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INSURANCE / SOCIAL SECURITY
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Watson Wyatt has analyzed the contrasting investment risks faced by defined benefit pensions and 401(k) plans during the current financial crisis. The predictable, mainly guaranteed income of pensions (including hybrid plans like cash balance plans) contrasts sharply with the day-to-day fluctuation of 401(k) account values, which are wreaking havoc on planned retirements. “We are in uncharted territory. The 401(k) plan has been around for less than 30 years, and we’ve not yet had a generation of workers retire on all or mostly 401(k) assets,” said Alan Glickstein, a senior retirement consultant at Watson Wyatt. “What happens when market volatility makes 401(k) investment returns and retirement income anything but predictable?”
Individuals bear investment risk in 401(k) plans, but with pensions, companies take on the risk and the incentive to provide benefits in a more cost-efficient manner. With pensions, sponsoring companies invest assets as one large pool and with a longer time horizon than individual employees. They can, therefore, more easily ride out market downturns. In addition, pension plan assets are guaranteed by the sponsoring company, as well as the Pension Benefit Guaranty Corporation, for most benefits.
“The current environment underscores some latent employer risks with 401(k) plans, ” says Glickstein. “For example, they make it harder for companies to predict who will retire and when. Employees who mostly rely on 401(k)s are also more likely to worry about their financial security, creating an additional drain on morale and productivity during turbulent times.”
Employers providing pensions are dealing with new funding rules that became effective in 2008. Companies must fund their pensions based on the value of plan assets relative to liabilities (the present value of projected retirement payouts based on accrued benefits). Under the prior funding rules, pension sponsors could smooth their asset values based on market returns over a five-year period. Under new rules created by the Pension Protection Act of 2006, companies can only average returns over a two-year period, and the averaged assets cannot exceed current market value by more than 10 percent. The new rules are much closer to the so-called mark-to-market rules that have been implemented in corporate accounting. Assets are “marked” or valued at what the market will pay for them on a given day, rather than smoothed over time.
“The federal bailout of the credit markets is an acknowledgment that in extreme cases, the mark-to-market principle does not work,” said Kevin Wagner, a senior retirement consultant at Watson Wyatt. “This crisis should increase pressure generally to revisit mark-to-market principles. Without some relief, a sustained downturn in asset values will noticeably increase required contributions to pension plans starting next year, when plan sponsors will also be facing significant business pressure.”
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