Monday, June 20, 2005

Defined Benefit vs. Defined Contribution Retirement Plans

“What is the meaning of “substantially equivalent?”

by Charles R. Mansfield
President, Laboratory Retiree Group, CLE Executive Council

The issue of Defined Benefit vs. Defined Contribution retirement plans has recently come into national prominence with the financial problems facing United Airlines, General Motors and other corporations. This issue is also a point of contention in the rebid of the contract to manage the Los Alamos National Laboratory. This is especially true in light of the promise that the new plans will be “substantially equivalent” to the plans offered under the present contract with the University of California.

First, let us examine the differences between these two types of retirement plans. A Defined Benefit plan states that the members of the plan (annuitants) will receive a certain amount of money per month upon retirement. The formula for calculating the amount promised to the annuitant may depend on factors such as age at retirement, number of years of service, and the amount of money earned at or within a few years prior to the time of retirement. A Defined Contribution plan only states that the employee and/or the employer shall contribute a certain amount of money per pay period into an account for the member. Examples of Defined Contribution plans are 401k and 403b programs.

Where does the money come from that is paid to a pensioner from a benefit plan? The simple answer is that the money comes from investment of the account funds. The primary investment vehicles are usually stocks and bonds. Large organizations such as United Airlines and the University of California can take advantage of the efficiencies of scale and the ability to hire competent fund managers (trustees) in order to provide benefits with the minimum cost. What then is the difference between a Defined Benefit and a Defined Contribution plan. The answer is simple. A Defined Benefit plan must maintain sufficient funds to provide the promised benefits during times of economic slowdown. A Defined Benefit plan trustee may have to adjust the amount of payment to the plan in order to ensure sufficient income to cover the costs of operation. Defined Contribution plan compensation varies with the overall national economic health, which determines the return on investment. A trustee may have to adjust the compensation (annuity) from a Defined Contribution plan to ensure the costs are covered. In other words the benefit payments of a Defined Contribution plan may decrease significantly during periods of an economic slowdown.

The concept of pension plan funding is simple. So, what is the problem? The answer can be illustrated by the following story:

If you put a pot of honey in a forest, a bear will come along and put its paw in it. You can’t blame the bear because the bear is doing what bears do. If you put a pot of money somewhere, everyone (Corporate Managers, Legislators, Administrations, Courts, individuals ...... ) will come along and put their paws in it. ....

Why did you put an unprotected pot of honey out in the forest in the first place? This bring us the question of the reliability of the trustee. The job of the trustee is to manage the funds (guard the pot of honey) in a proper manner. Congress set up an insurance program to help make certain that the funds are there for each retiree. Unfortunately, it now appears that the trustee did not do its job in the case of United Airlines. According to some news reports, sufficient payments were not paid into the pension funds and insurance premiums were not paid to the federal insurance plan. >From the news reports it is not certain who the trustee was. It could have been United Airlines, the employees union or a third party who assumed liability for proper maintenance of the fund. Cases of fund mismanagement by all of the above have occurred.

In the case of the University of California Retirement Plan (UCRP), the plan has been funded and managed very well. Governors Wilson and Schwarznegger attempted to gain access to the UCRP funds to help balance the State budgets. In both instances they were unsuccessful in their attempts. Why would California Administrations attempt this attack? The reason is simple, the UCRP is so well funded and managed that employees have not had to contribute to the plans for around 14 years (a big pot of honey). Why were the raids on the UCRP unsuccessful? A part of the answer may lie in the recognition of employment contracts under California law. Employees and Retirees of LANL have signed contracts with the Board of Regents of the UC. The State of California recognizes employment contracts as legally binding. Two other factors help protect the UCRP from predation by the State and other governments. First, the Board of Regents of the University was established under an amendment to the state constitution. Second, the funds in the UCRP are not arranged by individual annuitant contributions. This makes establishment of a separate account for LANL annuitants very difficult, if not impossible, to accomplish for those currently enrolled under UCRP.

There is a great deal of confusion and concern about the federal Social Security System in relation to Pension Plans. While Social Security has some outward similarity to a Defined Contribution plan it is neither a Defined Benefit nor a Defined Contribution Plan. The monies in the Social Security system are not invested in the economy and do not grow in value with time. In fact, there is no money in an individuals account in Social Security. The only thing of “value” in a Social Security account is an IOU issued by Congress. Congress has borrowed the money to spend on other programs. As a result, the payments that an individual makes into Social Security are, in effect, taxes paid to fund welfare payments to the elderly.

Questions for employees and retirees to consider

All persons affected by the selection of a new contractor to manage LANL should examine how their economic future will be affected by a new contract and then choose a course of action based on the answers. The central issue is that the Request for Proposals (RFP) states only that the new plan must be “substantially equivalent” to the present plan. The term “substantially equivalent” is a relatively strong statement but it does leave room for interpretation by both the contractor and contractee. Moreover, the RFP requires placing the LANL pension funds in a “separate, stand-alone plan.” Employees and retirees must satisfy themselves that such a plan would have the long term stability of the present retirement plan. From the standpoint of the DOE/NNSA a standalone plan would be transportable between future contractors. It is true that a Defined Contribution plan is more portable by the employee when moving to a new job. This portability is often limited by the number of years of service required for the employee to become “vested” in the plan.

