Traditional pensions are on the decline. Is there any hope for a revival?

By Michael Fickes

"To put it bluntly, I don't think there is much of a future for DB plans in their present form," says Martin Gremm, a principal with Pivot Point Advisors, LLC, a pension fund consulting company.

The chief problem: rising costs. Private defined benefit (DB) pension plans cost employers more and more every year. Returns that have been lower than anticipated in the stock market have required employers to contribute more resources than expected to company pension plans.

		Will the Government Follow the Private Sector's Shift to Defined Contribution Plans?

As some companies have found themselves unable to make adequate contributions, Congress has enacted more stringent regulations to ensure that funds receive adequate support, raising costs further for employers. When employers cannot keep up with the required contributions, their plans fail and soak up resources from the Pension Benefit Guaranty Corporation (PBGC), which then needs higher contributions from employers running healthy plans. The PBGC is a federal corporation created by the Employee Retirement Income Security Act (ERISA), which ensures the pensions of American workers and retirees.

Today, rising pension fund costs are causing companies to freeze their pension plans and turn to some other kind of retirement plan. For example, as of Jan. 1, 2007, Stride Rite Corporation will freeze its DB pension plan, while beginning to increase matching contributions to its defined contribution (DC) plans. A freeze means that new assets or employees won't be added within the plan but existing retirement benefits will be preserved for current as well as retired employees.

With assets of $48.5 billion and obligations of $46.4 billion, IBM's DB plan is one of the nation's largest and healthiest.

Yet the company has announced that it will freeze its plan as of Jan. 1, 2008.

Another aspect of the problem is that companies don't meet commitments. A good example of this occurred recently when the PBGC assumed responsibility for the shortfall of the bankrupt Pittsburgh Brewing Company's DB pension plan, which covers 532 workers and retirees. The PBGC estimated that the plan was just 50 percent funded, holding assets of approximately $12 million to cover nearly $24 million in promised benefits.

So far this year, PBGC has taken over five additional DB pension plans from airlines, healthcare firms, manufacturing companies and retailers. All were severely under-funded or terminated during bankruptcy proceedings.

In short, the decline of DB plans sponsored by private employers is continuing. In 1985, private DB plans peaked at 112,000 plans, according to a December 2005 report from PBGC entitled, "An Analysis of Frozen Defined Benefit Plans." Today, private DB plans only number around 30,000.

Also in the report, between 1986 and 2004, 101,000 single-employer plans with 7.5 million participants were terminated. About 99,000 of those plans owned enough assets to cover promised benefits to participants. PBGC took responsibility for more than 2,000 of the plans.

Today, private DB plans represent one of the smallest segments of the $14.5 trillion U.S. retirement fund universe, according to research conducted by the Investment Company Institute and the Federal Reserve Board (see accompanying chart). Private DB plans account for just $1.8 trillion of that total, while Individual Retirement Accounts (IRAs) and defined contribution plans each hold $3.7 trillion in assets. State and local DB and DC plans have

$2.8 trillion in assets. Federal DB and DC plans hold $1.1 trillion. Approximately $1.4 trillion in annuity reserves make up the balance.

Some observers downplay the depth of the crisis in DB plans by pointing out that, despite the precipitous drop in number of plans, the number of participants are covered by DB plans have increased from 28 million in 1980 to 35 million today. The PBGC report responds to this argument by saying that the increasing numbers of participants only mask the downward trend.

Today's 35 million covered participants include active workers, retirees, surviving spouses and other participants. Yet, they are a reflection of past coverage patterns. The report says: "A better forward-looking measure is a trend in the number of active participants who continue to accrue benefits. That number is moving downward. In 1985, there were about 22 million active participants in single-employer DB plans. In 2002, that number had declined to 17 million."

In fact, data show that total covered participants actually have begun to decline. The 2004 Pension Insurance Data Book (PIDB), available on the PBGC Web site, shows estimated total insured participants at 34,617,000. New research in the 2005 PIDB will revise the 2004 participant number to 34,523,000 and add a 2005 estimate of 34,221,000. "So even the total number of participants has begun to decline," says PBGC spokesperson Gary Pastorius.

What's The Matter with DB Plans?

Observers list a host of reasons for the declining fortunes of DB pension plans.

Today's workers, they note, are more mobile than yesterday's workers who often spent their careers working for one company. Unlike DC retirement plan benefits, DB plan benefits cannot move from one company to another.

DB plans invest for the good of the whole plan. Yet today's workers often prefer to control their own savings and investments.

Additionally, DB plans require expensive employer contributions every year—and even more expensive contributions at the end of a bad investment year. As a result, many companies would rather give their employees the responsibility for basic investment decisions through DC plans.

In a 2005 Pension Research Council working paper entitled "Resurrecting the Defined Benefit Pension Plan: A New Perspective," authors Douglas Fore and P. Brett Hammond suggested that DB plan woes stem from even more basic problems.

First, employers have mixed incentives to protect retirees. That problem has given rise to pension fund regulations designed to ensure the protection of plan participants. The regulations have driven up employer costs and caused them to shift to DC plans.

Second, financial economics suggest that DB portfolios hold more fixed income assets and employers make larger contributions. This is another example of higher costs driving employers toward DC plans.

