As the U.S. population ages, issues surrounding retirement security for baby boomers and future generations loom large. Thirty years ago, employer-sponsored defined benefit (DB) plans that provided guaranteed monthly payments during retirement were a standard employee benefit. However, the number of DB plans has declined sharply in recent years, from 112,208 in 1985 to about 29,600 in 2004.¹ As U.S. businesses struggle with mounting costs and try to remain competitive in a global economy, the trend away from DB plans appears to be accelerating (see Chart 1). In their place, businesses increasingly are offering defined contribution (DC) plans that allow employees to contribute to an individual account owned and managed by the employee, placing more responsibility on employees to save for retirement and to manage their own funds.

Chart 1

Several factors have coalesced to pressure the DB system in recent years. The system was designed when U.S. manufacturing companies such as General Motors dominated U.S. and world markets for generations at a time. In today's period of fierce global competition, when new companies routinely emerge to challenge the old, employee benefit costs can reduce earnings and hamper flexibility for many companies in old-line industries. In addition, recent periods of negative equity returns and low interest rates have contributed to volatility in the value of pension assets and significant underfunding in a number of plans. Amid these developments, DC plans have gained in popularity among companies as a means to shift some of the cost and risk of retirement savings to their employees.

This article explores some of the cyclical and structural causes of the recent shift from DB to DC retirement plans. It discusses the motivations for companies to shift from DB to DC plans and the specific risks inherent in both types of plans. Although many companies have moved from DB to DC plans, such as 401(k) plans, many others maintain healthy DB plans and are finding creative ways to invest and manage the costs. With 34 million participants, the private single-employer DB system remains a vital, though increasingly less available, component of the retirement infrastructure.²

The Evolution of Defined Benefit Plans

Although DB pension plans have been around for decades, they gained in popularity during and after World War II as a means to boost employee compensation in an era of binding wage and price controls.³ Because employers could not increase employees' pay, they instead offered deferred income in the form of generous health and retirement benefits. As employee benefits became commonplace, they also became a bargaining tool for unions, allowing companies to negotiate future payments in lieu of pay increases, even after wage restrictions were lifted. Historically, then, the majority of workers covered under DB plans tended to be in the unionized, goods-producing and transportation industries, which had a much more significant market presence 60 years ago. In 1945, manufacturing, utilities, wholesale trade, and transportation services made up more than half of the gross domestic product (GDP), and about 20 percent of workers were unionized. Today, those industries represent about a third of GDP, and 12 percent of the workforce is unionized.⁴

DB plans remained the norm until the 1970s, when the legal structure governing pensions made plan sponsorship more onerous. Enacted partly in response to the Studebaker Company's default on its pension obligations, the Employee Retirement Income Security Act (ERISA) of 1974 standardized all aspects of DB sponsorship, including funding, investment and administration.⁵ In addition, ERISA created the Pension Benefit Guaranty Corporation (PBGC), the federal agency that insures pensions and provides benefit payments to retirees in the event of a DB plan termination. Employers pay annual, per-participant premiums or variable premiums to the PBGC, depending on plan funding levels.⁶

Driven by widespread corporate restructuring and movement away from lifetime employment during the 1980s, alternative retirement funding vehicles began to emerge. In addition, employee tenure declined, and traditional jobs in the goods, manufacturing and transportation sectors increasingly were replaced by jobs in the service sector. Companies in newer industries, such as information technology, have been much less likely to sponsor DB plans.

Today, DB plans primarily are offered in the airline, automobile, and manufacturing industries. Many companies in these industries have experienced stiff pressures in recent years from globalization and other market forces, exacerbating the burden of decades of accrued pension liabilities.⁷ Even companies that are better positioned in their core businesses and under less pressure are finding it difficult to compete with more efficient rivals that do not sponsor DB plans. Taken together, these factors have created intense competitive pressure to freeze or terminate DB plans in favor of DC plans.⁸

Why Are Defined Benefit Plans Under Pressure?

Interest Rates and Market Returns

Particularly notable of late has been the inherent volatility of DB funding levels. Dubbed "the perfect storm" by some industry observers, the low interest rate environment of the past few years, in tandem with equity market volatility, has negatively affected the net market value of DB plans. The sensitivity of pension plan obligations to short-term fluctuations in interest rates and market performance creates significant uncertainty for plan sponsors about future contribution levels.