The issue of interpretation is further complicated by the process of contractor selection. The selection of a new contractor takes place in two stages. First, the proposals by various bidders are evaluated and a winner is selected. At that point the DOE/NNSA must enter into negotiations with the winner to work out the details of the contract. It is possible that an agreement could not be reached. This would require that negotiations with the second bidder would begin. The permutations on this process are beyond the scope of this paper.

Employment Contracts

Once an agreement is made, then it is presumed that each employee will have to make a choice of whether or not to accept an employment contract with the new contractor. The employees may or may not be protected by the employment contracts that they sign. Some states, such as the State of California, do recognize employment contracts as a legally binding instruments. It is my understanding that the State of New Mexico does not recognize employment contracts. The critical question for employees is the degree of stability of any retirement pension under a new contractor.

Substantial Equivalence

While this term may have some legal strength, it is still open to interpretation. My personal feeling is that replacing a Defined Benefit pension with a Defined Contribution pension does not meet the standard of “substantial equivalence.” Since the final contract is subject to negotiation, will the present verbal assurances of substantial equivalence be converted to legally binding contract language?

Who will be the Trustee for the Pension Plan?

The relation of the plan trustee to the parties (employer and employee) is of extreme importance. Employers often favor the “company” being designated as the trustee. In this capacity the company can often claim the monies in a pension plan as an asset of the company. Those assets have been lost to the employee in the case of a declaration of bankruptcy on the part of the company. This loss has been extreme when payments to the pension account have been made in the form of company stock (Enron). On the other hand there are cases where employee unions have been able to deplete the assets without employee knowledge. Even the designation of a third party can have its pitfalls.

The ultimate question for employees is “Will any new pension plan have the same assurance of stability as the current plan”?

The LANL pension fund is between 2 and 4 billion dollars. With the health of social security in peril as the baby boomers start to collect, pensions become much more significant. 40-60% of the corporate employees in our nation are facing substantial shortfalls- some have lost their retirement funds.

The new LANL contract runs at least 7 years, we must insure that these monies are well protected and continue to grow under a good steward. Most of us would not select DOE for that task. Therefore we must impress upon our contractor the importance of guarding these funds.
I'm not sure that there is any way to know the answer to the question posed, but I don't think it is the "ultimate question". It is an important one, but one that is probably unanswerable because there is no way of knowing future events which will determine the stability of any pension plan. One make their best judgment as to do they feel secure enough and does it matter to them. There are many other issues for people to consider with regard to employment at Los Alamos, particularly for younger folks.
I will say it again and this post makes a strong case. There is no way any of my earned pension benefits is being transferred to anybody period. I don't care what they say or promise.
Since you are talking about public pensions as well as private, here is an article about some problems creeping up in public plans.


By Nanette Byrnes, with Christopher Palmeri in Los Angeles
BusinessWeek Online

How public pension promises are draining state and city budgets
I think anyone expecting a dollar-denominated pension of any kind that begins in 15 or 20 years, public or private, defined or otherwise, is in for a nasty surprise. Someone please explain to me how any pension beneficiary group will stop lawyers and politicians from looting the funds? They will change the laws and rewrite policies at the bidding of their corporate paymasters. Needs testing, reallocation, redefinition of benefits: all these will be used to reduce the pension liabilities, no matter what the plan type.
As far as the long term stability of any economic system is concerned, John Maynerd Keynes is reported to have responded to objections for his touting of Deficit Spending as a cure to economic woes "In the long run we are all dead."
Re "stability" of UCRP. Some quick math:

Let's say the fund currently has $3B (8:36 says it's between $2-4B), and continues to earn 8% per year. Let's further postulate that the average annual payout to retirees is $60K. This means the fund can currently support 4000 retirees without needing contributions from active employees.

Question: How many LANL retirees are there? UC-wide, the ratio of active to retired employees is projected to hit 2:1 by 2010 (UCOP's estimate). With 8000 active employees, this would be the 4000 retiree mark for LANL.

So by 2010 (plus or minus), even with NO CHANGE in our contract, active employees should expect to start contributing to UCRP. This is a simple demographics problem, the same one that's faced by Social Security. It's only going to get worse as lifespans continue to increase and as more and more Boomers reach retirement.

Bottom line: There is no reason for any employee under the age of 40 to expect a Defined Benefit pension plan to provide anything of the sort. If you're not protecting yourself by maxing out your own 403(b) account, you're not planning for retirement.

Personally, I'm kind of looking forward to working for a private company that might offer to match my 401(K) contributions.
Actually, UC has said that they may have to start making contributions in 2-4 years. One cannot expect to keep adding people to a pension program with no contributions indefinitely. On the other hand, if no new people are added to the LANL component of the pension plan, the math is somewhat better than the previous post indicates. The $3 B only has to last as long as the last annuitant lives. It can be drawn down over time as the number of remaining annuitants decreases. It should not be dependent on contributions from new workers as long as the funds are invested wisely.
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