Third, the PBGC requires an infusion of cash to ensure its ability to perform—another potentially expensive cost hike. "The odds against a comeback of traditional DB plans are very long indeed," Fore and Hammond wrote.

REITs Have Their Role

Marc Louargand, managing director and chief investment strategist for Cornerstone Real Estate Advisers, LLC, speculates that DB funds will continue to decline. "However, this is a very large pool of assets," he says. "DB plans today cover 30 percent of the work force. You probably won't see many new plans created, but they won't disappear over night."

Fore and Hammond's paper recommended a number of changes to DB plans that address specific problems, such as making the plans portable, adjusting benefit levels to prevent employer contributions from growing unacceptably high or using better asset-management and asset-liability matching models to better control costs. Fore and Hammond contend that these and other measures would reduce regulatory and compliance costs below traditional DB plans.

To better address this issue, Louargand and others have been advocating an asset allocation model for DB pension plans similar to what Fore and Hammond recommended in 2005 that is based on the investment income characteristics of securitized real estate, in the form of REIT stock or commercial mortgage backed securities (CMBS).

Retirement Assets in the United States
Private defined benefit plans	$1.8 trillion
IRA accounts	$3.7 trillion
Private defined contribution plans	$3.7 trillion
State and local defined benefit plans and defined contribution plans	$2.8 trillion
Federal defined benefit plans and defined contribution plans	$1.1 trillion
Annuity reserves	$1.4 trillion
TOTAL	$14.5 trillion
Source: ICI and FRB

Real estate securities are income-producing assets that match well with DB plan liabilities. In fact, Louargand notes that many DB fund investment portfolios today allocate 10 percent to 15 percent to real estate, up from the 5 percent to 10 percent common in the 1990s.

That recommendation is similar to the results of a 2001 study conducted by Dr. Timothy M. Craft, an associate professor of finance at Wichita State University, who researches the performance of asset-liability matched pension plan portfolio allocations. "Private real estate allocations should at most account for 12 percent to 16 percent of a portfolio, while public real estate should make up 4 percent to 10 percent of a portfolio," he says.

Higher real estate allocations may not solve all the problems of under-funded DB pension plans. Then again, they are a

part of delivering the promise that should be made on part that satisfies both employers and employees.

Underfunded DB Plans

Over the last six years, funding problems have hammered conventional DB plans. In addition, low returns in the equity markets and low interest rates in the bond markets have caused many funds to fall even further behind. According to Pensions & Investments, a trade publication that follows the pension industry, 73 of the largest 100 private DB funds were under-funded at the beginning of 2006.

The remaining 27 fully funded plans included companies like AT&T, Bank of America, General Electric, Lucent Technologies, Prudential and UPS. All have plans where assets have more value than obligations. The healthiest DB plan on the Pension & Investments list was BellSouth, which held assets of $16.3 billion at the end of 2005, compared with obligations of $11.9 billion.

By contrast, Delta Air Lines' plan assets stand at $6.5 billion, while its benefit obligations are $12.7 billion.

The news isn't completely bad. Pension & Investments also reports that unfunded liabilities of DB pension plans declined during each of the past four years. "The case has improved," Louargand says.

According to Pension & Investments, the top 100 firms owed $50.6 billion to their pension funds in 2005, compared to $69.5 billion in 2004 and $89 billion in 2003. As a result, contributions have declined as well, to $35.7 billion in 2005 from $36.9 billion in 2004. "Today, because interest rates are escalating, and because the stock market has come back down, unfunded liability has declined a little bit," Louargand says.

Still, the cost and risk of DB pension plans has proven enormous over the years. "Pension accounting reports on future events," Louargand says. "You have liabilities in the amount of what you think you will have to pay out to retiring annuitants. That's a function of how many years they work and live, which you can't predict. In addition, you are funded or unfunded based on the amount of assets you currently have today, and what you predict to earn in the future.

FASB Has Its Say

The PBGC estimates that private DB pension plans require an infusion of $450 billion for all underfunded plans to make them whole. Furthermore, the agency estimates that plans with serious funding problems are about $100 billion behind. Those kinds of numbers make Congress recall the pain associated with the $130 billion bailout of the savings and loan industry in the 1980s.

The Financial Accounting Standards Board (FASB) has undertaken a high profile effort to cinch up company reporting standards related to their pension funds. "Today, financial statements include information pertaining to a company's ability to meet the obligations of its pension plan, but much of the information is buried in footnotes and isn't clear," says Gerard C. Carney, director of public relations for FASB. "So the board is proposing that information be taken out of the footnotes and put into the balance sheet so investors can get a better reading on whether promises can be honored."

Many observers view the FASB initiative as a turning point for private DB pensions. "The second phase of the accounting project will have many employers who never would have considered terminating their DB plans going back and doing a fresh re-assessment," says Jack VanDerhei, research director with the Employee Benefit Research Institute. "A large number of publicly traded firms may find that the increase in volatility of their pension expenses under these rules will be more than they want to take on."

These firms are likely to consider terminating their plans rather than freezing them. "Unfortunately, when it comes to pension expense volatility, pension freezing doesn't do much," VanDerhei says. "About the only thing you can do is an out and out termination."

One industry observer who prefers to remain anonymous agrees with VanDerhei, while noting that the problem isn't FASB's fault. "People will point fingers at FASB," he says. "But these are obligations that companies have made, and investors and retirees want to see how this stuff will be paid for."