Because pension payments accrue and are paid out over decades, DB plans are highly sensitive to changes in interest rates. The discount rate used to establish current liabilities (based on an average of investment-grade corporate bonds) is critical in determining a plan's funding level. The lower the interest rate, the higher the present value of the liability and the annual contributions needed to avoid underfunding.⁹ But this is only part of the toll that low interest rates have taken on the net market value of DB plans. Asset returns for DB plans also were reduced in 2000 and 2001 by the combination of low interest rates and equity market losses, a situation that has only gradually improved in the years since then.¹⁰ As corporate DB plans became increasingly underfunded, ERISA and Internal Revenue Code rules began to require that firms raise their annual contributions.¹¹ In some cases, these plans also incurred additional PBGC premiums as well as "shortfall" charges.

Despite the gradual improvement in asset yields in recent years, 81 percent of corporate pension plans remain underfunded at present; during the past two years the plans have regained only 14 percent of the $392 billion in surplus assets lost over the preceding three years.¹² The Government Accountability Office estimates that in aggregate, DB plans are underfunded by a total of $450 billion, with more than half the largest plans underfunded.¹³ It is estimated that unfunded pension liabilities of S&P 500 companies in 2005 were close to $218 billion.¹⁴

Legacy Costs

Plan sponsors in some traditional sectors of the economy face large "legacy costs" on their balance sheets that are closely related to DB pension obligations. The product of decades of labor negotiations in which corporations and their unions agreed to increased pension benefits in lieu of wage increases, pension costs that were once viewed as comfortably far in the future are now coming due.¹⁵ As more people retire and companies increase productivity by reducing their payrolls, fewer workers are available to contribute to the funding of rising heath and pension costs. Moreover, the workforce is not only aging, but people are living longer; the average lifespan of retirees has increased from 68 years in 1950 to 78 today.¹⁶ Hardest hit by these legacy costs are traditional industries, such as airlines and automobile manufacturing, which are facing significant competitive pressure in their core business lines as well as the rising burden of pension obligations and steadily increasing numbers of retirees.¹⁷

Intense Competition

To cope with severe underfunding, more companies are freezing or terminating their DB plans as part of bankruptcy reorganization or efforts to improve their balance sheets. Recent events in the airline industry illustrate this trend.¹⁸ Faced with rising fuel prices and increasing competition from newer, low-cost airlines, such as Southwest and JetBlue, which do not sponsor DB plans, legacy airlines (major carriers operating under the hub-and-spoke system) have posted a record $32 billion in losses during the past four years, with an additional $4.8 billion in losses projected for 2005.¹⁹ Delta and Northwest filed for bankruptcy in September 2005, joining the ranks of other major carriers in Chapter 11, including United Airlines, US Airways (which emerged from bankruptcy in September 2005), ATA, and Aloha Airlines.

After filing for bankruptcy in 2002, United terminated its DB pension plan in 2005, saving $645 million a year.²⁰ Industry analysts also expect Delta, Aloha, and Northwest to turn over their pension obligations to the PBGC. The remaining legacy airlines with defined DB plans face more than $60 billion in fixed obligations during the next four years (including $10.4 billion in pension contributions), which figures to place additional financial pressure on them.²¹

The domestic auto industry has seen a similar weakening in profitability as a result of excess capacity, price competition, changing consumer preferences, and rising employee benefit costs. After announcing an $8.6 billion loss in 2005, General Motors (GM) revealed recently it would begin freezing benefits in its DB plan for salaried workers, replacing it with a 401(k)-type DC plan. GM estimates that by restructuring its pension program from DB to DC, it will reduce its 2006 pension liability by $1.6 billion. When GM announced its plan to freeze benefits in the DB plan, it noted the difficulty of competing with companies that do not carry these legacy costs.²² GM has fewer than 200,000 U.S. workers, but nearly 1 million retirees and dependents. In 2004, the cost of pension and health benefits for retired GM workers represented $1,784 per vehicle, compared with Toyota, which does not offer a DB plan and whose employee benefits represented only $200 per vehicle.²³ With a retiree-to-employee ratio close to one-to-one, Ford Motors also is having trouble meeting its benefit obligations.²⁴ Going forward, analysts expect Ford to negotiate with its labor unions to restructure benefits, or possibly even switch to a DCplan.²⁵

