Who Killed the DB Plan?

story_images_gravestonesOver the past 20 years there has been a steady erosion of interest in DB plans while DC plans have become popular.  This change has occurred in part due to the growth in the size of DB liabilities and the increasing awareness that interest rate and investment risks embedded in DB plans can pose a major financial risk for sponsors. Solvency funding requirements have created financial havoc for several well known North American corporations. The publicity related to the financial impact on the financial heath of many companies in distress has heightened the awareness of DB plan funding risk. At the same time the legal and fiduciary risks and liability inherent in DC /401K plans is not appreciated or ignored by sponsors.

There are many factors that have contributed to the demise of private sector DB plans. I’ve listed a few major ones below.

a) Employers gave benefit increases away “like candy at Halloween”. Correspondingly, unionized employees often insisted on better pension benefits and early retirement with no appreciation for the eventual cash funding required and risk to the employer.

b) Many plan sponsors had no idea of the concept of risk (volatility) in terms of the impact of volatility of interest rates and equity returns on funded ratios nor did they have the time or resources to do this and, hence, they relied on someone else to look after this vital financial interest.

c)  For many years interest rates and equity returns were high (a version of “fat tails”) masking the potential for financial issues.

d) Somehow the concept of liability and asset matching got lost. Liability Driven Investing (LDI) should have been a basic principle and a legislated requirement right from the beginning. The actuaries should have beaten the drum harder about liabilities.

e) Boards and Pension Committees accepted the advantages of diversification without recognizing the limitations and, the risk of “fat tails” i.e., diversification does not work when it is needed most. Focusing on returns and “labels” i.e., value vs. growth, active vs. passive etc. etc.  was also far easier to accept than understanding the underlying risk concepts.

f)  The accountants and auditors who focused on a short term view of expenses, liabilities and deficits for a long-term obligation. Having different methods for calculating the accounting and funding liability and, different discount rates added to the cost, confusion and frustration.

g)  Equity managers and financial advisors  managed to emphasize the potential gains of investing vs. the risks. Funding requirements also played a role in this by delaying “paying the piper”. The common theme was “invest 60% in equities and 40%in fixed income and everything will be fine over the long term”. Unfortunately solvency funding is determined on a short term basis. Was this ignorance or intentional?

h) Organizations didn’t have the time or resources to understand DB pension liabilities and the actuarial and accounting implications. HR vs. financial people was often administrators and bought into the actuarial approach – but it wasn’t the whole story- not by a long shot.

i) A fragmented and piecemeal approach to managing the DB was common i.e., relying on actuaries, financial advisors and auditors rather than having a competent financially experienced administrator to oversee both sponsor and member interests. This resulted in confusion, wasted resources, and higher costs.

j) The financial advisors were often weak in the area of liabilities and accounting and focused primarily on assets. They tended to focus on relative returns (market based benchmarks) rather than on focusing on a primary return objective e.g. CPI +4% and absolute return strategies.

k) Legislation and regulators and sponsors did not keep up with the changing nature and requirements of DB plans. In the US however the regulators also added to the admin costs and confusion with ERISA, PBGC, TEFRA, DEFTA, PPA, EGTRRA, PFEA, OBRA, and TAMERA. In Canada, having 11 different sets of legislation and regulators was a sufficient hurdle.

l) Plan sponsors felt that transferring investment and longevity risk to employees through DC plans or RRSPs was a good idea.  They did not consider the impact on the employees’  retirement savings  and,  the new and daunting fiduciary roles, responsibilities and legal risks they were assuming with DC/401k plans.

m) The final point that has been over looked is that governance has been ignored in most plans as an effective management tool: the focus has been asset performance. DB plans if properly managed provide what most employees claim they want: very limited or no involvement in vesting, and a guaranteed pension income i.e., minimal risk represented by the risk of employer defaulting. 

The demise of the private sector DB plan is the result of many outside factors and to a large degree, a lack of attention by sponsors. The employer simply has more control of the retirement income outcome in a DB plan. The investment and return issues and problems related to DC/401K plans and members are no longer key issues: sponsors realize that encouraging the average CAP member to effectively become an informed balanced fund manager is extremely difficult and unproductive.  It is really a question of providing a pension program that is most effective in attracting and retaining employees i.e., DB vs. DC. Perhaps the best approach is to offer both types of programs or a hybrid plan and give the employees the option to select the one they are most comfortable with.

Pension governance is a process which focuses on having a prudent delegation process and approach to overseeing the pension program in place which has often been overlooked.  A good pension governance framework and internal compliance is the sponsor’s best defense if something ends up in court. How many sponsors fail in this regard – and will be eaten alive by lawyers who will point out the sponsor’s shortcomings from a fiduciary perspective.

Spending a small amount now to put in a governance framework for your DB or DC plan then monitoring the plans in an appropriate manner will mitigate the potential for costly legal risk and is money well spent.