DB Pension Plans: 2011 Review and 2012 Outlook

Ten years ago, we were experiencing a “Goldilocks” economy where everything was just right—interest rates were moderate and the stock market was steadily rising. Today, a combination of economic factors—the recession, the volatile equity market, and continued low interest rates—are putting stress on the defined benefit (DB) pension system.  

The question is, are DB plans going the way of dinosaurs and headed for extinction? 

Primarily as a result of the introduction of 401(k) plans, the number of DB plans has fallen precipitously over the past two decades. Today, the percentage of the workforce covered by DB plans has dropped by half and, in many cases, benefits are being frozen or the plans are being closed to new participants. 

In a DB plan, retirement benefits typically are based on a worker’s earnings and years of service. DB plans offer workers predictable, secure, benefits for life. They are especially valuable to workers because: 

DB plans are funded primarily by employer contributions so benefits do not depend on how much a worker is willing or able to contribute

• The employer bears the investment and longevity risks 
• Plans must offer an annuity for life with surviving spouse protection, and 

• Benefits are insured by the Pension Benefit Guaranty Corporation. 

Despite these advantages, the number of DB plans continues to decline. PBGC reported the number of ongoing plans decreased from 27,800 in 2009 to about 25,600 in 2011.   

For members of the Committee on Investment of Employee Benefit Assets(CIEBA), however, declaring the extinction of DB plans is premature. DB plans continue to be the primary retirement plan provided by CIEBA members, but more than 90 percent of members sponsor both DB and DC plans. 

Outlook for 2012 

In an effort to stimulate the economy, the Federal Reserve is expected to continue to keep interest rates artificially low. Pension liabilities are very interest rate sensitive, and even a small decrease in interest rates results in a large increase in the value of liabilities. For example, for FY 2011, PBGC’s interest factor decreased by 10 basis points resulting in an increase of more than $1 billion in the value of liabilities. One unintended consequence of the Fed’s low interest rate policy is that pension liabilities have grown, making healthy DB plans appear less well-funded. As a result, plan sponsors are now facing substantial increases in required contributions.  

The Society of Actuaries (SOA) recently issued a report on the huge increase in pension contributions that companies sponsoring DB plans are facing. The SOA estimated that DB contributions averaged about $70 billion per year over the five years ending in 2009, and projected that required contributions for the next ten years will average about $90 billion per year—a 36 percent increase. Assuming that most plan sponsors contribute at minimum levels, the SOA expects required contributions to peak at $140 billion in 2016. 

In additional to increasing contribution requirements, DB plan sponsors are facing other challenges. As part of the deficit reduction and tax-reform fever gripping Washington, D.C., the Obama administration has proposed raising $16 billion by substantially increasing PBGC premiums. In addition, the administration wants to allow PBGC to set premiums based on the financial health of the plan sponsor. And in a more recent development, PBGC announced that its FY 2011 deficit had grown to $23.3 billion, the largest in the agency’s history. As expected, PBGC used the increased deficit as an opportunity to stress the need for additional premiums. 

Employer-sponsored DC plans, such as 401(k) plans, are also under attack. There have been proposals to lower the deductible contribution levels to 410(k) plans and to change the tax deferral of these contributions to a tax credit. 

During 2011, the CFTC and the SEC have been moving forward with a host of rulemaking projects. Most of these new rules will become effective in 2012, and many of the rules will affect the ability of DB plans to use interest rate swaps to hedge their liabilities. There are new Department of Labor (DOL) regulations will affect 401(k) plans as well. Beginning in 2012, these new rules will require the disclosure of fees by plan service providers to plan fiduciaries and the disclosure of investment costs by plan sponsors to participants. During 2011, DOL withdrew its proposed fiduciary regulation and PBGC withdrew its proposed rule on reporting substantial cessations of operations. Both regulations are likely to be re-proposed in 2012. 

2013 and beyond 

As Congress struggles to reform the tax code, there will continue to be political uncertainty around the tax deductibility of 401(k) contributions. In addition, as part of Congress’ effort to reduce the deficit, PBGC premiums are likely to increase. 

Despite the greatest financial turmoil in many decades, fewer DB plans terminated than many observers had expected. However, when interest rates eventually rise, liabilities will shrink and many plan sponsors may decide to leave the voluntary DB system.