Increased Investor and Regulatory Scrutiny

Regulators, investors and analysts also have become increasingly concerned about the lack of transparency in DB pension plans and the leeway the current rules provide in reporting a plan's financial condition. Under current rules, plan sponsors may value plan assets at anywhere from 80 to 120 percent of market value, and earnings may be projected using a long-term expected rate of return, with gains or losses amortized over five years. On the liability side, valuation is based on a four-year weighted average of investment grade corporate bonds, where the rate must fall between 90 and 100 percent of the index.²⁶ Under this approach, plan sponsors are able to reduce funding volatility by "smoothing" fluctuations in interest rates, making future payment more predictable.

Critics argue, however, that this flexibility allows sponsors to mask the plan's true health, and that today's underfunding is due, at least in part, to current rules that allow sponsors to amortize gains or losses on assets and liabilities over extended periods and use credits in lieu of cash contributions.²⁷ It has been reported in the financial media that the Securities and Exchange Commission is reviewing whether some companies changed their assumptions about pension obligations to meet short-term earnings targets. The agency has not formally charged any company with wrongdoing.²⁸ In addition, investors and analysts increasingly are wary of the impact pension obligations will have on earnings and cash flow. Since 2002, a number of analyst reports have criticized large corporate funding obligations, and credit rating agencies have noted pension problems as contributing factors in ratings downgrades, such as in the cases of Ford and GM in 2005. A recent Bear Stearns report warned that investors who fail to consider a company's pension liabilities do so at their own risk.²⁹

The increasingly common practice of using the bankruptcy process to shift legacy costs to the PBGC is prompting discussion about the potential for moral hazard (where, to the extent allowed, the plan sponsor may take unnecessary risks or not fully fund the plan, expecting the PBGC will take over the plan in the event of bankruptcy). Critics argue that the ability to socialize pension obligations by shifting them to the PBGC has eroded incentives for companies to rein in these obligations on their own. Further, the series of large DB plan terminations of the last few years has impaired the financial position of the PBGC itself, further fueling the national debate about the future of DB plans. With the PBGC currently operating at a $23billion deficit, sponsors of healthy plans are implicitly subsidizing plans that are currently underfunded or that have been terminated due to bankruptcy. Legislators and policymakers face the possibility of a taxpayer bailout should the agency not return to solvency before more large terminations occur.³⁰

The Transition to Defined Contribution Plans

To reduce costs and manage pension risks, more companies are shifting out of the DB system and into DC plans, in which employees contribute a portion of their salary to an individual account that they own and manage.³¹ Facilitating this trend was a piece of legislation enacted in 1978 that allowed the deferral of income in retirement plans on a tax-advantaged basis; this section of the Revenue Act of 1978 became Section 401(k) of the Internal Revenue Code. The regulations were finalized in 1981 when the Internal Revenue Service (IRS) sanctioned the use of employee salary deductions as a source of retirement plan contributions.³² Within two years, nearly half of all large firms were either offering or considering a 401(k) plan.³³

Between 1985 and 2005, total assets in defined contribution plans grew 560 percent, from $430 billion to $2.8 trillion (see Chart 2).³⁴ According to the Employee Benefit Research Institute (EBRI), about 60percent of private retirement assets are now held in 401(k) plans and individual retirement accounts (IRAs).³⁵ Employees covered under a DC plan increased from 41 percent in 1985 to 51 percent in 2003, while those covered under a DB plan fell from 80 percent to 33 percent during the same period.³⁶ Despite their relatively recent emergence, DC plans have quickly become commonplace, and are viewed by many companies as a cost-effective alternative to the DB system.³⁷

Chart 2

Employers are not alone in their newfound affinity for DC plans as a vehicle for retirement savings. Many workers have become concerned about relying for their retirement security on employers that may not be in business in 20 or 30 years. Further, as lifetime employment with one company has become less common, employees have begun to prefer greater flexibility and portability of their retirement savings, as well as the ability to manage their own assets. The increased mobility of the workforce has fueled growth in DC plans, as younger employees tend to change jobs more frequently than in previous generations. Payouts under DB plans are typically based on ending salary and tenure; an employee maximizes the DB potential by staying with the company for an extended period. In contrast, DC plans have shorter vesting periods and do not impose penalties for changing employers as long as fund proceeds are reinvested in another qualified retirement plan.

