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Submitted by: Frank Armstrong
Frank Armstrong, is President and founder of Investor Solutions, Inc. He is a pioneer in integrating academically driven portfolio management techniques with institutional best practices for individual investors around the world. Frank has over 30 years experience in the securities and financial services industry. He holds a B.A. in Economics from the University of Virginia and is a CERTIFIED FINANCIAL PLANNERŪ practitioner.
The traditional American retirement plan allows you to sit down with a calculator and plan documents to determine exactly what your benefit will be at retirement age. A defined benefit plan provides a safe, predictable income stream for the balance of a retiree's life.
As the name implies, in a defined benefit plan we know the benefit, but not the cost to provide it. But, as employees we don't care. It's somebody else's problem.
All of the funding requirements, the investment policy decisions, the actual investment results, the administrative costs, are the responsibility of the employer or plan sponsor. If all goes well, from the employee's viewpoint, the plan is on autopilot and he's along for the ride. The employee makes no decisions, has no responsibilities, seldom contributes a single penny, can count on a known retirement income and has no worries.
The employer has almost the opposite perspective. Employers are solely responsible for the operation, cost, administration and success of the plan. Worse yet, funding requirements cannot accurately be determined in advance. Plan underfunding shows up as a balance sheet liability which can rapidly destroy shareholder equity and torpedo stock prices. During the stock market downturns of 2000 to 2002, several giant household name companies had unfunded liabilities far in excess of their net worth. Pension fundliability has a very high priority in the event of plan termination or corporate bankruptcy. The plan stands close to the head of the line when it comes time to divvy up remaining corporate assets.
Defined benefit plans are very expensive to run. Because funding adaquecy is so difficult to determine, the plans must have an annual actuarial certification. Additionally, after many high profile plan failures the 1974 pension reform act, (Employee Retirement Income Security Act, or ERISA) requires most plans to pay an annual per participant insurance fee to the Pension Benefit Guarantee Corporation (PGGC) to partially guarantee benefits under the plan. (Small company plans sponsored by a Professional Corporations and owner-only plans may be exempt.)
The inability to accurately forecast annual costs and the exposure to potential for liability swings due to outside influences (the stock markets) beyond the control of the company have forced many companies to abandon defined benefit plans entirely. While not extinct, defined benefit plans are a shrinking part of the retirement landscape.
Like all other qualified pension plans, there is an initial employment period before an employee joins the plan. After that, the employee earns benefits according to the plan formula. But, those benefits may vest over time. In other words, if the employee doesn't stick around for the required vesting period, he may forfeit all or a part of his accrued benefits. After the forfeiture period, the employee is vested in all past and future benefits he accrues. Participation requirements and vesting serve to reduce cost for short term employees, making it possible for employers to reward their most loyal long term employees.
A typical benefit formula might look something like this: Retirement Income payable at age 65 = (2% for each year of service) X (the average gross pay for the last five years of employment pay). This basic benefit may then be adjusted for early or late retirement, and then further adjusted for the form of annuity selected by the retiree. This type of formula strongly favors older employees and employees with long service. Older employees that join the plan have fewer years until their benefits must be funded, so it takes proportionally more to fund their benefits than for younger employees. The formula is often referred to as "back end loaded" because most of the benefits accrue during the last few years of service. Two factors of the formula, final average pay and years of service both increase with longevity. As a result, most employees that don't stay with one company for an entire career end up with only a collection of token benefits.
These token benefits are generally not "portable", which means that they can't be rolled over into an IRA, or the next corporate plan to grow for the future. They are typically "frozen" in the former employer's plan until normal retirement date. This feature may not be an optimal arrangement in today's mobile employees.
Beginning January 1, 2004 the maximum benefit that a Qualified DB plan can fund toward is 100% of compensation or $165,000 per year at normal retirement whichever is smaller. There are a variety of additional regulations designed to prevent the plan from blatant discrimination in favor of highly compensated employees that would reduce that maximum benefit for many plans.
While the benefit formula imagines a level payment to a single retired person for life, that's not the usual outcome. ERISA requires that a married participant's default option is a Joint and one half annuity. A lesser benefit is paid to the retiree for the balance of his/her life in order to provide for a death benefit to a surviving spouse of one half the remaining amount. For instance, a retiree that had a nominal benefit of $50,000 a year might find that his Joint and One Half annuity benefit was $40,000 in order to assure that if he/she died before the spouse, the spouse would receive a benefit of $20,000 for the balance of their life. To protect the spouse, this benefit arrangement can only be waived with the written and notarized consent of the spouse.
Some, but not the majority of plans, will allow the retiring employee to elect a lump sum settlement in lieu of a lifetime annuity. The amount of the lump sum is the calculated cost of providing the single life annuity. This amount will vary inversely with current interest rates and cannot be determined in advance. However, employees may attempt to retire when they think interest rates are at a historical low point. In extreme cases where many employees attempt to bail out at the same time, the large lump sum payments can weaken the funding for remaining employees.
Unlike their defined contribution cousins, defined benefit plans do not segregate assets for each employee. The employee cannot look at "his" account to see what the balance is. Instead, the plan has a single pooled account to satisfy all the expected liabilities. The employee should receive an annual statement called a Summary Annual Report detailing the plan's financial condition and annual benefit statement. The annual benefit statement will disclose the employee's accrued benefits, and the Summary Annual Report should show the status of the plan's funding.
In reality, most plans are under-funded if for no other reason than the difficulty of estimating future benefit levels. How could a company accurately estimate 20 or 30 years in advance what an employee's final five years' average pay might be? It's an ever changing exponentially growing target. Reasonable amounts of under-funding are not generally critical problems for a healthy company because it is allowed to amortize the underfunding over many future years. Additionally, companies are allowed some leeway to "normalize" funding by over contributing or under contributing to the estimated target contribution level depending on their annual financial results. But, a chronically weak company that has a severely underfunded plan is a ticket for disaster for both employee and employer.
While a guaranteed income for life with no investment responsibilities or risk sounds pretty nice, there is a dark side: if things go wrong, it can get pretty awful pretty quickly.
Coming up: What to expect if your Defined Benefit Plan terminates.
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