Intro Help Topics Retirement Planner Retirement Perspectives Manage Your Retirement

Unlocking The Mysteries of Defined Benefit Plans By Stephen J. Butler

Archives

Nathaniel West, author of the book "Day of the Locust," also wrote a short story entitled "The Dream World of Balzo Snell." It was the tale of a man who managed to do movie deals in Hollywood, but as a consequence of each completed deal, he would lose an appendage. By the end of the story, Balzo was nothing more than a trunk. His plight somehow reminds me of our struggle to make defined benefit pension plans answer the retirement needs of American workers. Every time we think these sophisticated plans have met our expectations, they leave us without a leg to stand on.

A defined benefit retirement plan is one that promises a specific retirement benefit --- $20 per month, say, for each year of employment. Someone who works for the same company for thirty years would get a retirement benefit of $600 per month that would start when they reached age 65. Another typical benefit is to receive half your average monthly salary based on the average monthly salary for the last five years of employment. These plans typically have vesting schedules that require that you work for the company for several years before you earn a right to your full scheduled benefit.

To fund these promises, companies deposit money into a pension account where it accumulates tax-free like 401(k) money. The tough question for companies is always, "How much should we deposit to meet that future obligation?"

To best understand how such a plan works, we look at the start of the benefit payments. These payments are funded by something called an annuity. An annuity is a financial product that guarantees an amount of income for the rest of one's life. While life insurance offers protection if you die too soon, an annuity protects you if you live too long. An annuity guaranteeing one dollar of monthly income ($12 per year) for the rest of your life costs about $135. If you live to 105, it is a terrific deal. If you die next month, you just blew $134, and you've helped to support the people who lived long lives. Defined Benefit plans don't actually buy annuities, but they use the concept to determine how much their retirement obligation is expected to cost.

Designing, operating and computing these complex promises is called "actuarial science" and the practitioners are, of course, actuaries. The cost of the future promise is influenced by many events over time. The turnover of employees, for starters, determines how many people actually get to the finish line with any meaningful benefit. When the average length of employment is only about seven years, the number of people benefiting is not as large as we would think. Future salary increases must also be taken into consideration when determining what the ultimate funding requirement might be.

Defined benefit plans, then, require enough deposits and investment earnings to be able to buy that $135 annuity to support each dollar of monthly income that they have promised to a retiring employee. By comparison, a 401(k) plan offers no promises. Whatever you see at retirement is what you will get.

While defined benefit plans offer security and a predictable benefit guaranteed by both the employer and the U.S. Government, they also can wreak havoc with corporate cash flow. Thanks to very fortunate stock market performance throughout the nineties, many pension plans required little or no contributions from employers. In many cases, the excess earnings from the pension plans were credited back to the sponsoring companies where they appeared as earnings on the income statement.

Now, it is a far different story. Warren Buffett, in FORTUNE's latest cover article, warns of the emerging liability that these plans represent and the impact that funding obligations will have on corporate earnings. This is just the beginning of the problem. The Pension Benefit Guarantee Corporation (PBGC) is a government agency that guarantees with government money any pension shortfalls in companies that are bankrupt. Remember the $6 billion bailout loan we taxpayers made to Chrysler in the Lee Iacocca era? What escaped notice at the time was that the Chrysler pension plan was exactly $6 billion under water. If we hadn't made the loan, Chrysler would have gone under and we would have had to spend $6 billion of the PBGC fund.

Another abuse of these plans occurred during the merger and acquisition heyday of the 1980's. Many plans had excess funding which meant they had more money than was needed to fund future benefits. Corporate raiders were able to "repatriate" and use these excess funds to pay off the junk bond debt they had used to seize control of the company. To put a stop to this practice, Congress passed a law that applied a 50% tax on all excess funding, but by that time, the opportunists had had their way with these bloated plans.

Today, pension reporting on corporate financial statements is practically nonexistent. Accounting rules require only a footnote which is only a discussion of the pension cost. It is not arithmetic that becomes part of the calculation of corporate income. Not surprisingly, however, many companies were quick to report pension investment income on their books in the glory years of the 90's when it suited their purposes. According to a report of Credit Suisse First Boston, 12 percent of the earnings growth registered by the S&P 500 companies in 2000 came from pension income. We should all be as concerned as Warren Buffet when we see our investments impacted by this black box that few understand and whose costs nobody can predict with any certainty.

Books like "The Great 401(k) Hoax" rant on about how American employees have been left to their own devices where these wonderful defined benefit plans once offered a guaranteed retirement benefit. The facts are that portable 401(k) plans generate five times more money at retirement than the traditional succession of retirement plans offered by the collection of employers that most Americans work for over the years. The people writing those books and articles are just pandering to the money management industry that preferred to operate inside the black box rather than out there in the mutual fund world of 401(k)'s where participants can see every dime of assets and earnings. They also have money with 100% certainty without being buffeted by the whims of non-vested forfeitures and corporate downsizing.

The bright spot of "defined benefit" plans is the opportunity they represent for owners and management of small, successful companies and professional practices. These aggressive plans, often coupled with 401(k) plans, can offer opportunities for company owners to contribute huge tax-deferred annual sums into a retirement account. Someone with only ten years left until retirement might be able to contribute as much as $130,000 per year if they wanted to fund a retirement benefit of $160,000 per year starting at age 62. This is a grossly simplified example, but it illustrates the extent to which pension laws designed mainly for large companies can be applied to small companies in a way that creates dramatic tax sheltering. For some, it's an opportunity to catch up on some long-overdue retirement plan contributions. This is the silver lining in the cloud.

I've never suffered at the short end of a defined benefit plan, but I have had my disappointments with Hollywood. Years ago, as a real-life Balzo Snell, I helped to produce the movie "Sheena" which Columbia studios spent $30 million to make. They sent a trained hippo to Africa among other extravagances. The film debuted the same week as "Ghostbuster" and closed a week later. Pauline Kael called it the best "animal acting" she had ever seen. The film has yet to make a profit, but I still have all my arms and legs so I guess I can consider myself fortunate.

BUYandHOLD does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular security, portfolio of securities, transaction or investment strategy. Any investment decisions you make will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs. The securities mentioned above are being used for illustrative purposes only and should not be regarded as an offer to sell or as a solicitation of an offer to buy and past performance is no guarantee of future results. The opinions expressed above are not necessarily those of BUYandHOLD, its officers, directors or its affiliates.