The expense of DB plan sponsorship has become too much for even some healthy companies that are relatively well positioned in their markets.³⁸ Some recent examples of the shift from DB to DC plans include large employers in high-tech industries. Verizon Wireless, which opted in 2005 to shift to a DC plan, estimates savings of $3 billion over the next ten years. In January 2006, when IBM froze its pension plan in favor of a DC plan, executives claimed the move would result in savings of $450 to $500 million for 2006, and $2.5 to $3 billion for 2006 through 2010.³⁹ In 2005, Hewlett Packard also announced plans to freeze its pension plan. Sprint, Motorola, and Lockheed-Martin are among the other companies that have recently announced plans to phase out their DB plans, and many expect the list to grow in the near term.

Who Bears the Risk?

Saving and investing over the long term carry significant risks for companies and individuals. Participants in and underwriters of both DB and DC pension plans must make assumptions over several decades about the direction of interest rates, market returns, and life expectancies that, taken together, will determine the plan's long-term financial viability. The uncertainties associated with this forecasting process introduce threetypes of risk: longevity risk, market risk, and bankruptcy risk.

Longevity risk is the risk that plan beneficiaries will live longer than expected. DB plans pay benefits essentially in the form of an annuity. Therefore, a longer average lifespan for beneficiaries raises the expected value of the plan's liabilities and increases the chance the plan will run short of funds. Certainly, the longer average life expectancy of retirees in recent years has contributed significantly to the financial pressure facing DB plans. In the case of DC plans, however, longevity risk is borne by the individual. This tends to convert longevity risk from a factor that could bankrupt a pension plan into one where the beneficiaries risk outliving their financial assets. Instead of receiving a guaranteed amount each month during retirement, retirees must plan and invest, taking distributions according to their specific circumstances. This is in contrast to DB payments, which generally are not adjusted for inflation and cannot be exhausted, mitigating the possibility of over- or under-consumption. Further, in a DB plan, employees cannot cash out before retirement, as they can in DC plans.

Market risk affects the value of DB plans in two ways. First, the value of the assets held by DB plans is determined by the returns, which typically take the form of stock dividends and capital gains as well as interest earned on fixed-income investments. To the extent that market returns or interest rates underperform expectations, the value of DB plan assets may not grow fast enough to keep pace with the obligations. In addition, the market value of a DB plan's liabilities is determined in part by discounting at a market rate of interest. In this case, low interest rates can increase the market value of DB plan liabilities and force a refunding of the plan. By comparison, the market risk associated with DC plans is concentrated on the asset side. Lower-than-expected interest rates and market returns drive down the asset value of DC plans and make it more likely that beneficiaries will outlive their financial assets.⁴⁰

DC plans tend to push longevity risk and market risk off the corporate balance sheet and onto the household balance sheet. What do employees get in return for assuming these large, long-term risks? Besides the opportunity to make more decisions for themselves, employees in DC plans are rewarded with a significant reduction in the risk that their retirement benefits will be reduced or eliminated by bankruptcy or other forms of repudiation. As long as the assets and liabilities of the DB pension plan reside with a corporation that could file bankruptcy or terminate or modify the plan over its long life, the beneficiary could experience a significant decline in lifetime benefits. Corporate bankruptcy, which shifts pension liabilities to the PBGC and often results in substantial reductions in benefits, is one example of bankruptcy risk. But perhaps an even more common and less visible risk that faces DB plan beneficiaries is the erosion of pension and health benefits that could occur through negotiation and fiat during the life of a DB agreement. It is perhaps in this regard that DC plans offer the greatest perceived value to today's workers by simplifying and solidifying the ownership rights they have to the proceeds of their retirement plan.

What Is the Future of Defined Benefit Plans?

