January 19, 2006

I. The Plans

1. Defined Benefit Plans Explained

   A defined benefit plan is one where the benefit is guaranteed without regard to the amount of assets in the plan. Traditionally, these plans guarantee a fixed percentage of the participant’s compensation multiplied by the number of years of service with the employer. DB plans are, by statute in most jurisdictions, required to be funded on a sound actuarial basis. This means that an actuary must analyze the projected cost of the plan using a series of predictive assumptions relating to future salary growth, mortality, investment performance, among others. These assumptions are used to determine the annual contribution necessary to ensure that a member’s benefit will be fully funded by the time that individual retires. Generally a minimum period of service is required to “vest,” or earn a guaranteed right to the benefit.

2. Defined Contribution Plans Explained

   Defined contribution plans provide a fixed employer contribution. The contributions are credited to individual accounts and may be invested collectively or as directed by each participant. The aggregate contributions and earnings at the time a member is eligible to retire constitutes the entire retirement benefits. It may be taken in the form of an annuity or as a single sum. No actuarial analysis is required. DC plans are highly portable and may be taken through rollovers from one employer to another. Unlike DB plans, vesting occurs on an expedited basis, or may even be immediate.

II. What Caused The Debate?

1. It’s All About the Money

   In the 1990′s, the dramatic rise in stock prices led to full or nearly full funding of many DB plans. As a result employer contributions were drastically reduced or eliminated in their entirety. Plan surpluses were used to create additional benefits with the future funding presumed to be available from continued superior market performance.

2. The Effect of Rising Contribution Rates

   When the stock market began its precipitous decline in 1999, there was no immediate panic among retirement plans and employers. Most plans employed actuarial “smoothing” or the averaging of returns over time to ensure a level employer contribution rate. As the downward market continued over a period of years (the worst three year cycle since the Great Depression) employer contribution rates skyrocketed.

   For example, Louisiana saw employer contribution rates for several of its statewide plans rise from 9% of payroll to over 25% of payroll within two budget cycles. A group of Louisiana cities and parishes (counties) sued, seeking a declaration that they were not required to pay these increased rates, despite a constitutional mandate that plans be maintained on an actuarially sound basis. The Supreme Court of Louisiana, ruling for the plan, held that relief from statutory funding requirements must come from the Legislature or through constitutional amendment rather than from the courts. See, Louisiana Municipal Ass’n v. State of Louisiana and Firefighters Retirement System, 893 So.2d 809 (La. 2005).

3. Dramatic Improvement in Plan Performance vs. Contributions

   Beginning in 2002, market conditions began a dramatic improvement, but contribution rates did not immediately decline. The actuarial smoothing employed to spread gains and mute early losses, had the effect of prolonging the impact of poor performance on employer contributions. Only in 2005 was the improved market performance first observed, more than three years after the down cycle ended.

4. A Few Problems Affected Everyone

   While virtually every defined benefit plan suffered losses equal to the market decline and employer contributions rose across the board, some spectacular failures created a new public debate about the future of defined benefit plans as the cornerstone of public employee retirement programs.

   The Houston, Texas Police Pension Fund was required to sue the City of Houston for substantial unpaid contributions. The case resulted in a settlement providing a greater contribution, but leaving a growing unfunded accrued liability for a future generation of public officials and taxpayers.

   In San Diego, California, an agreement to put excess earnings into additional benefits resulted in a calamitous unfunded liability after market returns declined. In 2002, an agreement was reached to permit the city to intentionally delay funding in return for enhanced benefits, which further increased the pension debt. In the wake of this multi-billion dollar liability, several current and former pension officials were charged criminally with breach of ethics and fraud charges claiming they accepted increased retirement benefits in exchange for permitting the underfunding.

III. Recent Legislative Activity

1. The California Adventure
   1. The Richman /Jarvis

      This constitutional and legislative initiative called for the closure of all defined benefit plans in California and mandated all future employees to be enrolled in a defined contribution plan with specific maximum contributions. The new plans did not provide either death or disability benefits. Constitutional restrictions in California required this new plan to apply on a prospective basis.

   2. The Public Employees Fight Back

      Faced with the prospect of firefighters and police officers in the proposed plan having no benefits should they be injured or killed in the line of duty, an aggressive public relations campaign was launched. The Governor was literally pursued at venues around the country criticizing his support for the effort. After a strong turn of public opinion against the initiative, the Governor withdrew his support.

   3. The Future of Defined Benefit Plans in California

      Improved market performance and declining employer contributions seem to have quieted the anti-DB forces for the moment. The strong ideological opposition, however, means that DB plans will enjoy at best an uneasy truce of indefinite duration.

