Defined benefit pension plans provide meaningful economic security to millions of currently retired Americans. But far fewer future retirees can look forward to the peace of mind and lifetime income provided by these valuable plans. Since the mid 1980s the number of plans and covered workers has steadily declined. Today, every week seems to bring news of another employer closing a pension plan or considering termination, often owing to the burden of unfunded liabilities.

Future American retirees face a daunting challenge. Social Security has never been, and never will be, enough to maintain a reasonably secure retirement, although it may keep retirees minimally out of penury. IRAs and 401(k)s offer an enticing solution, transferring the responsibility and investment risk to the individual. These relatively new retirement vehicles (IRAs were created by ERISA in 1974 and 401(k)s by the Revenue Act of 1978) offer promise but have yet to demonstrate they can produce real security in retirement for many Americans. While they offer the advantage of tax-favored asset accumulation, there are many obstacles to widespread retirement security:

• Most IRAs and 401(k) plans are voluntary, and there will always be many who choose to use their funds for pressing current needs as opposed to the uncertain needs of the future.

   

• The savings rate of Americans is amazingly low: Even as IRAs and 401(k)s have grown, the savings rate of Americans has declined from 10% in 1980 to less than 2% in 2003.

   

• No amount of investment education will make all Americans excellent investors. The very nature of our investment markets assures us that there will be both winners and losers among individual investors – on average, half the investors will have below-average results.

   

• Managing an asset pool during a spend-down period is a different challenge from accumulating the asset pool. Investing in your 70s and 80s is different from accumulating assets during your 40s, 50s, and 60s.

   

• Managing the longevity risk is expensive. Approximately half of all people live beyond the life expectancy, some considerably longer. Ensuring that an asset pool lasts an entire lifetime can cost 30-35% more than planning for the average life expectancy.

   

It does not have to be this way. In the 1940s, 1950s and 1960s, many employers adopted new pension plans, at least partly because they recognized the plans would fulfill an important need for employees – a highly efficient way to provide economic security in retirement. Assets accumulate for all employees, not just those who choose to save. The assets are managed professionally and are pooled to provide efficiencies in expenses, investment management, and longevity.

The American retirement system can be reinvigorated. A universal Social Security system, supplemented by a robust employer-based pension system, can provide Americans with a basic level of lifetime income and security. Healthy IRA and 401(k) components can provide additional funds to make retirement the golden years we anticipate.

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Major reforms Are necessary

The path to this secure future starts with major reform of the current defined benefit rules. Few employers would consider implementing a new plan in today’s environment. Minor fixes or patches to the system are not enough. The funding rules of the past 30 years were America’s first experiment in mandatory funding of all pension obligations. We have learned much from this experiment. Far too many plans have become seriously underfunded. Far too many employers have thrown in the towel and ended coverage because of the complicated and volatile rules. It is time to start over. The funding rules need radical change, not just patchwork.

The current rules are far too complex, lack transparency, lack intuitiveness, and impose penalties on companies that attempt to fund plans well. Most important, they do not produce well-funded plans. Let’s look at a few examples.

• The funding standard for plans is arbitrary. ERISA allows a plan sponsor to choose among six different funding methods. These methods can produce dramatically different mandatory funding requirements, yet it is the sponsor’s choice of method that often dictates the level of funding required, not an independent objective measurement of plan liabilities. To overcome this shortcoming, an amendment to ERISA imposed another definition of plan liability – current liability – with an additional, highly volatile, funding requirement.

   

• Liabilities that arise for different reasons have different funding periods, currently ranging from 5 to 30 years, creating strange anomalies. It is not unusual for a plan with a large unfunded liability to have net amortization credits (reductions in required funding) if the plan experiences investment gains. This happened frequently in the 1990s.

   

• Benefit improvements are funded over 30 years, producing situations in which the required funding period is sometimes longer than the expected lifetime of the benefit recipients.

   

• Plans that have funded ratios over 100% on conservative assumptions may be required to pay extra “risk-related premiums” to the Pension Benefit Guaranty Corporation. Plans that are poorly funded and expose the PBGC to substantial risk pay exactly the same premium rate.

   

• Smoothed asset values and average interest rates result in meaningless funding ratios. Some plans with 100% or higher funded ratios may have assets insufficient to pay their accrued obligations. Other plans with funded ratios of less than 100% may have more than enough assets to pay all accrued obligations.

   

• Plans that experience large asset losses sometimes see funding requirements decline. Plans that experience large asset gains sometimes see funding requirements increase.

   

• The PBGC is sometimes required to guarantee benefits that employers are not required to fund (contingent benefits or early retirement subsidies).

   

• An employer that makes an advance contribution to the plan has that contribution credited with interest at a fixed rate regardless of the return on the invested funds. A $1 million contribution in 1999 might accumulate to a credit for the employer of $1.26 million by the end of 2002 even though the invested funds might have declined to approximately $0.8 million.

   

• Employers are prohibited from contributing to plans in some years when they have very strong cash flow and are required to make large contributions in other years when their business turns down.

   

The list of such anomalies is seemingly endless. We could go on, but the point is clear – the current rules are broken and require major changes. The good news is we have learned much over the past 30 years and it is not hard today to create funding rules that will work.

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New objectives

The first step is to establish a few basic principles or objectives:

1. Plan Solvency – The most important objective is to produce a system of well-funded, financially secure retirement programs. Plans must be able to meet their obligations without excessive dependence on the future financial success of the sponsoring entity. The goal should be 100% solvency, and plans should not be allowed to stray far from it.

    

2. Predictable Contributions – Sponsors need to be able to plan and budget for substantial pension contributions. Temporary fluctuations in plan assets or interest rates should not cause enormous changes in required contributions. Yet secular changes in interest rates or the value of plan assets need to be reflected and built into contribution levels so that solvency is attained.

    

3. Objective Rules – The funding rules should be the same for all employers, not be subject to the sponsor’s choice of funding methods or the actuary’s choice of interest rates. Demographic assumptions about employee turnover and retirement age may change by plan and be selected by the actuary with appropriate consideration of expected experience, but the basic measure of the liability and the interest rate used to value the liability should be established for all plans in a similar fashion.

    

4. Intuitive Results – Simply said, the results should make sense. When assets decline, funding requirements should increase and vice versa. Funding ratios should have real meaning based on the economic conditions at the time they are measured.

The objectives are relatively simple. The application can be relatively simple also. You can look at it one step at a time by downloading this PDF of the complete proposal.

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