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Hot Topics : Why Pension Plans Are Becoming Extinct

Lately, we have been hearing the news of Delta and United filing bankruptcy and terminating their pension plans.  In addition, IBM and Alcoa are moving away from pension plans to 401(k) plans.  The news will continue to be bleak, as other companies are considering moving away from their pension plans as well.  So, why are companies moving away from these plans?  First, pension plans is usually referencing a defined benefit pension plan where employees earn a fixed benefit for life when they retiree (i.e., $xxx per month).  This differs from a 401(k) plan where the employer provides employees an annual a benefit while working based on a % of pay (usually through matching their employee's 401(k) contributions).   The reason why Delta and United got rid of their pension plans is due to bankruptcy, yet the question is why are healthy companies getting rid of their plans?  One may accuse companies of doing this to reduce costs.  Headlines are usually about how much money these companies will save,  however this may be misleading which I will explain later.  One of the main drivers is really about controlling risks.  And, employees need to be aware of this because companies are controlling their risks by diverting the risks to the employees and retirees.

Why are these risks are being transferred to employees?

Pension plans became popular in the 60's and 70's when employees were working for a corporation for most of their careers.  To reward these employees, companies gave lifetime monthly pension benefits to its employees.  Starting in the 80's and continuing in the 90's, the trend switched to move away from these pension plans to 401(k) plans for several reasons:

  • Employees no longer worked their whole careers for one employer and wanted more portable benefits that 401(k) plans provide
  • Many employees did not appreciate the real value that these plans provide because receiving $x,xxx per month in retirement did not have the same tangible value of receiving $x,xxx per year in a 401(k) plan because $x,xxx paid in retirement seems so far away
  • Congress and IRS put an extra layer of regulatory burden on pension plans which made pension plans more complex and costlier to administer

Yet, the final two nails in the pension coffin appear to be:

  • The stock market downturn from 2000 to 2002 created large investment losses for many pension plans that either had to be made up by higher than expected investment returns to offset these losses (which has not happened) or by the company contributing money to offset these investment losses
  • Companies like United and Delta that suffered from a prolong business downturn could not survive in an environment of loosing money and needing to make large pension contributions to make up for the investment losses from 2000 to 2002.  Thus when they terminated their plans, PBGC (Pension Benefit Guarantee Company) was left to pay out these pension benefits using the company's pension plan assets which were underfunded by several billion dollars due to investment losses from 2000 to 2002.

  • Pending legislation aimed at saving the PBGC by shortening the time period that companies have to contribute money (to make up for investment losses) will drive many companies to drop their plans

    In the end, a pension plan will have a hard time surviving in this economic environment.  Businesses need to have flexibility to meet the needs of the market and fend of competition from newer leaner competitors.  With this pending legislation, a company with a pension plan will lose flexibility because the time period they need to make contributions for the market losses will decrease from 5 to 10 years to 3 to 5 years.  This means that during an economic downturn, a company not only needs to have cash to meet payroll but also to find cash to make a much larger contribution to its pension plan to make up for investment losses in its pension plans.  This will make it difficult and if not impossible to compete with a competitor that does not have a similar pension plan burden.  Therefore, companies are looking for greater stability in their cash flow needs that 401(k) plans provide.

So what should I do if I am in a pension plan?

  • Do not panic - Even if a company drops its pension plan, they can not decrease the benefit that you have already accrued.  So if you are older and near retirement, the benefit you have accrued can not be taken away.  If you are younger, you have time to increase your 401(k) plan to make up the difference.   In addition, in case your company goes bankrupt, most pension plans are covered by the PBGC which guarantees to pay out lifetime benefits up to $3,971 per month at age 65 (for plans terminating in 2006).  For many employees, this means that their benefits will be fully protected.  Those that may lose some of their benefits (those who are on the news) are higher income individuals such as the United and Delta pilots.  Note, when you hear of rank-and-file employees losing their benefits, this is future benefits that could have been accrued if they continued to work to retirement.  Yet, as we all know, there is no guarantees of future employment, let alone future benefits.
  • Do not blame the company - Many companies take this step as a part of the ultimate survival of the company (even if they are not in trouble currently).  Companies are trying to fend of competition from smaller firms that may provide smaller benefit packages.  So, the question is, would you want to ensure your future benefits at the risk of losing your job?  I have been in meeting with several companies when they are making these decisions.  Many are not trying to find ways to pull a fast one on their employees, rather they tend to go out of their way (if they can economically) to find ways for their current employees (in particular those who are most affected) to be protected as much as possible from such a change (e.g. continue to provide benefit accruals for several years).  Remember, blame will only hold you back in the past rather than taking charge of your financial future.
  • Figure out what you need for retirement - As companies are moving the responsibility of retirement benefits to its employees, employees need to take responsibility for knowing what they need to to be able to retire.  Even if you can not save right now, figure out what you need to save in the future to meet your retirement needs.
  • Do not wait for your company or Social Security to change, act now - The writing is on the wall that we can not depend on receiving as much from our government or our companies for retirement, so get a head start on your retirement security by factoring in a cut back in future benefits from both your company and Social Security.  You can wait to act.   Yet, it will only make it harder if and when these changes do occur.

As a side note, why do company's save millions when they change their pension plans?  There are several reasons why this can be so.  Many would initially believe that it is because employees benefits are reduced.  Yet, this is not necessarily so.  Due to accounting rules, many company's have accrued on their financial books larger pension benefits than what actually has been accrued (due to projecting salaries to retirement).  When companies freeze their plans, they reflect that benefits accrued to date are less than what is actually on their financial books for accounting purposes.  So, they need to reduce this accounting number and it shows up as a reduction of costs for accounting purposes.  Yet, in reality the employees accrued benefits have not changed.  The money saved may be just an accounting issue.  The Financial Accounting Standards (FAS) wants to accrue the ultimate benefit over a specified number of years and usually does not correlate to what an employee's actual benefit is at a given point of time.   It, also does not mean that the average employee will receive less of a benefit at retirement compared to what he would have received if the prior plan continued.  So, it is improper to jump to the conclusion that a change in pension benefits is done just to save money at the expense of its employees.

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