For many years, some of your clients have been counting on their defined benefit (DB) pension plans with the same confidence they have in counting their own fingers.

Most people have five fingers per hand, and most DB plans have enough stability and assets to pay 100% of promised retirement benefits. Or do they?

If you initiate this discussion with clients who participate in DB plans, you may learn that they have recently begun asking themselves this same question. Although the number of DB plans has been steadily shrinking from a peak of 112,000 in the late 1980s to an estimated 42,000 today, total assets of all U.S. DB plans (public and private) are still a gargantuan $5.3 trillion. About 50 million employees or retirees in the private sector and 15 million in the public sector rely on DB plans for part of their retirement security.

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How secure are the promises of DB plans on a scale of 1 to 10? Most of these plans are not rated or independently assessed for pension-paying ability, so the answer is unknown. However, a good guess might be that they form a bell-shaped curve in which a few plans are strong 9′s or 10′s, a few are vulnerable 1′s or 2′s, and all others fall in the middle. For reasons explained in this article, the potential failure of the 1′s and 2′s could skew this curve to the detriment of many retirees.

Now is the time to help your clients who participate in DB plans answer complex, anxiety-inducing questions. The ideas, tools and techniques in this article will help you.

DB Plan Funding – Reviewing the Basics

A DB plan's "funding ratio" measures the market value of its assets divided by discounted future liabilities, and a ratio of 1.0 or above is considered to be "fully funded."

All DB plans in the U.S. fall into three tiers, summarized in the table below.

Tier Estimated # of Plans Estimated # of Participants Est. Total Assets Est. Average Funded Ratio for All Plans
State/local govt. 1,000 15 million $3.2 trillion 80-90%
Private single-employer 40,000 32 million $2.0 trillion 85-90%
Private multiemployer 1,500 10 million $500 million 75-80%

Sources: Department of Labor, Pension Benefit Guaranty Corp. and National Conference on Public Employee Retirement Systems. Estimated # of participants includes both active and retired.

All three tiers of U.S. defined benefit plans were fully funded, on average, before the bear market of 2000-02. During the bear market, investment losses caused all three tiers to fall below fully funded status. While most DB plans have made some progress reducing the shortfall since 2002, all three tiers remain below fully funded status now, on average. The estimated total shortfall across all three tiers is estimated at about $400-600 billion.

Most private plans (single-employer and multiemployer) are backstopped by the Pension Benefit Guaranty Corp. (PBGC). In effect, PBGC acts as the nation's largest private DB plan, having taken over the liabilities of more than 3,800 terminated plans representing 1.3 million participants or retired beneficiaries. As of 9/30/07, PBGC had total assets of $68.4 billion, compared to total liabilities of $82.5 billion. Therefore, PBGC's own funded ratio was 83%.

This past February, PBGC Executive Director Charles E.F. Millard made the following admission in introducing a change in how the agency plans to invest its assets: "The PBGC is responsible for the pensions of 1.3 million Americans, but we don't currently have the resources to keep all of our future commitments."

The new PBGC investment strategy will gradually reduce the allocation to fixed-income investments and increase the allocation to equities and alternatives. As of 9/30/07, the agency had 28% of its assets in equities, and its new target will be 45% in equities and 10% in alternatives. Therefore twice as much of PBGC's assets eventually will be exposed to volatile, risk-prone assets. It is worth noting that during PBGC's early years, the agency was required to invest virtually all of its assets in conservative fixed-income securities.

The change in policy toward riskier asset stands in stark contrast to the Social Security trust funds, which invests 100% of asset in special-issue Treasury bonds. It even runs counter to the current trend in large private DB plans, which is to align assets with liabilities through "liability-driven investing" (LDI) strategies. This is probably the most "bet-the-ranch" investment strategy ever undertaken by a U.S. government fiduciary entity, and only time will tell if it was a wise or desperate move. (Note: Director Millard is a Bush Administration appointee, and the PBGC investment strategy could be reversed under a new administration.)

Meanwhile, PBGC faces mounting potential liabilities because: 1) the discounted value of its future liabilities increases each time the Fed cuts interest rates; and 2) the continued decline of the U.S. manufacturing base may dump dozens of large plans in PBGC's lap, especially in the airline, automotive and construction industries. PBGC may be only one deep recession or bear market away from serious insolvency.

How to Help Clients Wake Up

Your clients in private DB plans should understand the following:

  • The first line of benefit protection is the financial health of the employer and its ability to adequately fund the plan, combined with the plan's current funded ratio. Fortunately, the Pension Protection Act of 2006 (PPA) requires private DB plans to begin fully amortizing funding shortfalls over a seven-year period. It also mandates increased funding and reporting requirements for seriously under-funded ("at-risk") plans, mandates more transparency into under-funded plans, and requires use of a yield curve-based discount rate to value future liabilities
  • The funded ratio that applies to an active plan may understate liabilities if the plan is terminated and taken over by the PBGC, because many workers in such plans choose a lump-sum benefit or retire early. According to testimony by former PBGC Executive Director Bradley D. Belt: "Bethlehem Steel's plan was 84% funded on a current liability basis but turned out to be only 45% funded on a termination basis, with a shortfall of $4.3 billion?U.S. Airways' pilots' plan was 94% funded on a current liability basis, but the plan was only 33% funded on a termination basis, with a $2.5 billion shortfall." As of 9/30/07, PBGC's estimated loss exposure to under-funded plans sponsored by companies with below-investment grade credit and classified as "reasonably possible terminations" was $66 billion (about the same as its assets). However, this potential liability could be higher if all of these plans terminate.