The decision to maintain a DB pension plan or move to a DC plan is one that companies weigh carefully as they balance the sometimes conflicting needs and expectations of employees and shareholders. Despite the market and structural forces that have pressured DB plans and the companies that offer them, some 34 million working and retired Americans depend on company-funded plans to provide for their retirement. Many companies continue to fund their own retirement plans because they feel these programs reward loyalty and give them an edge in hiring and retaining the best people. However, the recent trend has been for more companies to bypass DB sponsorship altogether. It is likely that competitive pressures will continue to force companies to consider terminating their DB plans and offering alternative types of retirement savings programs to their employees.

In today's volatile business environment, where corporate structure changes frequently and large bankruptcies are not uncommon, many employees may feel more secure controlling their retirement assets and making their own investment decisions. Under DC plans, the advantage of portability is attractive to younger workers, in particular, and helps to offset the longevity and market risks they bear. However, neither structure eliminates risks entirely, and employees and employers must continue to work together to arrive at mutually beneficial ways to manage the risks inherent in long-term retirement saving and investment.

Alison T. Touhey, Economic Analyst

The author wishes to acknowledge valuable comments received on previous versions of this article from Stephen C. Gabriel, Senior Financial Economist, and Devin W. Sloss, Student Intern.

Footnotes

¹ Several types of DB plans exist: private, single-employer plans; multiemployer plans available through unions; and publicly sponsored plans offered to state employees. This article focuses on the private, single-employer DB system. (Pension Benefit Guaranty Corporation Pension Insurance Databook, 2004.)

² Pension Benefit Guaranty Corporation. This figure includes working and retired participants.

³ The first employer-provided retirement plan in the United States was offered by American Express in 1875.

⁴ Bureau of Economic Analysis, Bureau of Labor Statistics (BLS), Haver Analytics, and FDIC analysis.

⁵ During the past 30 years, ERISA and applicable sections of the Internal Revenue Code (which also applies to DB plans) have been amended a number of times, making compliance increasingly complex. Defined contribution plans are also subject to ERISA.

⁶ The recently enacted Deficit Reduction Act of 2006 raised premiums to $30 from $19 per participant. Pension plans are not fully insured. Rather, when a plan is terminated, the maximum amount the PBGC pays to beneficiaries is based on a number of factors and adjusted annually for inflation. In most cases, the PBGC payment represents less than a beneficiary would have received had the plan not been terminated.

⁷ According to the PBGC, 56 percent of workers covered under DB plans are in the manufacturing, transportation, utilities, and wholesale trade sectors.

⁸ When a plan is frozen, it generally is closed to new participants, with none, some, or all prior participants accruing additional benefits. When a plan is terminated, the sponsor either purchases an annuity or issues a lump-sum payment to beneficiaries.

⁹ A plan is considered underfunded when the asset-to-liability ratio falls below 80 percent in a single year or is consistently below 90 percent. Plan sponsors must contribute to their plans at least annually and must fund them up to 90 percent for the plans to be considered "well funded." To calculate a plan's funding level, the plan converts long-term payments to a lump sum, representing the present value of the plan's liabilities. Increased required contributions tend to coincide with financial downturns, when the company can least afford to make these contributions.

¹⁰ When stock market gains declined in 2000, pension funds were among those investments most adversely affected. Because of the traditional "65/35" pension fund investment strategy, in which 65 percent of the fund's assets are typically allocated toward equities and the remaining 35 percent toward fixed-income securities, corporations experienced huge drops in funding levels when stock prices plummeted.

¹¹ Current tax rules offer no incentive for plan sponsors to fund pensions in economic good times. Currently, an employer may only deduct contributions that increase the plan funding level to 100 percent, with no deductibility after 100 percent.

¹² Millman 2005 Pension Study. http://www.milliman.com/pubs/EB/PDFs/PensionFundSurvey2005.pdf.

¹³ Government Accountability Office. May 2005. Recent Experiences of Large Defined Benefit Plans Illustrate Weakness in Funding Rules. GAO-05-294.

¹⁴ Davis Zion and Bill Carache. Credit Suisse First Boston, Pension Update:Pension Plans getting weaker this year. October 25, 2005.

