The pitfalls of defined benefit schemes

Bruce Bartlett
Posted: Nov 23, 2001 12:00 AM
A new study suggests that defined-benefit pension plans were a key culprit in the stock market bubble of recent years. As the value of such plans were inflated by stock market gains, companies were able to withdraw excess pension assets, which went directly into corporate profits, further buoying stock prices. This is yet another reason for shifting workers away from defined benefit (DB) plans to defined contribution (DC) plans. Under a DB plan, which historically was standard for most workers, an employer promised to pay workers a specified monthly sum at retirement for as long as they lived. This sum was based on a formula that took into account wages and the number of years worked. It was often back-loaded so that a worker who spent, say, 20 years with the same employer got significantly higher benefits than one who only stayed 19 years. The law requires companies to have sufficient assets in their pension funds to pay promised benefits. But, should those assets grow more than necessary, companies can withdraw them because they, not the workers, own the funds. Under a DB plan, workers are only entitled to the specific benefit they have been promised no matter how large their pension fund is. The bull market of recent years led the value of many DB plans, which are heavily invested in stocks, to increase far more than necessary to pay promised benefits. As a result, plan sponsors were able to withdraw vast sums from their pension plans. According to Bear, Stearns, IBM took $1.24 billion out of its pension fund last year alone, accounting for 11 percent of the firm's operating income. DuPont took out $469 million, 10 percent of its operating income. As excess pension assets swelled the profits of many companies, their own stock prices rose. Thus, the bull market fed on itself as higher stock prices increased profits, which further increased stock prices. Today, of course, we are seeing the opposite effect. Falling stock prices are leaving many DB plans underfunded, forcing companies to take money out of profits to meet their pension obligations. Thus the bear market also feeds on itself, as lower stock prices reduce profits, which further reduce stock prices. This situation would be much more serious except for the fact that a majority of workers are now covered by DC plans. Under these, such as the popular 401(k) plan, employers make no promises to pay pensions at retirement. Rather, they and their employees put away money annually into individual accounts that the employee manages. At retirement, the worker either withdraws living expenses from the fund or converts the assets into an annuity. Since the worker, rather than the company, owns the assets of a DC plan, this means that he gets all the gains from a rising stock market. Moreover, he cannot withdraw such assets before retirement without paying a hefty penalty. Thus, while companies withdrew funds from DB plans during the bull market, workers continued to pour funds into DC plans. According to the Federal Reserve, there have been substantial net withdrawals from DB plans every year since 1995. Last year, companies took $36 billion out of them. By contrast, workers and employers added $55 billion to DC plans. Not only are all such contributions tax deductible, but there is no tax on capital gains, either. As the stock market rose, therefore, many Americans found that adding money to their 401(k) plans was the best way for them to benefit. Because workers have an incentive to increase their contributions to DC plans during rising stock markets and cannot withdraw their gains, the trend toward DC pension plans is very bullish for the long term. According to the Department of Labor, the number of workers covered primarily by a DC plan doubled between 1986 and 1996, from 12.7 million to 24.2 million. Over the same period, the number covered primarily by a DB plan fell from 28.5 million to 23.3 million. Not only is the trend toward DC plans likely to continue, it is spreading internationally, as well. In June, the Japanese government announced plans to give workers in Japan the opportunity of having a DC plan for the first time. It hopes that this will give a boost to that country's slumping stock market. DC plans are better for workers and investors, as well. Workers gain when stock prices rise, and investors of all kinds benefit because DC plans don't take their profits prematurely -- the way DB plans do -- and because DC plans eliminate the distortion in corporate profits caused by DB plans. The continuing shift from DB plans to DC plans therefore benefits everyone.