Corporate Pension Plans - Term Paper Example

Introduction Corporate pension plans include two major types of plans, Defined Contribution and Defined Benefit. The two plans are very different in many aspects. Defined contribution plans Limit participant contribution to a maximum annual amount. Defined benefit plans allow contributions based on the amount needed to provide a fixed benefit amount upon retirement. Defined benefit plans provide guaranteed income security for retirement. Defined contribution plans do not provide such security. They are based on a percentage of contribution, rather than on an expected retirement benefit. They also rely on a percentage of contribution as investment annually. A drawback of defined contribution plans is that the benefit payable is based on the amount in the plan upon retirement. In times when markets are up, participants may receive higher than expected benefit. When the markets are down, the opposite occurs. If there is nothing left in the plan account at retirement, the participant receives no benefit. “Those with defined contribution plans are much less confident about meeting their income needs in retirement” (Cohn, 2009). However, if markets are doing extremely well at the time of retirement, participants may receive greater benefit than required. The problem with this type of corporate pension plan is that results are based on market performance and participants may need to alter the timing of retirement, to coincide with higher market performance. A negative aspect of defined benefit plans is the specified limits on benefit, upon retirement. Participants will not receive additional benefit if markets are performing very well at the time of retirement. This can also be considered a positive aspect of defined benefit plans, as participants are guaranteed a specified benefit. The health of the corporation can influence the amount of participant contribution, to meet the projected retirement benefit. Corporations are expected to maintain assets at a level which will cover benefits of all participants. However, when economic conditions prevent this, participants may need to increase contributions to maintain the appropriate level. Literature Review The current health of corporate pensions is questionable and may remain so for years, according to analysts. Even with the recent pension reforms, markets have made marginal gains, so returns are not at expected levels. According to Craig Rosentha,l of Mercer, LLC (in Cohn, 2009), which has studied the current corporate plan situation, “looking ahead to 2010, barring enormous market recovery, we expect that many defined benefit plans will face significantly increased required contributions." Of the 874 plans surveyed by Mercer, nearly one fourth required major increases in contributions. Pension plan managers do the best they can in most cases. However, when they also are paid commissions based on returns to shareholders, they many not act in the best interest of plan participants. Changing the manner in which pension plans are managed could be useful. There are often conflicts between interests of shareholders and corporate plan participants. Assigning or hiring different managers for different interest might be feasible. Lynn Siewart (2009) explains benefits and drawbacks of both defined contribution and defined benefit plans and the differences in formulas used to determine benefit, in an informative report intended for plan participants and corporate managers. Siewart provides a table that shows the difficulties in comparing benefits of both plans, in Appendix A, Table 1.1 Though there is no discussion or comparison of financial management aspects of the two plans. In comparing the differences in benefit, Siewart states that the defined benefit “is more likely to satisfy income replacement objectives.” The statement suggests that financial managers of defined benefit plans must meet with each worker who participates in the plan, to determine retirement objectives. The explanations of both Cohn and Siewart suggest managers of defined benefit plans must spend considerably more time monitoring such plans. In their publication Types of Qualified Plans, Defined Benefit Plans, Defined Contribution Plans, Other Qualified Plans, and Individual Retirement Accounts, Etti Baranoff, Patrick Lee Brockett, Yehuda Kahane suggest that “employers like cash balance plans because they are less expensive than traditional plans, in part, because they do not require the high administrative costs. While all reports express the need for continued and experienced monitoring for defined benefit plans, Cohn implies that managers of defined benefit plans may need to increase levels of competence and knowledge, to choose the right asset mix. Problem Statement Given the serious condition of today’s economy, the challenge for corporations is in determining which type of corporate pension plan will be most cost-effective. Administrative fees, management strategies and corporate financial health are aspects that must be considered in determining the type of plan offered to workers. Levels of plan participation by workers also influences the health and performance of plans. Balancing the needs and financial health of the corporation with the expected level of participation are considerations that must be made in choosing the type of plan to offer workers. Questions of how to manage pension plans in both defined benefit and defined contribution plans (where workers manage their own portfolio) also exist. There are different types of risks to workers participating in defined benefit and defined contribution plans. Defined contribution plans face financial market risk, while defined benefit plans face risk of job change, early retirement and severe reduction in earnings. “Without careful study, it is difficult to gauge the relative risk of these two types of plans” (Poterba, Rauh, Venti & Wise, 2009). Many workers within the airline industry have taken