce its workforce but older employees can't afford to retire.

As the manager of a large pool of assets, DB sponsors can potentially achieve superior investment performance. Evidence suggests that DB plans rebalance their portfolios more often than 401(k) participants and achieve higher returns on average. ⁷ DB plan sponsors are required to offer an annuity, which gives retirees the opportunity to insure against longevity and investment risk.

From a workforce management perspective, DB plans provide different incentives for employees and achieve different workforce goals, encouraging employees to stay with the employer at all ages, with near-universal five-year vesting provisions and higher accrual rates. DB plans also allow significant design flexibility. Plans may use early retirement subsidies or delayed retirement incentives, Social Security integration and retention bonuses to manage workforce retirement and retention behavior. While DC vesting schedules offer some early-career retention incentives, employers have fewer options for varying contributions due to nondiscrimination regulations. Indeed, survey data show that DB plans exert more influence on attraction and retention, particularly among older employees. ⁸ This may become increasingly important to employers as the workforce ages and labor force growth slows.

Looking Ahead: What Is the Future for DB Pensions?

Most companies today are in the process of evaluating their retirement benefit programs. While some sponsors are turning away from DB offerings, many are discovering good reasons to keep their DB plans. We surveyed more than 500 companies with a DB plan and found that over a six-year period between 2000 and 2005, two-thirds did not change the basic DB/DC structure of their retirement plans for new hires. A significant number of companies (17 percent) froze or closed their DB plan and adopted a DC-only package. However, many companies (about 9 percent) actually added DB plans, increased benefit accruals or expanded DB coverage, and 4 percent converted their traditional plans to a hybrid design between 2000 and 2005 — a period that coincides with many of the significant regulatory and market challenges to the DB system described above. ⁹

Interviews at a number of companies that decided to stay with or expand their DB programs revealed several recurring themes:

• Nontraditional hybrid plan designs are important in companies' decisions to retain and expand DB coverage.
• The workforce goals of attracting, retaining and managing retirement behavior are fundamental to the decision to stay with DB pensions.
• Corporate change, notably mergers, frequently plays an important role in triggering expansions of DB coverage.
• Companies that retain or expand their DB plans almost always also offer a DC savings plan.
• Finally, DB plan sponsors understand that they incur some risks. They know they must accept short-term funding requirements in exchange for the longer-term benefits of lower costs and more effective workforce management afforded by the DB designs.

Three case studies illustrate these themes in action.

Case Study One: Opening a Closed Plan

The Aerospace Corporation, a mid-sized, federally funded research and development center, closed its hybrid DB plan to new entrants during the recession of 1991-1992, replacing it with a generous DC plan. The company wanted to provide a portable benefit and was following the general trend toward DC retirement plans. A decade later, several converging issues prompted Aerospace to revisit its retirement programs. The DC-only retirement program was not supporting its workforce goals. Aerospace employs a highly skilled workforce, and long tenures are key to the overall human resources (HR) strategy. The company has a vibrant phased retirement program and also employs a number of full-time employees well into their 70s and 80s. While the DC plan was important in attracting new talent, its portability did not support employee retention.

Aerospace wanted to offer the same retirement program to all its employees, rather than a hybrid DB plan for workers hired before 1992 and a DC-only plan for workers hired after 1992. Having two plans also contributed to potential nondiscrimination testing problems for the DC plan. After examining a range of options, including dropping the DB plan entirely, Aerospace came to a creative solution: cut both of the existing retirement programs (the pre-1992 DB plan and the post-1992 DC plan) in half and combine them into a single DB/DC retirement program.

The resulting plan is both complex and competitive. The DB plan is a combination of a Social Security-integrated and inflation-indexed hybrid plan with a hybrid variable benefit plan. To simplify communication, the DB plan's benefits are expressed as annual accruals in the guaranteed and variable benefit balances. The company felt comfortable providing such a complex benefit largely because it employs mostly highly educated engineers and scientists. Aerospace also provides an online modeling tool that combines DB and DC accruals and provides an annuity-value estimate for each component. It also allows employees to change assumptions about rates of return, salary increases and retirement age. On the DC side, the employer contributes 4 percent of salary. Age-based life-cycle funds are the default investment option and hold nearly two-thirds of plan assets.