  • Even if PBGC is able to take over a failed plan and pay pensions, many affected retirees will receive far less money than their own plans promise. The maximum annual benefit guarantee for plans terminating in 2008 is $4,313 per month on a straight-life annuity basis, starting at age 65 ($3,881 for joint and 50% survivor). For a table of maximum benefits for various termination years and starting ages, see:

http://www.pbgc.gov/workers-retirees/benefits-information/content/page789.html

  • Part of PBGC's funding is provided by insurance premiums charged to its members, and PBGC has an obligation to raise premiums if its funded ratio falls sharply in the future. However, with an ever-shrinking base of private DB plans, a greater premium burden could become punitive for some plans, hastening their termination.
  • What would happen if PBGC itself became insolvent, unable to pay future claims? Although PBGC is a U.S. government-owned corporation, the U.S. Treasury has no direct obligation to back PBGC liabilities. There is great debate about whether U.S. taxpayers would have a moral obligation to bail out the agency and upon what terms. Some experts believe that the future fate of the PBGC will be similar to that of the Federal Savings and Loan Insurance Corporation (FSLIC), which was abolished and merged into the FDIC in 1989 after several taxpayer-assisted recapitalizations.

    • Public Pension Plans

    How safe are public employee pensions? In some cases, the answer may be that they are even less reliable than private DB plans with PBGC protection. This month, the Northern California city of Vallejo (population 117,000) voted to enter bankruptcy court because it lacks sufficient assets to pay salaries, benefits and pensions of its employees. While the fate of the Vallejo pensions remains murky, this could be the first domino in a series of municipal failures that affect public pension rights. The culprit behind Vallejo's fiscal dilemma is declining revenues from residential real estate taxes and transactions ? a large shadow slowly spreading across local governments in California, Florida and other bubble markets.

    In government-sponsored DB plans, there is no uniform guarantor like the PBGC standing behind promised benefits. If a town, county or even a whole state goes broke and can't pay pension benefits, participants must look to state statute for relief. Here, they would find a maze of legalese. In a few states, the law is clearly favorable for pensioners by stating: "Membership in employee retirement systems of the State or its political subdivisions shall constitute a contractual relationship. Accrued benefits of these systems shall not be diminished or impaired." This language requires the state to use its taxing power to make good any pension benefits, if necessary.

    On the opposite extreme are states that treat pension rights as gratuities – meaning workers has no contractual right against the state. In between are states such as California that provide no constitutional or statutory protections but do have strong histories of case law protecting public pensions. The NCERS provides a useful summary of provisions in all 50 states here:

    An equally serious threat to public pensions is the recent trend toward converting DB plans to defined contribution plans or otherwise reducing the value of promised benefits through legislation. Hank Kim, an attorney for the National Conference on Public Employee Retirement Systems (NCPERS), recently listed twelve states in which there is a significant legislative threat to DB pension promises: California, Hawaii, Illinois, Michigan, Minnesota, Montana, New Jersey, Oklahoma, Ohio, Oregon, Virginia and Wisconsin. You can stay abreast of trends on the Government Affairs page of the organization's Website at:

    How to Help Your Clients Evaluate Pension Benefits – Action Steps

    Here are a few ideas for counseling working and retired clients who participate in DB plans:

    • Educate clients on their rights to pension benefits under ERISA. The U.S. Department of Labor provides a free online guide called What You Should Know About Your Retirement Plan located here:

    http://www.dol.gov/ebsa/publications/wyskapr.html

  • Pay particular attention Table 5, which describes information the plan administrator must provide automatically, and Table 6, which lists information that must be provided to the participanton written request. For purposes of evaluating a plan's financial health, the most important document is the Annual Report (Form 5500). ERISA requires that this document be filed by all private plans (single or multi-employer) with 100 or more covered employees, within seven months after the end of the plan year, and it must be provided to all participants upon written request. You can look up your clients' plans most recently filed 5500′s here:

    • http://www.freeerisa.com/5500/Form5500.asp

  • Help clients study their annual Summary Plan Description documents. Pay attention to: 1) the current funded status of the plan; and 2) any provisions that allow in-service or accelerated pensions or lump-sum payment options at retirement. In any seriously under-funded DB plan, pension money in hand may be worth more than money "in the bush."
  • Become familiar with useful information provided by the PBGC, including a searchable data base of terminated plans already taken over by the agency at:http://www.pbgc.gov/workers-retirees/find-your-pension-plan/content/page676.html

  • You can access summary information about the number of plans and workers PBGC protects in your state here:

    • http://www.pbgc.gov/about/annreports.html

  • Help clients understand that conservative retirement planning probably should expect some discount in the value of promised DB plan benefits, especially at older ages. The cracks now beginning to appear in DB plans may widen over time, and the backstops provided by PBGC (for private plans) or state governments (for some public plans) may become less reliable.

    • In retirement planning, there is no sure thing. The best way to help your clients increase retirement confidence is through flexible planning with regular annual reviews, combined with a healthy skepticism about the future value of present pension promises.

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