¹⁵ According to the 2005 National Compensation Survey published by the Bureau of Labor Statistics, 73 percent of union workers have access to DB pensions, compared with 16 percent of non-unionized workers, making heavily unionized industries more likely to face large legacy costs. These industries also tend to be those that have significantly downsized during the past 30 years, increasing the ratio of retiree/nonactive participants to active participants.

¹⁶ Centers for Disease Control and Prevention. www.cdc.gov/nchs/data/nvsr/nvsr53/nvsr53_06.pdf.

¹⁷ Manufacturing and transportation companies comprise a third of single-employer plans, yet they represent 90 percent of PBGC claims during the past 30 years.

¹⁸ In general, a plan sponsor may terminate its plan under a "distressed termination"; however, the employer must prove to a bankruptcy court or to the PBGC that it cannot remain in business unless the plan is terminated.

¹⁹ David Pauly. "U.S. Airlines—All-Time Losers, and Counting," November 4, 2005 (Bloomberg).

²⁰ United's pension obligations were underfunded by about $9.8 billion and represented the largest claim in PBGC history.

²¹ Don Young, Chairman of the U.S. House of Representatives Committee on Transportation and Infrastructure. www.house.gov/transportation/press/press2005/release85.html.

²² General Motors press release, March 7, 2006.

²³ www.businessweek.com/magazine/content/04_29/b3892001_mz001.htm.

²⁴ Bradley A. Rubin. December 7, 2004. Ford Motor Company: Driving Profitability Through New Model Introductions, BNP Paribas, Fixed Income.

²⁵ Fitch: Successful UAW Negotiations Vital for Ford upon Restructuring. www.theautochannel.com/news/2006/01/23/208239.html.

²⁶ The previous benchmark was the 30-year Treasury rate; however, the Pension Funding Equity Act of 2004 temporarily replaced the 30-year rate with the composite index of bonds.

²⁷ Pension overhaul legislation, which attempts to resolve these issues, among others, is now working its way through Congress. In 2005, the House and Senate passed reform legislation, and a conference is currently working to resolve differences between the bills. The Bush administration released its reform proposal in January 2005.

²⁸ "Pension Inquiry Shines Spotlight on Assumptions; Small Changes in Calculations at Companies Have a Big Effect on Retiree Liability - and Profit," The Wall Street Journal, November 9, 2005.

²⁹ Bear Stearns. January 2006. Accounting Issues Pension Tension: Hurricane Watch Estimated 2005 and Forecasted 2006–2007 Funding Status.

³⁰ Pending pension reform bills also address PBGC solvency and aim to give the agency more pricing power, while introducing a risk-based premium structure. The PBGC has the authority to borrow $100million from the Treasury, but Congress must act to provide additional funding.

³¹ Current IRS rules allow employee contributions of up to $15,000 in 2006.

³² In 1986, the Federal Thrift Savings Plan was established and signaled to the private sector that the DC plan structure was an acceptable alternative.

³³ Employee Benefit Research Institute (EBRI). February 2005 History of 401(k) Plans, An Update.

³⁴ Federal Reserve Flow of Funds.

³⁵ Fast Facts from EBRI, February 3, 2006. www.ebri.com/pdf/publications/facts/fastfacts/fastfact020306.pdf.

³⁶ EBRI Databook 2005. http://www.ebri.org/publications/books/index.cfm?fa=databook

³⁷ The most popular DC plan type is the 401(k); other forms are thrift savings plans, employee stock ownership plans, and profit sharing plans. Companies also are offering hybrid plans, which combine characteristics of DC and DB plans; the legal and regulatory environment surrounding hybrid plans, however, remains uncertain.

³⁸ The cost difference between these types of plans is striking: DB plans cost companies $2.21 per hour, on average, compared with $0.27 for DC plans. (Bureau of Labor Statistics. September 2005. Employer Costs For Employee Compensation.) Millman estimated that for the 100 companies in its survey, pension expenses increased $4.1billion dollars in 2004, producing an aggregate pension cost of $18.3 billion.

³⁹ IBM. www-03.ibm.com/press/us/en/pressrelease/19090.wss.

⁴⁰ The need for financial education is significant; however, employers are restricted in what advice they can provide employees. Certain provisions of the proposed pension reform legislation would make it easier for employees to access investment advice and allow automatic enrollment of employees.