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The Defined Benefit Requiem Continues

Rick Roeder, FSA       February 2015

I was somewhat saddened to get a notice from my former employer, Gabriel, Roeder, Smith and Company, late last year, in regard to my pension from the firm. There was an offer to give up my pension in favor of a lump sum. All the more telling, since GRS’ bread and butter is doing defined benefit (“DB”) valuations for large public systems. Their offer was not in the least bit skewed in favor of GRS. In fact, the reverse held true. Lump sums in qualified pension plans must be calculated on the interest rates mandated by Internal Revenue Code Section 417(e). These rates have been really low (think in the 3.75%–4.5% range) as they reflect the historically low rates in key indices in recent years. Low rates mean higher lump sum payouts.

So, I should have been happy because the lump sum offer was as close to a pension gift as a 62–year–old was going to get. However, the fact that GRS was so willing to offer me an extra option was yet another bleak portent for the ebbing DB universe. GRS wanted so badly to get me and others “off the books” that they felt their largesse was a prudent business decision. And GRS is far from the only private sector entity following a similar path.

What was behind their thinking? And why have the relatively few remaining DB sponsors in the private sector treating their existing plans as toxic? And in the bigger picture, how did DB plans in the private sector evolve from such a business staple to an afterthought in the span of 40 years? The most recent factors relate to complex actuarial requirements, due to an increasing maze of federal law, that significantly restrict the flexibility of the plan sponsor compared to the funding requirements in the early years of ERISA. Not to mention the lack of funding requirements prior to ERISA’s 1974 passage. Another factor relates to ERISA’s establishment of the Pension Benefit Guaranty Corporation (“PBGC”) and their annual premium payment requirements.

The PBGC is one of the saddest indictments of the unintended consequences from a bureaucracy. Its initial premium rates of $1 per participant were arbitrary and incredibly unfair. Well funded plans paid the same rate as funds in actuarial peril. Eventually, Legislators smartened up and had the better funded plans pay less than the poorly funded plans. But the initial inadequacy of PBGC rates led to an unending spiral of premium increases. The PBGC premium spiral ignored one basic fact: Offering a DB plan was not mandatory. The less attractive DB sponsorship became, the smaller the universe of DB sponsors became. Rising premiums in a universe of a continually smaller number of insureds helped bring about a classic “death spiral.” One of the other reasons that DB sponsorship declined markedly was due to a new section of the Internal Revenue Code, initially obscure at its 1978 implementation: 401(k). The byproduct was a continually increasing PBGC budget deficit as premium increases were vastly insufficient to bail out troubled plans. For plan years starting in 2015, the PBGC flat–rate portion of the premium has skied to $57 per participant – with another large increase to $64 scheduled for 2016 plan years. God forbid if a plan has unfunded vested benefits: a variable rate premium also kicks in.

As union coverage vastly declined in the private sector, the public sector has become the last bastion for DB plans. In addition to a much greater degree of unionization, the early retirements of safety workers, combined with their sometimes hazardous duty, has helped make public plans more impervious to change. But not immune. The only new hires for the City of San Diego eligible for a DB plan are Police. Even the City’s new Firefighters are in a defined contribution plan – a development I could scarcely have imagined five years ago. As the private sector DB exodus continues, the public sector should be not be so confident that they can escape the trend – particularly for non–Safety members. Taxpayers will be reluctant to fund pensions that they cannot have, especially the next time their 401(k) balances take a bear market dive.

As further evidence that my former employer is not a lone wolf, a pension administrator told me that some of his competitors had a good business year in 2014, partly due to administrative work relating to lump sum distributions and the ongoing wave of pension terminations.

This cannot be a healthy trend for our country. 30 years ago I proposed an approach that might have worked if implemented in the 1980s. The approach was to reduce PBGC premiums significantly but have them apply to the entire universe of tax qualified plans. Today, the PBGC hurdle is just one of many which would cause a company, considering establishment of a DB plan, to question its sanity. Clearly, much momentum, now totally absent, is needed to reverse a trend that has some dire consequences for our society. My own view is that it will take another sustained bear market and a full generation of generally inadequate retirement income to create momentum for a DB renaissance. Until then, I will be shamelessly paternalistic in this regard to the need for broader DB coverage while holding my breath that I am not being too pessimistic.

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