A Thought on Defined Benefits vs Defined Contributions

The Wall Street Journal described some of the problems with defined benefit plans—pensions.

When United Parcel Service Inc said last month that it was taking a noncash charge of $3 billion tied to its pension plan, the package-delivery giant blamed what might seem like an unrelated event: the downgrade last summer of several big banks by Moody’s Investors Service.

But the connection between the two incidents illustrates the complexities of calculating pension liabilities—and how little power companies have in keeping them under control.

UPS is typical, though, not at all unusual, in the problems they’re encountering with their pension plan:

Across America’s business landscape, the gap between the amount that companies expect to owe retirees and what they have on hand to pay them was an estimated $347 billion at the end of 2012.  That is better than the $386 billion gap recorded at the end of 2011, but the two years represent the worst deficits ever, according to JP Morgan Asset Management.

A big source of the problem: persistently low interest rates, set largely by the Federal Reserve.

I’ve written about the impact of those artificially low rates here and here.

There are additional major factors in arming this defined benefit bomb.

Putting a value on a pension liability is tricky business. Benefits for individual workers typically are based on their pay and years of service.  A company must also take into account how long retirees are likely to live.


Pension liabilities change over time as employees enter and leave a pension plan [including]…the fact that people are living longer.


For financial-reporting purposes, companies use a so-called discount rate to calculate the present value of payments they expect to make over the life of their plan.

The discount rate serves as a proxy for the hypothetical interest rate that an insurance company would expect on a bond today to fund a company’s future pension payments.  The lower the discount rate, the greater the company’s pension liabilities.

Boeing’s discount rate, for example, fell to 3.8% last year from 6.2% in 2007.  The aircraft manufacturer said in a securities filing that a 0.25-percentage-point decrease in its discount rate would add $3.1 billion to its projected pension obligations.

That discount rate falls out of those artificially depressed interest rates the Federal Reserve Bank is imposing on our economy.  And that, at the indicated drop in the discount rate works out to a nearly $30 billion increase in Boeing’s defined benefit—pension—liability over those intervening half-dozen years.

Here’s how Moody’s (entirely appropriate) bank downgrade enters into all of this:

Moody’s decision last summer to lower the credit rating of big banks hurt UPS and other companies by booting those banks out of the calculation [because those banks no longer were “safe” enough to have their rates included in the suite of rates used to estimate a discount rate].   And because bonds issued by some of those banks carried higher yields than other bonds used in the calculation, UPS’s discount rate fell 1.20 percentage points.

On the bright side, though, the WSJ article at the link suggests that

…just as falling interest rates have created a massive hole in pension funding, pension plans could quickly recover if interest rates started to climb.

This is a chimera, however.  When the Fed’s already long-term artificially suppressed interest rates are coupled with its massive money printing operation of the last few years, those interest rates will rise, but sharply, in an environment of explosive inflation.  All those dollars that will be paid out to (fixed income) retirees from their nominally recovered defined benefit plans will be worthless as prices those retirees pay with their dollars rise dramatically from that inflation.

Converting to defined contribution plans, like 401(k)s, removes all of these uncertainties from the companies’ liabilities—strengthening them, making them stronger competitors in the market, more stable employers, and so on.  In addition to this, a company’s failure to plan accurately, to fund appropriately its defined benefit plan given that planning, or just to avoid bad luck severely impacts all of its employees (its future retirees) and all of its current retirees.

In contrast, placing these retirement plans into defined contribution plans will let each employee make his own decisions about funding what is now his plan (rather than his employer’s catchall plan), how he wants to accumulate retirement savings, and all in accordance with his own goals and imperatives.  He can tailor his plan to his needs and desires, rather than being dependent on a plan that his employer must drive from a company liability perspective more than from a good for the employee perspective.

Also, should an individual employee fail to plan accurately, to fund appropriately his retirement plan given that planning, or just to avoid bad luck, he only impacts himself and a very few others.  The damage from failure of an individual’s defined contribution plan is enormously circumscribed compared to the damage from failure of a defined benefit plan.

Moreover, an American citizen isn’t as mind-numbingly stupid as our Progressive objectors to defined contribution plans make him out to be.  He’s at least as capable as a company—or a government—in making his own decisions about his future.

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