substantial reductions in pay, to keep their jobs. Others are offered early retirement, as a means of reducing corporate financial liabilities. An additional challenge is the liability or financial responsibility of the corporation to workers who participate in the plan. Defined benefit plans pay according to earnings of the worker’s highest three years or the last three years. There are also adjustments for inflation. Though proper management of such plans by financial officers or managers includes balancing risk with potential growth, this may not occur if the plan is poorly managed. “In addition, plan sponsors face potential penalties for non-compliance with the full-funding provisions” (Krieg, 2008). Severe shortages in recent years have led many corporations to file for bankruptcy, to rid themselves of the financial burden of pension plans. The liability of pension benefits is then transferred to a guarantee agency in which the corporation has paid insurance premiums. The guarantor is required to cover a portion or percentage of the benefit. Plan participants may not receive enough benefit to retire. Workers may or may not be required to participate in corporate pension plans. Some plans use automatic enrollment to maintain higher levels of participation, requiring workers to decline participation, if they are not interested. The automatic enrollment strategy has been shown to “increase participation to levels up to 94%” (Cohn, 2009). While this contributes to the financial health of a defined benefit plan, it is only one aspect. Greater participation leads to greater liability. This is not the case with defined contribution plans. Participation is strictly voluntary. Much of the risk and liability of plan managers depends on the type of defined contribution plan. For the common 401K plans, risk is assumed by participants, who are expected to monitor and manage their own asset mix. Despite increased efforts, there are fewer workers participating in corporate pension plans for a variety of reasons. The increase in part-time workforce, where no benefits are offered, reduces the number of workers eligible for participation. Though many corporations have a higher percentage of full time employees participating, they may have fewer employees participating overall. This depends on the nature and type of and its hiring practices, as well as the industry it operates in. Service industry corporations, for example, have a tendency to hire more temporary or seasonal workers. John Bogle (2005) of The Vanguard Group describes the current financial system, particularly related to retirement savings, as a “whole patchwork of retirement plans.” Bogle describes the complex mix of options as costly to administer. Many corporations off choice in defined benefit, defined contribution, a hybrid of both, or a hybrid of one with other types of retirement savings accounts. This mixture requires even more diligence in monitoring plans, for financial managers. Data James Poterba, Joshua Rauh, Steven Venti, and David Wise have developed a modeling system or simulation, to compare retirement wealth and distribution under both defined contribution and defined benefit plans. Their simulation uses a sample of respondents in the Health and Retirement Study, while also gathering earnings histories of respondents. For defined contribution plans, an employer-employee contribution is set at 7.7%. The asset mix of corporate stock, nominal long-term government bonds, and inflation-indexed long-term bonds is used for seven portfolios, using different combinations of this mix. For the defined benefit plans, earnings histories are again used to determine future defined benefit pensions for each worker. Each worker is randomly assigned a defined benefit plan for each of his or her jobs. Results of the simulation conducted by Poterba, et al.(2009) show that “wealth in defined contribution plans is somewhat higher than mean wealth in defined benefit plans - $177,000 vs. $156,000 for a worker with a high school education - even when defined contribution balances are invested conservatively in an all-TIPS portfolio. Joao F. Coco and Paolo F. Volcin (2005, p. 1), of the London Business School, Centre for Economic Policy Research, suggest a reason for lower performance of defined benefit contributions. In a paper that studies governance of defined benefit contributions, the authors claim that indebted corporations manage plans in a specific way. They “invest a higher proportion of the pension plan assets into equities, (ii) contribute less into the pension plan, and (iii) have a larger dividend payout ratio.” Poterba, et al do not elaborate on the level of debt or whether the corporations of the workers in the simulation are indebted. This can account for the higher level of wealth in defined contribution plans. It is unknown which years the simulation is using for its calculation, so there is no way of knowing how well markets are performing in the simulation. Poterba does explain one limitation of the simulation. Workers of defined benefit plans often take lump sum payments when they change jobs, rather than rolling their plans over into other types of accounts. The simulation assumes that this does not happen and in this manner is somewhat unrealistic. Donald Fuerst believes that in most cases, defined contribution plans can provide the same benefit as defined benefit plans. However, he cautions that defined benefit plans may lower employment costs. Defined benefit plans “provide incentive for long term employment, which decreases turnover costs” (Fuerst, 2009). Tax incentives to corporations are another favorable condition of defined benefit plans. The Transport Salaried Staffs’ Association (TSSA) also suggests that many corporations fail to include return on investment into overall costs of defined benefit plans. The higher the return, the greater cost reduction of such plans. However, the fact that many corporate defined benefit plans are currently