I give credit to the folks at www.401Ktoolbox.com for this article. I thought it was one of the best & simpliest explanation of the difference between defined contribution and defined benefit retirement plans. SWA uses a Defined Contribution Program (Profit-Sharing + a 401K Plan). We do not have a Defined Benefit program.
THE PENSION TIME BOMB: DEFINED BENEFIT PLANS
“The net effect is that many companies are way underfunded and facing a huge obligation to catchup.”
Last week, Delta Air Lines’ made front-page news by announcing that they were switching from a defined benefit pension plan to a less costly cash-balance plan. Over the past several weeks there have been several stories in financial publications, including the Wall Street Journal and Barron’s, about the problems some companies face with underfunding of their defined benefit plans.
How the Plans Work
To grasp the magnitude of the problem it’s important to understand the basics of how these qualified plans work. First of all, a qualified plan is simply a retirement plan that qualifies for special tax treatment. Basically the law says that if all employees are covered, contributions to the plan are tax deductible, by either the employer or the employee, and the assets in the plan won’t be taxed until money is withdrawn. In other words, it’s like an IRA on an individual level - money going in can be deducted, it grows tax deferred, and taxes are paid when the money is taken out.
There are two general categories of qualified plans: defined benefit and defined contribution . The most common defined contribution plans are Money Purchase and Profit Sharing plans. In a Money Purchase plan the employer is obligated to make a contribution each year, while in a Profit Sharing plan it is an annual decision, and the employer can forgo contributions if they choose. The contribution is usually specified as a percentage of payroll, and there are statutory limits on how much a company can contribute and deduct. 401k plans are a form of defined contribution where the employee elects to defer money from their pay, and the employer often matches a percentage of the employees’ deferral.
Regardless of the type of “DC” plan, the concept is easy to understand. Money goes into the plan and grows tax-deferred, and at some point in the future when the employee leaves the company or retires, the money in the account belongs to the employee. (There are usually “vesting” rules that require an employee to remain with the company for a specified number of years before they are entitled to the employer’s contributions.)
Upon separation from service, the defined contribution assets can be taken in a lump sum, rolled into an IRA, or annuitized and paid out over the participant’s lifetime. In short, money is put in today and whatever it grows to over time, good or bad, belongs to the employee.
A defined benefit plan is much more complex. As the name implies, in a “DB” plan the focus is on achieving a specified benefit in the future. A typical plan might provide an employee who retires at age 65 with 60% of their last three years average pay. For example, if an employee retires at age 60 and has earned $50,000 per year for the past three years, the plan might be obligated to pay him $30,000 per year for the rest of his life. To reach this “target” the company must make some complex actuarial assumptions. They use life expectancy tables to determine how many years the employee will probably live after retirement and they calculate how much principal will be needed to provide the $30,000 for that number of years. Then they work backwards to determine how much should be invested today to reach the amount needed to provide the“defined benefit”. A critical part of the assumption is the earnings rate on the invested assets. A higher expected return results in a lower current contribution obligation. If the plan is trying to reach a target number in 20 years, the company can invest less if the plan earns 8% per year than if the plan earns 4% per year. (chase comments: The money in the fund belongs to the company. It doesn’t belong to the employee. If the company goes bankrupt money, retirement pay is not guaranteed. Payoffs will depend on many factors but there is no guarantee .)
The Underfunded Mess
Each year, the company must project if they are on track to reach the defined benefit goal. If the actual investment results are higher than the plan assumptions, the plan might become “overfunded”. In that case, the company can reduce or even eliminate their contribution for that year because they are “ahead of schedule” so to speak. During the fantastic bull market of the 90’s, many plans experienced returns in excess of their assumptions, and rather than making a contribution they brought that money to the bottom line and boosted their earnings.
Unfortunately, as most individual investors have learned, the market doesn’t go up forever, and a hungry bear can turn spectacular gains into devastating losses in a hurry. It is a double barreled blow, because not only have the portfolios suffered huge losses, the companies must also reduce their assumptions for the future. The net effect is that many companies are way underfunded and facing a huge obligation to catch-up.
In October Barron’s published a list of companies, led by AMR Corp, Delta and General Motors, with plans that were underfunded by more than the entire company was worth just a few companies either. According to Credit Suisse First Boston, 360 companies in the S&P 500 had defined benefit plans and 240 of those were underfunded at the end of 2001.
What’s the Solution
There is no easy answer for corporations to get their retirement plans back on track - just as there are no easy answers for individual buy-and-hold investors who’ve suffered a similar fate.The best help would be an improving market that brings better returns. Accounting rules allow companies to smooth out gains and losses over a period of years. Many CFO’s are hoping and praying for a market turnaround they have to go to the other solution: pumping big bucks into the plan. If a plan remains underfunded, a company might be forced to direct its cash to pay pension obligations instead of making other strategic moves to grow the business. Just like an overfunded plan made the bottom line look good, a chronically underfunded plan can have a negative impact on a company’s earnings. Hopefully the market’s recent strength will continue and these worries will become nothing but memories. But meanwhile, the time bomb ticks.
