This story has been updated.
Why should corporate employers keep those fuddy-duddy old defined benefit pension plans around when they can simply offer defined contributions that transfer risks to workers and don’t have as many regulatory burdens?
Because DB plans today are a better deal for plan sponsors, according to a study by Jared Gross, head of institutional portfolio strategy, and Michael Buchenholz, head of U.S. pension strategy, at J.P. Morgan Asset Management.
They declare that “the pension industry appears to have developed a collective blind spot” about DB plans, believing they offer little value. This blind spot, they say, is rooted in “dated assumptions, such as the notion that DB plans represent a disposable, noncore business that sponsors would be better off without.”
DB plans have long since recovered from the disaster they suffered from the global financial crisis of 2008 and 20090, when their ability to meet obligations, called funded status, tumbled. Despite a punishing time for investments last year, the average U.S. corporate pension funded status stood at 106.3% as of early November 2022, by the reckoning of MetLife Investment Management.
This has produced a whole host of advantages to sponsors and beneficiaries alike, Gross and Buchenholz contend. The upshot is that DB plans closed to new hires should be reopened, in their view.
The JPM study is echoed by a similar conclusion from Zorast Wadia, principal and consulting actuary at consulting firm Milliman. Among other things, he notes that 2021 federal legislation, the American Rescue Plan Act, boosts DB plans via ensuring that interest rates for them will not dip below 5%, thus padding their income.
DC plans have an unappreciated downside, the authors write: The employer match grows most years, as beneficiaries’ salaries increase. As they put it, “DC contributions must be fully funded by the sponsor—in cash, every year— while DB benefits can be fully or partially self-financed through a combination of returns on existing assets and a more flexible contribution framework.” Gross and Buchenholz calculate that a typical DC plan over 10 years will cost an employer $20 million, but a DB plan will cost just 15% of that.
DB plans, on the other hand, generate surplus returns that a company can make use of, even though they can’t spend it, they reason. Indeed, if a company creams off that surplus, when the funded status is above 100%, there’s trouble: Such a maneuver, called a reversion, triggers a heavy 50% tax penalty.
But wise sponsors can instead gain from keeping the surplus on the balance sheet as a cushion against funded status volatility. More important, the authors say, surpluses “can be used to finance new liabilities, serve as a currency in mergers and acquisitions, or pay for retiree medical costs.”
Rising interest rates are favorable to DB plans, as they reduce liabilities much faster than they do assets, per the JPM strategists. Higher rates do that through reducing the future value of asset earnings by, among other factors, increasing the cost of borrowing.
DB programs also help in the competition for employees, they say, who see a nice traditional pension as a form of income. Even young people, who expect to jump to other jobs, can gain a benefit. After all, if they stick around for five years—not a huge amount of time—they typically can be fully vested in a DB plan.
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Tags: Defined Benefit Plans, defined contribution plans, Funded Status, Interest Rates, J.P. Morgan Asset Management, Jared Gross, Michael Buchenholz, surpluses, vested