underfunded does not make this the case in most instances. TSSA used Railway Pension Scheme as an example, to make comparisons of contributions required in defined benefit versus defined contribution plans. “A funding level of 20% might be necessary to meet obligations of the scheme. This would require contributions of the employee at 8% and the employer at 12%, using the 60/40 contribution ration. Using the same ratio, to produce the same benefit, employees would be required to contribute 5%, with matching contributions from the employer of 7.5%.” Again, this data makes the assumption that market conditions are favorable. If a funding level of 20% is required for a defined benefit plan, it suggests that economic conditions are not favorable and markets are down, barring severe mismanagement of the defined benefit plan by financial managers. Watson Wyatt has been comparing rates of return of both types of plans for over 10 years. Their findings suggest that defined benefit plans have outperformed defined contribution plans, even in years where markets were up dramatically (bull markets), with the exception of the late 1990’s. “This most recent comparison finds that between 1995 and 2006, defined benefit plans outperformed defined contribution plans by an average of 1 percent per year” (Watson Wyatt, 2009). Comparisons included organizations that provided one defined benefit plan and one defined contribution plan, with at least 100 participants. The data also incorporates workers participating in both plans and those participating in defined contribution plans. Watson Wyatt further explains the results in terms of basis points: “Over the 12-year span from 1995 to 2006, DB plans outperformed defined contribution plans.” Though the comparison indicates defined Benefit plans outperform defined contribution plans for the majority of pension plans, some additional fees are deducted from returns of defined contribution plans, which can account for the difference. Results It is argued that much of the performance of pension plans depends on competent management. With defined contribution plans, workers must management their own funds and asset mix, in most cases. It is said that workers often fail to make adjustments to changes in markets. Many do not possess the knowledge required to make such decisions. In this instance, it then should fall on plan managers to educate workers on how to manage their plans. Hotlines or centres for questions and answers should be available for workers at their convenience. Educational seminars that provide information on plan management in terms the least educated worker can understand will help to ensure that defined contribution plans are doing the most good. Management of defined benefit plans is the responsibility of the corporation, so performance of plans many depend on the skill of managers and the understanding of how the asset mix should be allocated. JP Morgan Chase recommends an approach that is similar to corporate finance. “This means that each pension plan will have a very customized asset allocation versus the standard 60% equity, 30% fixed income and 10% alternative assets allocations produced with traditional asset/liability optimization models.” Using this model, managers can determine how much risk is acceptable in the corporation in different economic conditions and in different business cycles of the corporation. This suggests a lower percentage of allocation in equity and greater use of alternative assets. Regardless of the asset mix, it is apparent that many corporations now favor defined contribution plans over defined benefit plans, due to reduced cost, elimination of risk and reduced liability. Information provided in research is incomplete and only provides a picture of benefit returns under favorable market conditions, in most cases. Poterba, et al. suggest that defined contribution plans create more retirement wealth that defined benefit plans, which is contrary to the findings of others. Greater returns and retirement wealth are possible, though not very likely in most instances, due to current lack of knowledge in plan management of most workers. Education in the types of assets and the effects of asset mix may alleviate the poor performance that some workers experience in their defined contribution plans. However, this effort is likely to occur rather slowly over a long period of time. Some workers who are nearing retirement age do not have much time. The suggestion that managers of defined benefit plans take the corporate finance approach, as recommended by JP Morgan Chase may come a bit too late in the game for most corporate plans. Cocco and Volpin also suggest that in times of corporate indebtedness, corporations behave in the exact opposite manner recommended by Chase. They tend to increase the equity portion of the asset mix. Many corporations across the globe have already transitioned or are in the process of transitioning to defined contribution plans. Given the risks and liabilities that many corporate defined benefit plans have faced in the past decade, it would seem logical that managers might have already taken the approach recommended by Chase. Despite other options, corporate financial health often determines the outcome of defined benefit plans, when corporations increasingly file for protection or bankruptcy, as in the US. The recommendations may be useful for corporations that have managed to survive recent economic conditions relatively intact. Asset mix can always be re-determined on a yearly basis. The fact that defined contribution plans yield less than needed retirement income, as Suggested by Fuerst and Watson Wyatt, has little bearing on corporate decisions of which type of pension plan to offer. It seems logical that corporations will follow trends and choose to offer plans with less administrative costs, no risks to the corporation and an expected amount of employer contribution, for those where employee-employer contributions