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Pensions Are Dying; Long Live Pensions

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Moshe A. Milevsky explains that with the decline of traditional defined beneft pensions, retirement income planning is more than just having the right mix of investments or saving enough in your 401(k) plan. A large sum of money in an investment plan—however you define large—doesn’t guarantee you a secure retirement. The strategy you employ and the products you purchase with your nest egg will be more important than the size of that nest egg.
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  • “...At present, the only way a company can manage the risk of long-lived workers is to work them so hard that they die within a few years of retirement; this is not a good way to retain staff....”
  • Financial Times, editorial, September 30, 2006

On Wednesday, August 25, 2010, construction giant, Caterpillar Inc., issued a press release that was distributed to newswires and the usual business channels. In a briefly worded statement, it announced that all management, support, and other nonunion employees in the U.S. would no longer be entitled to participate in the company’s traditional pension plan. The plan was being closed and frozen to all nonunion employees. Instead, new Caterpillar employees would be given the option of participating in the company’s enhanced salary-deferred, tax-sheltered savings program, also known as a 401(k) plan. Employees who elected to join the 401(k) plan would have their contributions or savings matched by Caterpillar, up to a limit, as is usually the case with these ubiquitous plans. They would be given the ability to manage and diversify their investments across a wide range of stocks, bonds, and other funds. In a sense, they would all become personal pension fund managers.

In the technical language of pension economics, Caterpillar had replaced its guaranteed defined benefit (DB) pension plan with a defined contribution (DC) pension plan. Like many other companies before it, and many others since, Caterpillar “threw in the towel” and went from DB to DC.

Hundreds of companies have made the same move as Caterpillar in the last few years, and most of them have been cheered on by the market. Major corporations are basically moving away from providing pension income for life. They are shifting the responsibility to you personally. This is why it is now more important than ever for you to answer this question: Are you a stock or a bond?

How Do Pensions Work, Exactly?

At its essence, a traditional defined benefit (DB) pension plan is the easiest way of generating and sustaining a retirement income. When you retire from a DB plan, the employer via the pension plan administrator uses a simple formula to determine your pension entitlement. He adds up the number of years you have been working at the company—for example, 30 years—and multiplies this number by an accrual rate—for example, 2%. The product of these two numbers is called your salary replacement ratio, which in the preceding example is 2% × 30 = 60%. Therefore, your annual pension income, which you will receive for the rest of your life as long as you live, is 60% of your annual salary measured on or near the day you retired. In the preceding case, if you retired at a salary of $50,000 per year, your pension would be 60% of that amount, which is $30,000 of pension income as long as you live.

Now sure, a number of DB pension plans have slightly more complicated formulas that are used to arrive at your pension income entitlement. The accrual rate of, say, 2% might vary depending on when you joined the plan, how much you earn, and perhaps even your age. In some cases an average of your salary in the last few years or perhaps your best year’s salary is used for the final calculation. Some pension plans adjust your annual pension income every year by inflation, whereas others don’t, which then results in the declining purchasing power of retirees over time. Nevertheless, regardless of the minutia, your initial income under a DB pension plan is computed by multiplying three different numbers together. The first number is the accrual rate, the second number is the number of years you have been part of the pension plan, and the third number is your final salary, or the average of your salary during the last few years of employment. Hence, the term defined benefit. Here is the key point: You know exactly what your income benefit will be as you get closer to the golden years. This knowledge provides certainty, tranquility, and predictability. This arrangement was the norm for most large North American companies and their employees for more than 50 years. In fact, the earliest corporate defined benefit pension plans have more than a 100-year history.

A defined contribution (DC) plan is the exact opposite of a DB plan and is a broad term that includes self-directed accounts such as 401(a), 401(k), and 403(b) plans. (In Canada they are known as Group RRSPs, or Capital Accumulation Plans.) Regardless of the exact name, in these plans there is no guaranteed benefit, or for that matter, any guarantee at all regarding pension income. As the name implies, only the contributions are known and determined in advance. The future benefit that you will receive upon entering retirement is completely unknown. If the stock market, or the particular mutual fund in which your money is allocated, experiences a bad month, year, or decade around the time of your retirement, then your nest egg will be much smaller. Anyone who retired around the financial crisis period 2007 to 2008 knows exactly what I mean by “bad timing.” In general, the responsibility, risk, and yes, the possible rewards, are in the hands of the employee as opposed to employer.

Once again, DC plans contain no formulas or income guarantee. In fact, they don’t really focus on retirement income at all. They are salary-deferred, tax-sheltered savings plans, where you and your employer contribute a periodic amount. Your final retirement nest egg will depend on how much you (and/or the company) contribute to the plan, how your investments perform on the way to retirement, and what you do with the money when you retire. A 401(k) is a number, not a pension. The amount of money in your 401(k) plan, at the time you retire, is unknown and unpredictable in advance. In the language of probability theory, it is a random number. Indeed, you might experience a bear market just before your retirement date, and the nest egg might lose 20% to 30% of its value, as most plans did during the bear market of 2008 to 2009. The 401(k) plan is, therefore, not a pension. You, the retiree, have to figure out how to convert this into some sort of pension—similar to the defined benefit pension described previously—as you transition into retirement.

I don’t mean to single out Caterpillar, because it is not the only company taking the DC course of action. Indeed, missing the evidence of the decline of traditional private-sector DB pensions is difficult. Countless company press releases, government studies, and scholarly reports have been documenting that DB plans are being frozen, replaced, and converted into DC plans such as 401(k), 403(b), and other hybrid structures. This is the new reality of personal finance. The responsibility is shifting to you.

