Defined Benefit Plan Termination
Your grandfather's Defined Benefit (DB) pension plan may be an endangered species. DB pension plans subject companies to high costs and risk that many prefer not to assume. So, it's becoming increasingly common to see these plans eliminated.
Unlike a defined contribution plan, a defined benefit has some or all of its benefits guaranteed by a government chartered corporation. If the plan is under funded, meaning that there is not enough money available to satisfy all the covered benefits, then the government corporation is required to make up the difference. So, as you might expect, terminating a defined benefit plan is much more complex than termination of a defined contribution plan. The following discussion applies only to DB plans.
Voluntary Freezes, Conversions or Terminations
If companies freeze existing plans, the plan continues, but employees accrue no further benefits. The company may need to make further contributions if the plan is under funded when frozen.
If the company terminates the plan, the accrued benefits (including all unvested benefits) must either be paid out as a lump sum equivalent, or the plan must purchase a commercial annuity from an insurance company. It goes without saying that the plan must be fully funded when terminated.
Usually, but not in all cases the company then starts some form of defined contribution plan to take its place. It's unlikely that the benefits of the two plans will be entirely equal. Defined benefit plans favor older, long term employees. These employees may be considerably worse off, while younger employees may find that they potentially have higher benefits projections.
Sometimes a plan will be converted into another form of Defined Benefit plan with entirely different sets of benefits. In a famous recent case, older IBM employees successfully argued that the conversion to a "cash balance" pension was blatantly discriminatory. The new formula actually reduced benefits with each additional year of service.
Distress or Involuntary Terminations
Occasionally, companies fail outright, taking their DB plans down with them. ERISA established the Pension Board Guarantee Corporation (PBGC) to provide employees with at least partial insurance of their accrued benefits in DB plans. Today, almost a million present and future retirees look to the PBGC for their retirement benefits.
Single employer plans pay an annual per participant fee of $19.00 as well as 0.9% of any amount the plan is found to be under funded. The premium is mandated by federal law, and has not been sufficient to cover existing liabilities. Even though the PBGC itself is insolvent, Congress has been reluctant to raise the premiums, perhaps fearing that it might accelerate the trend away from DB plans.
When a plan does not have sufficient assets to pay all its intended benefits and the employer is in such distress that continuing the plan might cause the company to fail, they can petition the PBGC for a distress termination. In a distress termination, the PBGC steps in to pay "guaranteed" benefits and attempt to recover the balance from the employer, either over time or in bankruptcy.
Should the PBGC find that it is in the best interest of the employees, the plan, or the PBGC itself, they can take over a plan without the employer's consent. Finally, if a firm suspends operation or cannot continue as a going business, the PBGC will have to step in to take over the plan.
How plans get into trouble?
The stock market decline of 2000 – 2002 devastated many DB pension plans. Much of this grief was self induced and avoidable.
Among the many factors that go into determining annual pension expense, none is more critical than the plan's rate of return assumption. If the plan assumes a high rate of return, then the annual cost estimate is reduced. This is very tempting. If a company can lower pension costs, the savings go right to their bottom line. But, hoping for higher returns doesn't make it so. If those returns fail to materialize, the plan will soon be under funded, and their annual costs will rise again to reflect the additional deposits required to fully fund the plan.
The only way to insure that a DB plan will not be under funded is to buy long term bonds that mature as needed to fund plan commitments, in other words, match assets with future liabilities. But, this implies a very low rate of return and high annual costs. So, most plans have a mixture of stocks and bonds to increase the rate of return. The more volatile assets we place in the plan the higher the assumed return, and the higher the risk.
During the late 80's and 90's, many plan fiduciaries increased rate of return assumptions to reduce estimated annual costs. Lulled by long market advances, their actuaries, the Labor Department, employees, and labor unions all bought into the decision. Then the plans took higher levels of risk to attempt to meet their rate of return assumptions. Finally, they were the victims of inappropriate asset allocation that failed to properly diversify their portfolios. When the market tanked some found themselves suddenly underwater at just the time that their businesses were in distress. In some well publicized cases, the pension liabilities exceeded the net worth of the company.
Legislation enacted in July 2004 relaxed funding standards across the board. It specifically allowed two industries distressed industries (airlines and steel), temporary additional under funding in the hopes that they will experience recovery. This legislation is a massive bet for the government. If the funding levels do not recover, PBGC will be forced to take on plans which are even more severely under funded than they are today. With the PBGC itself already severely in the red, the prospect of further allowing any employers to further under fund their plans may come back to bite the agency with a vengeance.
The airlines and steel companies, already financially weak, were particularly hard hit after 9/11. United Airlines just terminated all their defined benefit plans dumping an additional 120,000 employees into the system with a projected cost to PBGC of over $5 billion! This follows the distress termination of the US Air Pilot's Pension Plan.
As one airline after another dumps pension plans on the PBGC, the temptation of the remaining airlines to dump theirs increases. The industry is highly competitive, lacks pricing power, suffers from severe overcapacity, and established airlines are being undercut by start up ventures with much lower operating costs. Cutting costs by dumping their pensions may be the only way that some carriers can survive. Unfortunately the US taxpayer may end up paying the bill.
Effect on plan participants
Rank and file employees may be fully covered, but highly compensated employees will find that the PBGC guarantee covers only a small portion of their benefits. They can be financially devastated by a plan termination. While plans can fund to a maximum of $165,000 per year at normal retirement, the PBGC maximum guaranteed benefit for plans terminating in 2004 is $44,368.
Where plans offered by distressed companies offer a lump sum benefit the threat of possible plan termination can cause a "run on the bank" where senior employees attempt to secure their lump sum prior to the termination. For instance, Delta Airlines had 300 pilots retire in June 2004 alone, 266 of them early. Unfortunately, every employee that succeeds in securing a lump sum payment further weakens the fund for remaining participants. This downward spiral increases the probability that the plan will find itself in a distress termination.
Interestingly, if companies maintain multiple plans for different employee groups, they may have the option to pick and choose which pension to terminate. For instance, US Air, operating under Chapter 11 Bankruptcy, was allowed a distress termination of the Pilot's Pension while continuing other employees' pensions. (Senior pilots found their benefits cut by over $100,000 per year! Roughly that's about a $2,000,000 decrease in assets that had accrued over a 30+ year career for each of those professional pilots!)
The PBGC process is often arbitrary and capricious. When challenged, they have proved to be tireless litigators. For instance:
- When the PBGC took over the Pilot's Pension at Eastern Airlines it was almost fully funded, while other groups were greatly under funded. The pilots had, through the collective bargaining process, negotiated for increased funding for their plan which was paid for by reducing their pay. Never the less, PBGC promptly stole the pilot's funds to distribute to less fully funded Eastern employees' plans. The theft impoverished the pilot group, but reduced the PBGC's liability for the other plans. This theft was never challenged in court.
- When Pan American Airlines folded, its Pilot's pension plan was under funded. However, during the administrative process the stock market rebounded, greatly enhancing funding levels. The PBGC kept the additional funds and successfully argued in court that they were not fiduciaries of the plan, but its insurer. Pilots received minimum benefits rather than the benefits the plan could have provided with the enhanced asset values. .
The trend away from the traditional defined benefit plan is probably irreversible as companies attempt to reduce costs and avoid possible future liabilities for under funding. Employees currently covered under DB plans must consider in their planning that their anticipated benefits may possibly be reduced in the future. This is particularly of concern in distressed industries where highly compensated employees could experience draconian cuts. In any event, as in almost all other aspects of DB pension plans, employees are along for the ride with little or no control over their plans.