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The Rise and Demise of Corporate Pension Plans

The Rise and Demise of Corporate Pension Plans
September 06
00:03 2017

(The following is an excerpt from a chapter of the book From Cradle to Retirement – The Child IRA – How to start a newborn on the road to comfortable retirement while still in a cozy cradle.)

In April of 2001, The Economist decided to write a story exposing the unfortunate mathematical vulnerability of pensions. The well-respected international financial periodical chose to lead off with this sentence: “When Gertrude Janeway died in 2003, she was still getting a monthly cheque for $70 from the Veterans Administration—for a military pension earned by her late husband, John, on the Union side of the American civil war that ended in 1865.” The next paragraph summarized the article’s stern warning:

“A pension promise can be easy to make but expensive to keep. The employers who promised higher pensions in the past knew they would not be in their posts when the bill became due. That made it tempting for them to offer higher pensions rather than better pay. Over the past 15 years the economics of the deal have become clear, initially in the private sector, where pensions (and health-care costs after retirement) were central to the bankruptcy of General Motors and many other firms.”

Much has been written lamenting the near extinction of the corporate pension plan. Are reports shaded by rose-colored glasses? Pension and retirement experts familiar with the history of defined benefit plans have a rather different view.

The shift from an agrarian economy to a manufacturing economy prompted the need for some basic form of pension. In 1875, the American Express Company become the first private company in the United States to offer a pension plan. From this start, corporate pensions grew, slowly at first and mainly in the railroad industry, from 13 in 1899 to over 300 in 1919. Although many think companies offered pension plans to avert strikes and turnover, by 1920 it was quite apparent to corporations that pensions did neither. Instead, they viewed pensions as a way to define and communicate expectations regarding employee entry and exit from their employment. Even then, only a small percentage of workers stayed with their company long enough to earn a pension.

After ERISA, but before the introduction of the 401k plan, with the downward trend continued through the 1980s, and, again, before the 401k plan really took off. Only 38% of workers were covered by pension plans in 1980, while a mere seven years later that number had fallen further to just 31%. Ted Benna, the “father” of the 401k, says, “There is a widely held perception that we once had a wonderful retirement system where all employees received a pension. Only roughly 30% of the private work force were covered by pension plans when 401k hit the market. You couldn’t participate in the plan Provident Mutual had when I worked until age 30 if you were a male and 35 if you were a female. You had to stay until age 60 to have any vested benefits!!! In addition, when companies failed prior to ERISA, a large portion of the pension benefits were lost when an underfunded plan was terminated. It was far from a wonderful system.”

“ERISA?” You say you’re not familiar with ERISA? “ERISA” stands for the “Employee Retirement Income Security Act.” President Gerald Ford signed the ERISA legislation on Labor Day in 1974. ERISA came about as result of several high-profile pension failures, as well as a very effective media campaign. “The major events that stimulated the passage of ERISA were the Studebaker plan termination in the early 1960s, subsequent hearings that were held about pensions in response, the 1972 NBC documentary ‘Pensions: The Broken Promise’ (see http://archives.nbclearn.com/portal/site/k-12/flatview?cuecard=57200), and the Ralph Nader book You and Your Pension, published in 1973,” says Mitchell Langbert, Associate Professor Brooklyn College Koppelman School of Business. “Some of the problems included abuse of break in service rules, underfunding or pay-as-you-go funding, and unfair benefit accrual and vesting arrangements. Nader talks about them in his book.”

From the start, ERISA gave all the appearance of being very successful. “ERISA was intended to protect employee rights. ERISA’s eligibility, vesting, and funding requirements accomplished that very well,” says Bruce Gendein, president of The Senex Group and a specialist in tax-qualified retirement plans in Woodland Hills, California.

The problems it addressed, highlighted by the termination of the Studebaker pension plan. “There were essentially no funding requirements prior to ERISA, so a company could promise all these benefits in their defined benefits plan, but there was no obligation to set money aside to fund those promises,” says Adam Pozek, a partner and retirement plan consultant at DWC: The 401k Experts, based in St. Paul, Minnesota. “The other issue was that any money that was set aside wasn’t protected and was accessible by creditors to satisfy legal judgments, or by employers that wanted to use the money for other purposes (honorable or nefarious). ERISA was quite effective at addressing both these issues. It put protections in that require employers to fund defined benefit plans on an ongoing basis and it posed restrictions so that once the money was set aside, it couldn’t come back out for the employer’s use without being hit with a substantial excise tax. It also protects plan assets from creditors and legal judgments. As with any complicated law, in retrospect, you always see things that could have been done differently. Based on the objectives it was trying to achieve, it did an admirable job.”