exist. More corporations, especially those in services industry, hire part time and temporary workers. It is advantageous to offer a defined contribution plan, so all workers can participate. The argument of increasing worker loyalty and reducing employment turnover costs with defined benefit plans also fails to take into account recent trends. Many employers no longer value loyalty over performance. This means that many older workers become displaced anyway, putting them at risk of not meeting retirement needs. Defined benefit plans are often not portable, so a taxable lump sum payment is what may occur when older workers lose their jobs. “If you believe all the rhetoric about employees having seven jobs over their working careers ... then a defined benefit plan is never going to generate for that employee a significant amount of retirement income, whereas participation in seven different defined contribution plans could." (Marks, 2001, p.6). Additionally, in cases of layoff or other job loss, defined contribution plans are easily rolled over into individual retirement accounts or others, with no tax liability. Summary/Policy Implementation Though defined contribution plans may fall short of providing adequate retirement income for many workers, this situation can be remedied with increased education and awareness for workers who participate. This should include realistic information about asset mix, financial market terminology and the potential risks. With increased education, workers can also make better or more informed decisions when job changes occur, as to how their current plans can be rolled over or ported. As defined contribution plans become more common, global policy in which all plans are portable and do not penalize workers for moving their plans can be adopted. Not only do workers change jobs more frequently today, they also tend to move more globally. This will give workers incentive to take lucrative overseas jobs which may be seen as career advances. In Western Europe, many nations have designed hybrid plans, which allow for freedom in choosing plans that fit the needs of the corporation and its workers best. Appendix B, illustration 2.2 provides a picture of how popular hybrid plans are becoming. Some shortfalls are increased administrative costs, though there is little literature to suggest this is the case with all corporations. The trend in some nations does suggest the need for innovative thinking in design and management of benefit plans. The suggestions of JP Morgan Chase indicate that greater flexibility is needed, whether in a defined benefit plan, defined contribution plan or some type of hybrid mix. For those corporations that still offer defined benefit, the recommendations of Chase can be incorporated into plan management regulations, requiring documentation that a complete analysis of corporate finance is being used to manage the asset mix. Though only defined contribution plans are required to provide periodic summaries of plan accounts to workers, this should be the rule with defined benefit plans as well. This will help displaced workers make appropriate decisions, should they move from a job with defined benefit to one in which defined contribution is offered. Selected Bibliography Baranoff, Etti, Brockett, Lee & Yehuda, Kahane. “ Types of Qualified Plans, Defined Benefit Plans, Defined Contribution Plans, Other Qualified Plans, and Individual Retirement Accounts.” Ebook. Available at http://www.flatworldknowledge.com/node/29698 Bogle, John. “The Amazing Disappearance of the Individual Stockholder.” Wall Street Journal. (October 2005). Available from http://www.vanguard.com/bogle_site/sp20051003.htm. Cocco, Joao & Volpin, Paolo. “The Corporate Governance of Defined Benefit Pension Plans:Evidence fom the United Kingdom.” ECGI - Finance Working Paper No. 76/2005. (March 2005). Available at http://ssrn.com/abstract=670685. Cohn, Scott. “Corporate Pension Plans Facing Huge Shortfalls: Study.” CNBC. (October, 2009). Available from http://www.cnbc.com/ 33121233.htm. Fuerst, Donald. “Defined Benefit Pension Plans: Creating Value for Employees and Employers.” MMC Homepage. (nd). Available at http://www.mercerhr.com/Fuerst200404.php.htm. JP Morgan Chase. “JP Morgan Chase Asset Management Recommends Corporate Finance Approach to Pension Management in the US.” White Papers. (June 2007). Available at http://www.jpmorgan.com/news/jpmorgan/am/ia/news/rec_corp_fin_012007 Krieg, John. “The Shifting Corporate Pension Landscape.” (October 2008). Available at http://www.northerntrust.com/ oct08_shiftingcorporatepensionlandscape.html. Marks, Susan. “Manufacturing Finds Defined Contribution Plans Work Best.” Workforce. (March 2001). Poterba, James, Rauh, Joshua, Venti, Steven & Wise David. “Retirement Wealth in Defined Benefit and Defined Contribution Pension Plans.” NBER Homepage. (November 2009). Available from http://www.nber.org/w12597.html. Siewart, Lynn. “Defined Benefit Versus Defined Contribution.” Advanced Corporate Planning. (2008). Transport Salaried Staffs’ Association. “Defined Benefit Pensions V Defined Contribution Schemes.” Your Workplace page. (nd). Available at http://www.tssa.org.uk/article-1.php3.htm. Wyatt Watson US. “Defined Benefit vs. 401(k) Plans: Investment Returns for 2003-2006.” (June 2008). Available at http:// http://www.watsonwyatt.com/us/ showarticle.asp.htm. Appendix A Table 1.1: Defined Benefit vs. Defined Contribution Defined Benefit Defined Contribution Employees Attracted and/or Most Benefited Longer tenure and/or older employees Shorter tenure and/or younger employees Job Tenure Patterns Encouraged Longer tenure because employees receive greatest benefit accruals at end of long-time service. May lock people into jobs they would otherwise leave. Although employees receive benefits based on salary, not tenure, may encourage employees to change jobs in order to receive access to lump-sum distribution from retirement accounts. Influence on Retirement Patterns