Remember traditional pensions? They have been the envy of retirees everywhere, providing guaranteed lifetime payments that remain fixed despite any economic or stock market reversals. But as the late economist Milton Friedman used to regularly remind us, there is no such thing as a free lunch. And that applies to defined-benefit pension plans.
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Private pensions have been hammered nearly as hard as 401(k)'s, IRAs, and other self-directed retirement investments. During the past two years, the value of pension plan assets fell. The recession pummeled corporate profits as well. Thus, employers had trouble providing funding to shore up the plans. As a result, Congress enacted emergency relief to give companies several more years to establish the financial soundness of their plans. Despite the help, an unknown number of plan officials have seen the writing on the wall. Concerned that no amount of relief would help them return to desired soundness, they have chosen to cap their exposure by closing their plans to new retirees.
"There are still some open plans, but I think very few employers will keep them active forever," says Maggie Ralbovsky, managing director of Wilshire Consulting. "People are evaluating whether to close or freeze their plan," she explained, "so corporate plans are in the phase of being closed."
The problem here is that it's very hard to know the precise condition of plans. They are required to file only an annual report on their condition, so what we know about specific plans is pretty much their receding image as of Dec. 31, 2008. RiskMetrics, a New York financial services firm, does an annual review of the condition of more than 750 corporate pension plans with assets exceeding $250 million. Dan Mahoney, co-director of research, says he knows of no list of plans that have closed or restricted access and that public reporting of such decisions is not required.
Right now, however, nearly all plans will have to come up with added funding to recover from their market losses. "The average funding percentage (defined as pension assets as a percentage of pension liabilities) declined to 73 percent in 2008 from 93 percent in 2007," RiskMetrics recently reported in its study of plan condition as of at the end of 2008. "And 94 percent of plans were underfunded at year-end 2008 as compared to 71 percent of plans at year-end 2007."
If you are fortunate enough to be entitled to a defined-benefit pension, figuring out the true health of your plan is very difficult, Mahoney said. There are at least four significant financial decisions that pension-plan managers can make. There may be substantial differences in how different plans approach these decisions. The same plan can use different assumptions from one year to the next, and, he added, not all of the decisions must be publicly reported.
Discount rate. Pension plans must have adequate funds today for obligations that won't be paid until well into the future. So, they need to discount the level of these cumulative obligations, come up with a present value for them, and then compare this value with current pension-plan assets. This discount rate, then, reflects their assessment of future inflation and the structure (age and benefit entitlements) of their pension-plan population. The larger the discount rate used by a plan, the smaller will be the current value of required pension-plan assets. And because contributions to pension plans reduce corporate profits, there may be pressure on plans to use the biggest discount rates they can justify. Ask your plan administrator the size of its discount rate and how it has changed over the past few years. RiskMetrics found that the average discount rate is roughly 6.25 percent but that some plans had rates above 8 percent.
Assumed investment gain. As with the discount rate, larger expected investment gains reduce the current amount of required pension plan assets. These are long-term expectations, so even last year's huge market swings shouldn't have caused expected returns to collapse. For the most part, they didn't. Expected annual returns remained at about 8 percent. However, many companies used higher returns, and more than 20 were bullish enough to actually raise their projected returns by more than a quarter of a percentage point (a big swing in pensionspeak). What assumption does your plan use?
Expected rate of future wage gains. Because pension benefits are tied to wages, future salary increases will raise payouts, which means companies must set aside more money today to get ready for them. So, using an unrealistically small number for expected salary increases makes today's pension plan assets look better. Common projections for future wage gains range from a little more than 2 percent to a little less than 4 percent a year, with most plans clustered near 3 percent. In addition to finding out the salary assumption in your plan, ask how it has changed in recent years. Most likely, the recession does justify reducing future rates of wage gains. But if inflationary pressures get more pronounced when the economy recovers, there will be upward pressure on wages.
Smoothing interval. Companies that hit a rough patch with their pension plan assets get a further break in that they don't have to use the current value of those assets to meet this year's 94 percent funding adequacy level. They can go back two years and average out, or smooth, plan earnings, as long as the result is between 90 percent and 110 percent of the current value. Mahoney says companies can change their smoothing decisions and need not publicly report the specifics of their approach.
The good news is that investment markets are recovering. Corporate pension plans tracked by Wilshire showed a 10.9 percent gain in the second quarter, although they were still off 16.8 percent for the year ended June 30. Ralbovsky said the plans continued to shift from stocks to a more conservative reliance on bonds.
When plans freeze benefit levels or bar new participants, she noted, they can more easily estimate future pension payouts because they know who will be receiving them. And with retirees, they also know the exact amount of the payments they must make. For this "inactive" portion of their pension-plan obligations, she says, it makes sense for plans to invest in bonds with returns that match the plans' fixed obligations. But for plans with active participants, where future payments are not yet set, she said plans should be investing in assets with some inflation protection, such as TIPS (Treasury inflation-protected securities) or stocks of companies involved in commodities that historically have good performance records in inflationary periods.
A more conservative investment mix makes sense up to a point, Ralbovsky says. But like normal investors burned by the meltdown of stocks, pension plan managers may have become too risk averse. "I think in the next few years, people may have a knee-jerk reaction in overestimating risk," she said. Paradoxically, this effort to be cautious could wind up lowering pension plan earnings and "may make more people lose their defined-benefit plan benefits. I think that's a real risk we're facing."