Are Defined Benefits Plans Dead?

Defined benefit pension plans have had a string of bad luck. Since their peak in the mid-1980s, they have been on the decline as more employers close or freeze their plans each year. Is there a chance for a comeback?

In the 1990s, the robust stock market kept defined benefit plans well-funded, without the need for hefty contributions from the organizations sponsoring them. When things were going well, "these plans were out of sight, out of mind," says Bart Pushaw, a principal and consulting actuary with Milliman Inc. in Dallas. "Finance people did not need to pay much attention until suddenly pension plans became the squeaky wheel."

Then the dot-com bust and the accompanying stock market decline caused plan assets to take a hit. That was followed by years of low interest rates, which increased plan funding obligations.

At the same time, the federal government tightenedpension plan funding requirements and established new accounting rules for calculating plan assets and liabilities. The net result: Plan sponsors have less leeway when it comes tosmoothing out the ups and downs in a plan's funded status. This increased volatility. If there is anything corporate leaders hate, it is unpredictable expenses. So, more sponsors opted to freeze or close their plans altogether.

Funding requirements and accounting rules aside, the decline in defined benefit plans is basically about who should shoulder the risks associated with ensuring that employees have enough assets to retire. With the rise of 401(k) plans, employers clearly prefer the risk to be employees'. Has this shift gone too far?

Risks and Worries

When 401(k) plans gained popularity during the 1990s and began replacing defined benefit plans, the soaring stock market helped to ease the transition. It is ironic that the stock market meltdown in 2008 and 2009 and the Great Recession may have done more to educate employees about the value of defined benefit plans than any effort by employers. Employees also got a full appreciation of the investment risks associated with self-directed 401(k) plans, and they did not like it.

Employers have responded by improving 401(k) plan designs with automatic enrollment, target-date funds and professional investment advice for participants. However, the risk of these investments and of creating a stream of retirement income to last a lifetime still resides with individual employees.

As a result,more workers are concerned about their retirement security, especially young employees. In fact, 55 percent of employees are willing to trade some of their pay for a guaranteed retirement. That is a significant increase from 46 percent in 2009, according to a July 2011 survey of 9,218 full-time U.S. employees at nongovernmental organizations with 1,000 or more employees conducted by Towers Watson.

Employees younger than age 40 who are now participating in a traditional defined benefit pension plan are particularly concerned. Among this group, the number willing to pay for a guaranteed retirement benefit increased from 39 percent in 2009 to 66 percent in 2011.

This attitude is being driven by concerns that employers will continue to pull back on the retirement benefits they provide. Indeed, 44 percent 

of the respondents were concerned about reductions in their retirement benefits over the next two years. Among employees under age 40 who participate in a defined benefit pension plan, this worry was particularly widespread, with 63 percent concerned about benefit cuts.

Pay Attention

Since employers offer benefits to meet employee needs and to attract and retain talent, this survey data is something that employers should keep in mind. The data suggest that "workers are increasingly focused on things that are less available in the employment market," says Alan Glickstein, senior retirement consultant with Towers Watson in Dallas. "Plan sponsors would be wise to pay attention to this data because ultimately there will be growing competition for talent, particularly as Baby Boomers retire."

As employers look for ways to differentiate themselves in the war for talent, a defined benefit plan may be more of a selling point than corporate leaders realize. Twenty years ago, having a defined benefit pension plan was not much of a differentiator because so many other companies offered them. Now, an employer that offers some sort of guaranteed retirement benefit could really stand out from the competition.

Houston-based CenterPoint Energy, an energy distributor with about 8,800 employees, sponsors a cash balance plan with an annual company contribution equal to 5 percent of an employee's salary and a 401(k) plan with a dollar-for-dollar match on employee contributions up to 6 percent of pay.

Company leaders maintain dual retirement plans for two reasons: "We appreciate the need to have both a defined benefit and a defined contribution plan in order to maintain a stable, high-quality workforce and to stay competitive in our industry," says Ira Winsten, the company's director of compensation and benefits. Winsten notes that prospective employees tend to be "pleasantly surprised that we have both a defined benefit and a defined contribution plan."