Can be designed to encourage early retirement; may financially penalize workers for working additional years beyond the Normal Retirement Age. May pressure workers who would not otherwise retire to do so. Cannot be designed to encourage early retirement but instead rewards employees for working additional years. Cost/Funding Flexibility Concerns Cost variability/risk Employer assumes investment and possibly pre-retirement inflation risk, and therefore, annual plan costs are less predictable. While costs might be higher than anticipated, pension costs in a booming stock market may be zero because investment returns on past contributions. Employer assumes none of the investment risk on retirement fund assets. As a result, annual costs are more predictable although the employer cannot take advantage of high stock market or other investment returns on retirement plans assets. Annual funding flexibility However, there tends to be more flexibility as to when an employer may meet these costs contributions in defined benefit plans However, some types of profit sharing plans have less flexibility in when those costs are to be paid. In addition, defined contribution accounts can be designed to entail no employer contributions at all, unlike defined benefit plans. Termination benefits Termination benefits are usually small for employees with less job tenure Termination benefits equal account balances, when vested, based on both salary and years of plan participation. Tend to be larger than those for defined benefit plans, cet. par. Plan termination Can be very costly if plan is under-funded. Not applicable, because defined contribution plans are by definition never under-funded Administrative costs Managing a large pool of funds is less expensive than managing individual accounts, but may be more expensive because of the provision of annuities (which can be relatively complex to administer) and the need for professional actuarial and investment advice to ensure compliance with regulations. While actuarial services are not required to the extent necessary for defined benefit plans, the provision of participant investment education and the cost of administering many individual funds for loans, hardship, and/or retirement benefits may make defined contribution plans more expensive. However defined contribution plans generally are less expensive to administer, especially for smaller employers. Integration with Social Security Benefits Employers fulfill a specific retirement income objective (e.g., to replace 60 percent of pre-retirement income with Social Security and pension benefits), and therefore, Social Security integration is accomplished more efficiently under defined benefit plans. Integration can be accomplished, but the process focuses on disparity in contributions and does not attempt to target a specific replacement ratio Providing Substantial Benefits Over a Short Time Period Employees can be grandfathered into a new defined benefit system so as to provide special benefits that are not possible under a defined contribution approach (e.g., the quick accumulation of benefits to participants who have not participated in the system for a substantial period of time). Unless grandfathered into a defined benefit plan, shorter tenure workers leave service with more substantial benefits under a defined contribution arrangement. Flexible Benefit Retirement Plan Provision Defined benefit plans cannot be part of a flexible benefit package. Some types of defined contribution plans (401(k) and profit sharing) may be included in a flexible benefit package. Linking Benefits with Company Performance Investment of pension assets in company stock is prohibited beyond 10 percent of assets. Employer contributions may be in the form of employer stock so as to tie company performance to retirement funds. In addition, profit-sharing defined contribution plans tie employee productivity to retirement security. Investment risk given to participants Employer absorbs investment risk in exchange for investment control. Employees absorb investment risk in exchange for potential investment rewards. Inflation risk given to participants COLAS may be provided and are often done so for public plans. Employer may share responsibility for inflation after retirement if ad hoc COLAS are used in private plans. Employer assumes pre-retirement risk if defined benefit formula is based on final averages. No room in plan design for COLA adjustments. Employees assume risk for inflation both prior to and after retirement. Opportunities given to participants No pre-retirement access to accounts is usually provided. Pre-retirement access to accounts is often provided. Benefit provided at retirement Benefits are usually paid in the form of life annuities. Benefits are usually paid in the form of lump-sum distributions, with which the employee may spend as they please. Automatic enrollment? Enrollment is automatic. Enrollment usually is not automatic. Investment Horizons and Expected Impact on Investment Income A defined benefit plan allows the burden of retirement security (including the attendant investment risk) to be spread over a long period of time. In theory, defined benefit plans may be expected to hold a larger percentage of more risky (and higher yielding) investments since their relevant investment horizon spans several decades if the plan is assumed to be an ongoing operation. A defined contribution plan usually requires employees to invest for their retirement on an individual basis. This may cause them to increase their asset allocation in less risky (and lower yielding) investments to mitigate the impact of market downturns near retirement age. Tax Advantages In defined benefit plans, only employer contributions are given tax-favored status. In defined contribution plans, both employer and employee contributions may be given tax-favored status. Appendix B Illustration 2.2: Comparison of Defined Benefit and Defined Contribution Across Europe Read More