The Continued Decline of DB Plans

Companies such as Boeing (January 2009), Anheuser-Busch (April 2009), Wells Fargo (July 2009), the New York Times (January 2010), Sunoco (June 2010), General Electric (December 2010), and McGraw-Hill (April 2012) have all taken actions similar to Caterpillar’s. These companies—and many more—no longer offer a traditional defined benefit pension to their new employees. In many cases, they have frozen or terminated the pension accruals for existing employees as well as new employees, which means that even current members of the pension plan will no longer be entitled to any more credit-years beyond those they have already accrued.

This isn’t a result of the recent crises or the Great Recession. A 2006 survey by the Employee Benefits Research Institute (EBRI) claimed that one-third of all pension plan sponsors in the U.S. with “open” plans—that is, pension plans that still accept new members—were thinking about freezing their DB plan in the next few years. From a different perspective, according to Towers Watson, way back in 1985 a total of 89 out of the largest 100 companies in the U.S. offered a traditional DB pension to their newly hired employees. The vast majority offered traditional pensions. By 2002, this number dropped to 49 out of 100 companies, and in 2010 it was down to 17 out of 100. My hunch is that when the 2012 figures are released, this number might be in the single digits.

Let me stress, though, that few of these companies are in any financial distress, contemplating bankruptcy protection, being liquidated, or filing for protection from creditors. Many of the previously listed companies are quite healthy, successful, and growing entities that have decided to simply throw in the towel and abandon DB pensions. Why exactly have they shifted this responsibility to you?

One of the main factors that has been contributing to this accelerating pension trend is something that we actually should all be thankful for—namely good health and increased longevity. We are living much longer than anybody anticipated or planned for when these defined benefit pension plans were originally designed and set up more than 40 years ago.

As you can see from Table I.1, back in the 1970s life expectancy (at birth) for the entire U.S. population was approximately 67 years for males and about 75 years for females. The average of the two was slightly below 71 years. However, in the last 40 years this number has marched steadily higher so that by 2010 the average life expectancy was approximately 79 years. This is an 8-year gain within 40 years. Now just think about what life expectancy might look like in 40 or even 80 more years. And that’s not the full story because these numbers only apply at birth. As you age the life expectancy numbers get better, not worse.

Table I.1. Up, up, and away

U.S. Life Expectancy at Birth (years)





























Source: U.S. Census Bureau and U.S. National Center for Health Statistics, 2010.

A few decades ago, pensions were small sums of money paid for a few years between a formal retirement date and the end of the human lifecycle. But now, this period that was intended and estimated to be 5–10 years is turning into 20 or 30 years. People are retiring earlier (with full benefits) from their pension plan and living into their late nineties.

The resulting pressure on the pension system and plans is an unsupportable retiree-to-active workers ratio. There are just too many retirees and not enough active workers, and therefore not enough revenue to go around to continue to support these payments.

Notice from Table I.2 that the number of retirees per 100 workers is projected to creep up as we move into the middle part of the century. Who will pay for these retirement benefits? How high will these ratios get?

Table I.2. Number of U.S. Retirees Per 100 Workers











2030 (projected)


Data Source: Social Security Administration, “The 2011 Annual Report of the Board of Trustees of the Federal Old-Age and Survivors Insurance and Federal Disability Insurance Trust Funds,” p. 48.

In the last 10 to 15 years, the U.S. has experienced a remarkable shift in the way retirement is being saved for and financed. A mere 15 years ago, the total percentage of “retirement assets” (broadly defined) sitting within traditional defined benefit (DB) plans was close to 25%, similar to the percentage in defined contribution (DC) plans. Yet, today, the percentage that is comprised of DB plans is less than 15%.

No matter how you look at it, one would be foolish to assume this trend of reduced DB coverage in the private sector will halt or reverse anytime soon. The only question is the magnitude and speed.

In fact, some consumer advocates and free-market economists argue that this trend away from the traditional pension system is actually a positive change. The idea is that the increased flexibility, mobility, and clarity of defined contribution plans are more in line with the needs of today’s more mobile labor force. For this growing group that plans to be with more than one employer over time, the 401(k), or any defined contribution plan for that matter, is the only option.

But, Are the Shareholders Happy?

Using extensive data on pension freezes, I—together with one of my graduate students—found that during the 10-year period from 2001 to 2011, an average of one to two publicly traded companies per month announced intentions to freeze or shut down their DB plan and either replace it with a DC plan or enhance their existing DC plan with better products, more choices, and greater matches. In addition to the companies I mentioned earlier, Kraft, American Airlines, Bank of America, and Walt Disney Co. are just a few of the major household-name companies that announced freezes to their plans between 2010 and 2012. In 2010, I published a study with Keke Song in the Journal of Risk and Insurance, studying the positive impact of pension freezes on financial markets. The bottom line was that over a window of 10 trading days before and after the announcement of a pension freeze or close, the average increase in stock price was approximately 3.96%. Relative to the S&P 500 index (or in risk-adjusted terms), the effect was even greater—approximately 4.2%. If we expand the event window to 20 business days before and 20 business days after, the aforementioned impact increases to almost 7.3% in risk-adjusted returns.

Our hypothesis for the likely reason is the capping of risk and not necessarily the reduction in compensation expenses or costs. Rather, companies have taken this unquantifiable longevity risk off their corporate balance sheet and transferred it to the employees’ personal balance sheets.

I think this further reinforces the important financial fact for twenty-first century retirement planning. Soon, very few groups of new employees entering the labor force will be able to rely on a DB pension plan to provide retirement income. Whether you are on the verge of retiring, or think you are much too young to even think that far into the future, the responsibility of generating income in your retirement will more than likely rest in your hands. As part of your holistic personal risk management strategy, this book will motivate you to start thinking about how you and your loved ones can help convert the 401(k) and the sum of money you have saved in your retirement nest egg into a true pension that provides a retirement income that you can’t outlive.

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