But from these seeds of glory rose the monster that many believe would ultimately do in the pension plan.  “ERISA was created, in part, to provide greater security to participants and beneficiaries,” says Robin M. Solomon, an attorney in the Employee Benefits and Executive Compensation practice of Ivins, Phillips & Barker in Washington, D.C. “It met this goal in several respects. It created a system of federal insurance through the PBGC to guarantee the payment of benefits whenever a covered plan terminates with insufficient assets. It also established access to federal courts, where participants could recover benefits or enforce their rights to recover damages on behalf of the plan.”

ERISA created the Pension Benefit Guaranty Corporation – or “PBGC” – to prevent the Studebaker fiasco from happening again. While a noble, and in some ways successful intention, the law of unintended consequences soon reared its ugly head. “I used to sell defined benefit pension plans prior to the passage of ERISA,” says Benna. “It became impossible to sell them post ERISA due to the way PBGC is structured. The maximum benefit limits that were also part of ERISA played a major role in breaking the financial linkage of senior executives from rank and file employees. This was followed by the adoption of new accounting rules that made quarterly pension expenses very unpredictable. This financial uncertainty pressured senior executives to dump pension plans in an attempt to help drive up earnings thereby increasing the stock value for the benefit of shareholders and themselves. The defined benefit system would be dying even if 401k never happened and it will continue to die even if 401k is shut down tomorrow. I don’t rejoice that the defined benefit system is dying but it is a reality.”

For Preferred Members Only: Did the 401k Really Kill the Pension Plan? (Not a Preferred Member? Click here now to upgrade)

In December of 1985, the Financial Accounting Standards Board released “Statement No. 87” (commonly referred to as “FASB 87”).  FASB 87 changed the accounting reporting requirements for pensions, and this had a dramatic impact on all corporations offering pensions, most acutely among publicly traded companies. “FASB 87 required the use of the unit credit actuarial cost method in the context of recognition of pension liabilities on corporate balance sheets,” says Langbert says. “At that time managers were increasingly concerned about bottom-line performance because of an increasing emphasis on stock options in executive compensation. Anything that could boost stock performance in the short term meant potential returns to stock options, which magnify stock price volatility. Increased liabilities from pensions meant that a hostile takeover that involved a plan termination might boost balance sheet equity, hence the stock value.”

In requiring full accrual-based disclosure of pension liabilities and assets, FASB inadvertently provided vital information to arbitrage specialists. Indeed, this was precisely the them posed in the 1987 hit movie Wall Street. In that film, where Michael Douglass’ character Gordon Gekko famously declares “Greed is good,” we see the harsh reality of mathematics. Under the tutelage of Gekko, Charlie Sheen’ Bud Fox discovers the company his father (both literally and in the story, as the character was played by Martin Sheen) works for is worth more in liquidation than as a continuing operating business. Fox must decide whether to side with the dispassionate truth of corporate Darwinism or succumb to the emotion of family ties.

This Hollywood story was really “ripped from the headlines,” as such corporate takeovers were occurring regularly in the 1980s. “In many cases, like TWA, the corporate raiders used the companies’ overfunded pension plans to finance the takeover by terminating the pension plan, reverting the excess assets back to the company to be used as part of the takeover financing,” says Gendein. “It became a problem to the extent that Congress instituted a 50% excise penalty to discourage the practice. Pension plans move from overfunded to underfunded and back as funding and economic conditions change.”

As Benna states, the decline in pension plans began as soon as President Ford signed ERISA into law. “There was a gradual trend after passage of ERISA” says Langbert. “The compliance costs of regulation likely encouraged the trend toward plan termination. As well, global competitive pressures in the manufacturing sector made firms more cost-and-risk conscious. I recall the regulatory environment in the 1980s (ironically, during the Reagan years) as one of almost the end of the rule of law. Regulations were being passed so quickly and extensively that I was getting jet lag attending ERISA Industry Committee meetings. Large firms don’t mind constant regulatory shifts. However, I know of smaller firms that have been destroyed by regulation like MEPPAA (the MEPPAA stands for Multi-Employer Pension Plan Amendment Act).”

Pozek saw the first decline started between 1985 and 1990, followed by an even bigger drop-off from 1990-1995. “Since then,” he says, “the number of plans has remained relatively constant. There are a number of factors that have prompted private businesses to move away from defined benefit plans, but the primary reason is cost. As workforces and plan sizes have grown, these plans have become more expensive to maintain. Volatility in the stock market makes it harder to predict potential cash flow hits, and a drop in the market can lead to unexpected and significant expenses.”

The demise of the corporate pension plan in America, however, cannot be limited to domestic policy and actions alone. “Large public companies moved away from defined benefit plans when they started to compete internationally with companies in other countries who did not provide the same wage and benefit levels,” says Gendein.