Tim Chapman www.401Ktoolbox.com
THE PENSION TIME BOMB: DEFINED BENEFIT PLANS
“The net effect is that many companies are way underfunded and facing a huge obligation to catchup.”
Last week, Delta Air Lines’ made front-page news by announcing that they were switching from a defined benefit pension plan to a less costly cash-balance plan. Over the past several weeks there have been several stories in financial publications, including the Wall Street Journal and Barron’s, about the problems some companies face with underfunding of their defined benefit plans.
How the Plans Work
To grasp the magnitude of the problem it’s important to understand the basics of how these qualified plans work. First of all, a qualified plan is simply a retirement plan that qualifies for special tax treatment. Basically the law says that if all employees are covered, contributions to the plan are tax deductible, by either the employer or the employee, and the assets in the plan won’t be taxed until money is withdrawn. In other words, it’s like an IRA on an individual level - money going in can be deducted, it grows tax deferred, and taxes are paid when the money is taken out.
There are two general categories of qualified plans: defined benefit and defined contribution . The most common defined contribution plans are Money Purchase and Profit Sharing plans. In a Money Purchase plan the employer is obligated to make a contribution each year, while in a Profit Sharing plan it is an annual decision, and the employer can forgo contributions if they choose. The contribution is usually specified as a percentage of payroll, and there are statutory limits on how much a company can contribute and deduct. 401k plans are a form of defined contribution where the employee elects to defer money from their pay, and the employer often matches a percentage of the employees’ deferral.
Regardless of the type of “DC” plan, the concept is easy to understand. Money goes into the plan and grows tax-deferred, and at some point in the future when the employee leaves the company or retires, the money in the account belongs to the employee. (There are usually “vesting” rules that require an employee to remain with the company for a specified number of years before they are entitled to the employer’s contributions.)
Upon separation from service, the defined contribution assets can be taken in a lump sum, rolled into an IRA, or annuitized and paid out over the participant’s lifetime. In short, money is put in today and whatever it grows to over time, good or bad, belongs to the employee.
A defined benefit plan is much more complex. As the name implies, in a “DB” plan the focus is on achieving a specified benefit in the future. A typical plan might provide an employee who retires at age 65 with 60% of their last three years average pay. For example, if an employee retires at age 60 and has earned $50,000 per year for the past three years, the plan might be obligated to pay him $30,000 per year for the rest of his life. To reach this “target” the company must make some complex actuarial assumptions. They use life expectancy tables to determine how many years the employee will probably live after retirement and they calculate how much principal will be needed to provide the $30,000 for that number of years. Then they work backwards to determine how much should be invested today to reach the amount needed to provide the“defined benefit”. A critical part of the assumption is the earnings rate on the invested assets. A higher expected return results in a lower current contribution obligation. If the plan is trying to reach a target number in 20 years, the company can invest less if the plan earns 8% per year than if the plan earns 4% per year. (chase comments: The money in the fund belongs to the company. It doesn’t belong to the employee. If the company goes bankrupt money, retirement pay is not guaranteed. Payoffs will depend on many factors but there is no guarantee .)
The Underfunded Mess
Each year, the company must project if they are on track to reach the defined benefit goal. If the actual investment results are higher than the plan assumptions, the plan might become “overfunded”. In that case, the company can reduce or even eliminate their contribution for that year because they are “ahead of schedule” so to speak. During the fantastic bull market of the 90’s, many plans experienced returns in excess of their assumptions, and rather than making a contribution they brought that money to the bottom line and boosted their earnings.
Unfortunately, as most individual investors have learned, the market doesn’t go up forever, and a hungry bear can turn spectacular gains into devastating losses in a hurry. It is a double barreled blow, because not only have the portfolios suffered huge losses, the companies must also reduce their assumptions for the future. The net effect is that many companies are way underfunded and facing a huge obligation to catch-up.
In October Barron’s published a list of companies, led by AMR Corp, Delta and General Motors, with plans that were underfunded by more than the entire company was worth just a few companies either. According to Credit Suisse First Boston, 360 companies in the S&P 500 had defined benefit plans and 240 of those were underfunded at the end of 2001.
What’s the Solution
There is no easy answer for corporations to get their retirement plans back on track - just as there are no easy answers for individual buy-and-hold investors who’ve suffered a similar fate.The best help would be an improving market that brings better returns. Accounting rules allow companies to smooth out gains and losses over a period of years. Many CFO’s are hoping and praying for a market turnaround they have to go to the other solution: pumping big bucks into the plan. If a plan remains underfunded, a company might be forced to direct its cash to pay pension obligations instead of making other strategic moves to grow the business. Just like an overfunded plan made the bottom line look good, a chronically underfunded plan can have a negative impact on a company’s earnings. Hopefully the market’s recent strength will continue and these worries will become nothing but memories. But meanwhile, the time bomb ticks.
Tim Chapman www.401Ktoolbox.com
