Ponder the State of Pension Plans Today

Your grandfather's defined-benefitpension plan may bean endangered species. Suchplans subject companies tohigh costs and risks that many prefer notto assume these days. As a result, it'sbecoming increasingly common to seethese plans eliminated.

Unlike a defined-contribution plan, adefined-benefit plan has some or all of itsbenefits guaranteed by the government-charteredPension Benefit GuaranteeCorporation (PBGC). If the plan terminateswhile it is underfunded the PBGC isrequired to make up the difference. Asyou might expect, terminating a defined-benefitplan is much more complicatedthan terminating a defined-contributionplan, such as a 401(k).

Tricky Business

Tempting fate:

Among the many factors that go intodetermining annual pension expenses,none is more critical than the assumedrate of return. If the plan assumes a highrate of return, the annual cost estimate isreduced. If a companylowers pension costs, the savings goright to their bottom line. Of course,hoping for higher returns doesn't ensurehigher returns. If those returns fail tomaterialize, the plan will become underfundedand annual costs will rise toreflect the additional deposits requiredto fully fund the plan.

During the late 1980s and 1990s,many plan fiduciaries increased rate ofreturn assumptions to reduce estimatedannual costs. Lulled by long marketadvances, their actuaries, employees, andlabor unions, as well as the LaborDepartment, bought into the decision.The plans eventually took higher levels ofrisk to attempt to meet their rate of returnassumptions. Unfortunately, they becamethe victims of inappropriate asset allocationthat failed to properly diversify theirportfolios. Then the market tanked.

The only way to ensure that a defined-benefitplan will not be under-funded is tobuy long-term bonds that mature as needed.In other words, the company mustmatch assets with future liabilities. Butthis implies a very low rate of return andhigh annual costs. Most defined-benefitplans have a mixture of stocks and bondsto increase the rate of return—the morevolatile assets in the plan, the higher theassumed return and risk.

Up, Up, and Away

Legislation enacted in July 2004relaxed funding standards across theboard. It specifically allowed two distressedindustries (ie, the airline andsteel industries) temporary additionalunderfunding in the hopes that they'llrecover. This legislation is a massive betfor the US government. If funding levelsdo not recover, the PBGC will be forcedto take on plans that are even moreseverely underfunded than the currentplans. And with the PBGC alreadyseverely in the red, the prospect ofallowing any employers to furtherunderfund their defined-benefit plansmay come back to bite the agency.

The airline and steel industries, whichwere already financially weak, were particularlyhard hit after Sept. 11. UnitedAirlines just moved to terminate all oftheir defined-benefit plans, dumping anadditional 120,000 employees into thesystem at a projected cost to PBGC ofover $5 billion. This follows the terminationof the US Air Pilot's Pension Plan andContinental's announcement that itwould not fund plans this year.

As one airline after another dumpspension plans on the PBGC, the temptationof the remaining airlines to dumptheir plans naturally increases. The airlineindustry is highly competitive, lacks pricingpower, and suffers from severe overcapacity.In addition, established airlinesare being undercut by start-up ventureswith much lower operating costs. Cuttingcosts by dumping their plans may be theonly way that some airline carriers cansurvive. Unfortunately, the US taxpayermay end up footing the bill.

Frank Armstrong III is the founder

and principal of Investor Solutions,

Inc, a fee-only, SEC-registered

investment advisor. He is also the

author of The Informed Investor: A

Hype-Free Guide to Constructing a

Sound Financial Portfolio (Amacom; 2002), which

is now available in paperback. For more information,

visit www.investorsolutions.com.