A survey of 424 mid-size and large employers with defined benefit plans found that 

36 percent offer the plans to new employees; 

68 percent of those employers said they remain committed to offering the plans to new hires over the next two to three years. The top reasons for providing a defined benefit plan to new hires? Seventy-one percent said they want to attract and retain new employees, and 50 percent do it to maintain employee morale, according to the Towers Watson survey report, Pensions in Transition: Retirement Plan Changes and Employer Motivations, which was released in May.

Coming Back?

Is it possible that defined benefit plans could come full circle? Yes, it is possible but by no means certain. The problems associated with traditional defined benefit pension plans—including lack of portability, onerous regulatory requirements and fluctuating funding commitments—have not changed.

"Defined benefit pension plans were designed to provide retirement benefits for employees, but they also served as a long-term incentive," says Randi Miller, HR and benefits analyst with Allied Container Systems Inc., a Walnut Creek, Calif.-based company with about 100 employees that designs and installs modular buildings. But today, "it is becoming much more common to see people working for a company for only two or three years, then moving on."

Given defined benefit plans' lack of portability, expecting companies to unfreeze existing plans or establish new ones could be a nonstarter. "I do not see defined benefit plans as viable in today's industry," Miller says.

Miller is not alone. "I don't see a comeback in the cards for traditional defined benefit plans, given the current business and regulatory environment," Winsten says. "It is difficult to see who would champion that type of benefit in the future because it does not fit the mold of today's employment experience in which you can expect to work for several employers during your career."

"Employers are convinced that the risks of maintaining a defined benefit plan are not sustainable," agrees Jim McHale, a principal with PricewaterhouseCoopers LLP in New York City.

New Designs

If any sort of defined benefit plan is to take hold, it will require new thinking and plan designs. "Right now, we are stuck between two models for retirement plans—one that puts all the risk on the employer and the other that places all of the risk on the individual employee," says Richard Shea, a partner with law firm Covington & Burling in Washington, D.C. "To build a sustainable retirement plan, you need to have some risk sharing" among both the employer and its employees.

"Defined contribution approaches have gone too far to one side and left risks with the workers that they are unlikely to be able to manage on their own," McHale says. "A solution somewhere in the middle is going to be much healthier for the system."

At a recent standing-room-only conference called Re-Imagining Pensions: Using Innovative Pension Plan Design to Reduce Risk and Increase Retirement Income, sponsored by the Pension Rights Center, The Urban Institute and Covington & Burling, participants discussed how defined benefit plans could once again play an important part in the retirement landscape.

"There is recognition that we may see a different type of pension plan that combines some of the best features of defined benefit plans, such as employer contributions, pooled and professional investments, and annuities, with the best parts of 401(k) plans, including employee contributions and portability," said Karen Ferguson, director of the Pension Rights Center in Washington, D.C.

Newplan designs represent potential solutions for employers that want to offer a more secure retirement benefit without the costs and regulatory complexity of traditional defined benefit pension plans. However, it is important for employers to keep in mind that these designs may require regulatory clarification.

Government action or inaction could be a major roadblock for any kind of pension plan renaissance. "The federal government has to encourage innovation and get out of the way," Glickstein says. "While there is a need to protect the interests of workers and plan sponsors, it cannot be overly slow and cumbersome in writing rules that inhibit where plan sponsors and employees want to go."

Still, the conversation about a new approach to retirement plan design has started. If plans that offer some sort of guaranteed retirement benefit are to make a comeback, Pushaw predicts that it will be small or mid-size companies that lead the way.

"Executives and entrepreneurs in these companies are more likely to have an open mind about these plans and are less burdened by the political risk of changing direction than their peers in large companies," he says. "There is a lot of risk for an executive who tries to reanimate defined benefit plans when many companies considered these plans happily dead and buried for the last five or ten years."