The driving force behind the decision to re-open and revamp the DB plan was a desire to align the retirement plan with the overall HR strategy: attract the best and brightest with competitive benefits, reward them with the tax-advantaged savings vehicle and retain them with a retirement plan that encourages long service (Aerospace also removed an early retirement subsidy in the redesign). The company determined that the combination of a hybrid DB plan with DC plan best met this goal.

Case Study Two: Expanding a DB Plan to an Acquired Company

A food processing company in the midst of a merger faced a common dilemma: Which benefit plans should cover the salaried employees of the new, merged firm? The acquiring company sponsored a cash balance DB plan for its salaried employees, along with a DC plan. The acquired firm sponsored a fairly generous DC-only retirement plan. The business strategy for the merger was complete integration and harmonization of the two firms, including employee benefits. So the firm needed to decide between offering a DC-only plan or expanding the DB plan to cover the acquired employees. It chose the latter.

Several factors drove the company's decision-making process. First was a desire to compete effectively for talent in the food processing industry. Because DB plans were common in the industry, switching to a DC-plan-only approach would put the company at a competitive disadvantage in attracting managerial talent. The company also wanted to insulate some share of employees' retirement income from market risk. The DB plan structure protected at least a piece of the pie. Finally, the company believed that it could provide better benefits at a lower long-term cost through the DB plan, in which investment returns would offset some of the costs.

The company chose to modify and expand its cash balance DB plan to cover all employees of the combined firm. It enhanced contribution levels from the old acquiring company's plans to match the age-based contribution schedule of the acquired company's DC plan. This ensured that the employees of the acquired company would not lose benefits as a result of the merger. In the newly converted DC plan, the employer matched 50 percent of employee contributions up to 6 percent of salary with a two-year vesting period.

Case Study Three: Opening a New DB Plan

A large health care network with more than 8,000 employees faced some of the workforce challenges typical in that industry. Foremost among these were an aging population of critical- skill nursing staff and a limited pipeline of recruits. The organization decided it needed help from its retirement benefits to attract and retain employees.

The new retirement plan includes a DB and a DC plan. To enhance its long-term retention incentives, the organization offers a new career-average DB plan. To attract employees in a highly competitive labor market, it also provides an employer match on the DC side. The new design holds its own with the retirement packages being offered by competitors.

Two key workforce philosophies structured this decision. First, the company saw the retirement plan within a total compensation framework. Decision-makers wanted to ensure that the entire compensation package, including benefits, offered an appropriate mix of cash and non-cash remuneration. Second, the company wanted an optimal way of delivering this compensation within the constraints of the compensation and benefits budgets. A combination of DB and DC retirement plans emerged as the best solution.

Conclusions

While the woes of DB plans have featured prominently in the media, some companies that offer DC-only retirement packages have also become dissatisfied with their retirement plans. Congress is currently developing proposals to enable employers to offer features such as automatic enrollment, default investments into funds that shift out of equity as workers age, escalating contributions and default annuitization options upon retirement. In other words, DC sponsors want their plans to act more like DB pensions.

For many companies, offering a dual retirement package consisting of a DC plan (which appeals to younger and more mobile workers) and a DB package (which facilitates the stable accumulation of retirement savings and appeals more to older workers) provides a distinct competitive advantage. The DB plans that were designed to encourage older workers to retire in years past are now being turned around to encourage older workers to keep working, through design features like increasing accruals.

The financial market fluctuations of recent years have been a trial by fire for most DB sponsors, forcing them to come to grips with the risk in their pension portfolios. While some have responded by getting rid of their DB plans, others — recognizing the benefits of these plans — have turned to emerging tools for managing portfolio risk through asset/liability matching and hedging strategies.

The features that employers appreciate about DB plans — that they facilitate the stable accumulation of retirement savings and productive employment relationships — should also appeal to policymakers. Many employers that have chosen to retain their DB plans have converted to hybrid designs, highlighting the importance of clarifying the legal status of these plans. Moreover, while the PBGC must be allowed to limit its risk exposure, profitable plan sponsors should be allowed to overfund their plans when they can. A system that pools investment risk across time and across groups of workers can provide retirement security to employees while minimizing the risks to employers posed by volatility.