To read the headlines today gives the appearance there’s a consensus among retirement policy pundits that “things would be better if only we had our old pensions back.” Despite these rosy memories, actual history shows, with a few notable exceptions, pensions were never as universal or as lucrative as imagined. Nor have corporate expenditures receded as much as it seems. “There’s a lot of talk in the media about how employers aren’t spending as much on benefits,” says Pozek, “but if you look back to the mid-80s, the bureau of labor statistics shows that the typical increase in wages has been in the neighborhood of 140%, and there has been an increase of spending on retirement benefits of about 150%.  But over that time period, employers have had to increase their spending on health benefits by almost 255%. So, you can’t look at the death of one benefit just on its own, you have to look at what else employers are spending on. The money has to come from somewhere. It’s a combination of all these factors that have put pressure on each other. There has to be a give and take on what employers are spending on.”

The larger truth we must face, though, deals not with dollars, but with change (and not the small kind). The world that birthed pensions no longer exists. The change from the industrial age changed the working habits of families and created a need for a “corporate” retirement. It is surprising, then, as we evolve from a population dominated by factory and office workers to one dominated by workers engaged in ever changing gigs, that our definitive of retirement will also change? And with that change in definition comes a change in the logistics of the preparation for and delivery of that retirement. “Pensions depend on a corporate feudalism that the labor economist Arthur Ross noticed in the 1950s,” says Langbert. “The labor market became more flexible because of global pressures, so the 20-year vesting schedules that existed before ERISA failed to address the needs of Boomers entering the labor market in the 1970s. The picture of stable employment relationships received a death blow when IBM had mass layoffs in the early 1990s.”

In theory, the traditional corporate pension plan remains as originally advertised. Unfortunately, in practice, today’s work environment just can’t meet the assumptions of that theory. Pozek says, “I don’t think that the corporate pension plan necessarily failed to provide an adequate retirement income. The workers who were covered by plans did receive pretty good benefits. However, as the plans became more expensive to maintain, you had fewer and fewer employers offering them and, therefore, fewer and fewer employees who were covered by them. The other factor that might lead to the impression that these plans fail to provide adequate retirement income is that they were designed at a time when someone landed a job and stayed there their entire career. These plans rewarded longevity, so they would pay out bigger benefits the longer an employee stayed. The average job tenure started to drop off from the mid to late 80s to today. Now, in certain segments of the workforce, the average tenure is less than 3 years. That’s a far cry from getting to a company and staying there for 30 years. So, with shorter job tenure, you have a shorter amount of time to accrue benefits.”

We tend to forget that the greatest value of a pension occurs in the final years of employment. With the trend in job-hopping, it’s less likely workers will ever get to those “final” years. “The actuarial value of a pension benefit builds dramatically from ages 50 to 65,” says Benna. “Having a pension is great if you stay with one employer for 30 plus years, and are covered by a final average pay plan. They don’t work well if you change jobs multiple times. In fact, an employee builds very little value prior to age 35 in a standard pension plan. As a result, agonizing over reviving defined benefit plans make sense only if we expect future employees to have only one or two employers during their careers that are willing to assume the financial risks related to such plans.”

So, why are pension expenditures increasing in the face of fewer and fewer eligible pensioners retiring from the workforce? Again, we must concede to that awful curmudgeon, math. Oh, and increasing life expectancy. “Contrary to long-held beliefs, corporate retirement pension plans were never intended to provide adequate income for retirees, says Gendein. “These plans were only intended to provide for part of an employee’s retirement income as one leg of the proverbial 3-legged stool, with the other two ‘legs’ being social security and personal savings. Even so, as workers’ life spans grew over the past few decades, there was an important paradigm shift: rather than providing a pension for 5, 10, or 15 years, suddenly these plans were expected to pay an employee for 2 or 3 decades of retirement. That means that if an employee had worked for the company for 30 years and lived in retirement for 20, the company was in effect paying them for 50 years. It created a very difficult – if not impossible – scenario in a competitive world.”

In 2005, two years after the last surviving Civil War widow died; thus, ending Civil War veteran pension payouts, Roger Lowenstein wrote in The New York Times Magazine, “It is not hedge funds or the real-estate bubble – it is the pension system, both public and private. And it is broken.”

There’s no point trying to put the proverbial genie of the pension plan back in its nineteenth century bottle. Our country, our culture, and our economy has moved on.

Christopher Carosa is a keynote speaker, journalist, and the author of  401(k) Fiduciary SolutionsHey! What’s My Number? How to Improve the Odds You Will Retire in Comfort and several other books on innovative retirement solutions, practical business tips, and the history of the wonderful Western New York region. Follow him on Twitter, Facebook, and LinkedIn.

Mr. Carosa is available for keynote speaking engagements, especially in venues located in the Northeast, MidAtantic and Midwestern regions of the United States and in the Toronto region of Canada.

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Christopher Carosa, CTFA

Christopher Carosa, CTFA

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