Magazine

DB Focus | Published in May 2017

Can This Plan Be Saved?

Several ways to impact plan funding

By John Keefe | May 2017
Art by Dadu Shin

The defined benefit (DB) pension plan, an American invention, has been a national treasure, providing retirement security to workers in both the private and public sectors for generations. However, running these plans well for the long term is expensive and unwieldy, making them a target for criticism, and regulation, from all sides. Many corporate sponsors have given up on them altogether, while other private and public plan sponsors have been forced to starve them of the resources they need to grow and pay their obligations. Can the American defined benefit plan be saved?
 
Before the 2008 financial crisis, large U.S. corporate DB plans were declining in number—but, on average, were nearly fully funded. During the subsequent years of recession, funded ratios collapsed, and, notwithstanding a significant recovery in asset prices, the average funding has
since held at around 80%, based on financial accounting measures.
 
“I don’t think the world is satisfied with an 80% funding ratio,” says Ned McGuire, vice president at consultants Wilshire Associates in Santa Monica, California, and an author of that firm’s annual defined benefit plan analyses.
 
But corporate America is not being held to a higher standard: The Internal Revenue Service (IRS) is more lenient in its reckoning of benefit liabilities—a policy of funding relief meant to free up corporations’ cash in the Great Recession’s wake. A look inside the Form 5550s of some large plans shows that, under IRS methods, even plans with terrible funding for accounting purposes are fully funded under the agency’s more forgiving rules.
 
Thus, corporations could make more generous contributions but do not have to. Consultants at Willis Towers Watson report that, from 2009 through 2012, the largest 100 U.S. plans as a group received annual contributions, on average, of about $40 billion. Between 2013 and 2016, that annual average was cut to about $27 billion, although 2016’s contributions—at about $31 billion—were the highest in four years.
 
Sponsors, both corporate and public, have other tools available to improve funding. “A sponsor
can reduce or eliminate benefits, but that changes the funded status over time, and not right away,” explains Alan Glickstein, senior retirement consultant at Willis Towers Watson in Dallas. “And the actuary can change mortality or the retirement rate, but those are just assumptions and not real money, as the benefits are.”
 
The other immediate and real lever is contributions, Glickstein adds, but he points out a catch: “If you believe the IRS funding number, it might be irresponsible to make more than the minimum contribution. U.S. pension rules are asymmetrical, in that, if you put too much money in and end up with a surplus, you can’t get it back without paying corporate income tax, plus an excise tax, which costs about 85%.”
 
The sponsors of public pension plans face more pressing challenges in shoring up their plan. Wilshire Associates also compiles comprehensive summaries of state and municipal plans each year and, for fiscal year 2015, reported an average funded ratio for state plans of just 73%, down from 76% in 2014. In early 2017, credit rating agencies downgraded the bonds of Illinois and New Jersey, two cases of chronic and severe underfunding.
 
Public plans are quite different from corporate plans in their structure, but their recent histories are much the same: The average state plan funded ratio reached 95% in 2007, and plummeted to just 64% in 2009 during the financial crisis. Since then, average funding has recovered just 9%, despite significant recoveries in the financial markets.
 
What happens to a plan that is seriously underfunded? Much depends on contributions relative to benefit payments, concluded Michael Cembalest, chairman of market and investment strategy at J.P. Morgan Asset Management in New York City. In a 2016 report, he illustrated two hypothetical state plans with funding at 60%: In one, benefits and payroll grow faster, and contributions and investment returns fail to cover benefit payments. In the other, benefits and payroll grow more slowly, but contribution and return inflows are sufficient to meet benefits. Other measures, such
as expected investment returns and discount rates, are equal.
 
“In State 1,” Cembalest writes, “the funding ratio declines rapidly, with assets depleted by the year 2035 [i.e., in about 20 years]. In State 2, … the plan survives for many decades (albeit with a declining funding ratio).”
 
In a dire case, Cembalest says, the investments matter somewhat little: In the low-contribution case, even earning the full expected return buys only five more years.
 
However, when plans can clear the high hurdle of making actuarially required contributions (ARCs), they can recover to full funding in 30 years. For those that cannot, he proposes “a middle ground [which] could be a partial ARC—not enough to regain fully funded status but enough to stabilize the funding ratio at a lower level.”
 
Happily, for each story of crisis such as Illinois or New Jersey, there is a corresponding case at the brighter end of the funding spectrum. Large plans in Delaware, Florida, Georgia, North Carolina and Tennessee all are at or near full funding. What they have in common is that they have met their ARCs for many years, and while they, too, suffered setbacks in the financial crisis, through consistent proper contribution policies, they were able to recover.
 
The state plans of Indiana illustrate a work in progress. Prior to 1996, the Indiana Teachers’ Retirement Fund operated on a pay-as-you-go basis, where the state maintained no investment fund. In 1996, Indiana made a fresh start, closing the old plan to new members and establishing a new, funded pension arrangement for teachers joining thereafter.
 
On June 30, 2016, the new teachers’ plan stood at 91.8% funded, reports Steve Russo, executive director of the consolidated Indiana Public Retirement System in Indianapolis. And that admirable position reflects two recent steps back: 1) two reductions in the plan’s assumption for expected return, cutting it back from 7.5% to 6.75%—and thus raising the estimated value of liabilities—and 2) new assumptions of longer beneficiary mortality, which cut the funded status by nearly 5% in fiscal 2015.
 
The pre-1996 plan started with funding of zero about 20 years ago but, by the end of fiscal 2016, had managed, through special appropriations, to accumulate assets equal to about 30% of liabilities. Through continued contribution discipline, assets are projected to rise sharply and approach full funding in 20 years.
 
Russo points out that, among state plans, a key differentiator in the funded status is where in the state government the contribution decision is made. “In our case, it’s left to the pension trustees to determine what the contribution rate should be, and they have a fiduciary duty to do what’s right for the plan,” he says. “In many state plans, the contributions are determined by the legislature, and they likely don’t have the fiduciary stake the board [of trustees] does.”
 
Notwithstanding its progress, Indiana is going so far as to propose a constitutional amendment requiring contributions at least as great as the ARC. “The state wants to get it into the constitution, to make sure that people don’t start to think differently in the future,” Russo adds.
 
Of course American defined benefit plans can be saved. It will just take lots of money and smart long-term thinking. “Happy families are all alike; every unhappy family is unhappy in its own way,” wrote Leo Tolstoy in “Anna Karenina.” So, it seems, for pension plans: The happy ones look after their beneficiaries with the right contributions.

Key Points
 

• Since the 2008 financial crisis, average defined benefit plan funding has been held at around 80%, an unsatisfactory ratio to most.
 
• Although a sponsor can reduce benefit funding or adjust retirement or mortality rates, contributions are key.
 
• For states, the differentiator in funded status is apt to be which government body makes the contribution decision—e.g., a board of pension trustees, which has a fiduciary stake in the plan, or the state legislature, which has no such stake.
 
• Solutions exist to keep seriously underfunded plans afloat or to bring slow recovery.

 

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