2. The Alaska Disaster
   1. The Problem

      As a result of poor investment performance, Alaska’s state retirement system, which covers both state and city employees, experienced an unfunded liability. The response was a legislative initiative to close the system to new members and begin a DC plan for all new hires.

   2. The Cost of Not Being Ready

      Employee organizations were entirely unaware of the process until after the bill had already passed the State Senate. A late organizational effort stalled the bill in the Alaska House of Representatives until after the session expired. During a special session called by the Governor, the bill closing the DB plan was narrowly approved effective 2006.

   3. The Future of Defined Benefit for Alaska

      The adoption of Senate Bill 141 leaves Alaska with DB plans only for existing employees, and leaves open plans for the Alaska Railroad and the Electrical Workers plans. The only municipal plan, the Anchorage Police and Fire Pension System, was closed to new members in 1994. The absence of death or disability benefits for public safety employees and the relatively modest DC replacement is expected to have a substantial influence on recruiting and retention of future workers.

3. The Pendulum Goes the Other Way

1. The Nebraska Experience

   Nebraska conducted a legislative study in the early 1990s which concluded that DC plans did not provide an adequate retirement benefit. As a consequence, a new DB plan was created to replace the underperforming DC Plan.

2. The West Virginia Experience

   In a move mirroring Nebraska, West Virginia replaced its DC plan for educational employees with a DB plan in 2005. The bill was aimed at making teaching a more attractive profession

IV. The Status Of Defined Benefit Plans In America

1. The Corporate Plans
   1. 346 of the S&P 500 Companies Still Maintain Defined Benefit Plans
   2. 50% of the Fortune 100 Companies Still Maintain Defined Benefit Plans
   3. The Trend Away From Defined Benefit Plans was Slowing

      In early 2006, IBM, a longtime trendsetter in employee benefits announced it was freezing its DB and cash balance plans in favor of 401(k) DC plans. While it is too early to gauge the impact on private industry as a whole, it is expected to revive a trend away from DB plans that had been slowing.

2. Multi-Employer Plans
   1. The Effects of ERISA

      ERISA maintains specific statutory funding and actuarial requirements that do not apply to state and local government plans. The uniformity applicable to ERISA plans is not mirrored by the more than 2400 public plans, each of which has its own actuarial standards.

   2. The Cost of Participating in Multi-Employer Plans

      Private sector multiple employer plans charge a withdrawal liability to keep employers from avoiding pro-rata funding duties in underfunded plans. This potential liability has had the effect of retarding employer willingness to agree to unionized work forces.

3. Public Plans
   1. Defined Benefit is Still the Dominant Program
   2. Not All Scholars Support the Elimination of Defined Benefit Plans

      A study by the Wharton School of the University of Pennsylvania concluded that maintenance of a defined benefit plan is ultimately in the economic interest of both public employers and employees. See, Anderson and Brainard, “Profitable Prudence: The Case for Public Employer Defined Benefit Plans;” Pension Research Council, Wharton School, University of Pennsylvania (2004);www.nasra.org (Research and Resources).

V. Pros And Cons Of Defined Benefit Vs. Defined Contribution Plans

1. The Focus is on Who Takes the Risk
2. A “Pro for Employers” is Sometimes a “Con for Employees”
3. Plan Features
   1. Portability
   2. Benefit Levels
   3. Inflation
   4. Flexibility of benefit design
4. The Social Security Argument

VI. Volatility In Retirement Plans

1. Diversification, Asset Smoothing and Amortization
2. The Risks Associated With Long-Term High Returns
3. Investment Risk is Manageable
4. Defined Benefit Longevity Risk is on the Employer
5. The Effect of Inflation
6. DROP Plans and Benefit Design

VII. The Social Issues

1. The Cost of Delivering Benefits
2. Who Really Has the Higher Expenses
3. The Effect on the Capital Markets
4. What’s More Efficient for the Taxpayers
5. Paternalism

VIII. The Cost Of Closing A Defined Benefit Plan

1. Costs and Liabilities are Based Only on Current Membership
2. The Effect of Unfunded Accrued Liabilities
3. An Example
4. Use of Actuarial Methodologies

IX. Conclusions, Questions, And Predictions For The Future

FOR ANY QUESTIONS CONCERNING THIS PRESENTATION, CONTACT ROBERT D. KLAUSNER, KLAUSNER & KAUFMAN, P. A., 10059 NW 1ST COURT, PLANTATION, FLORIDA 33324, (954) 916-1202, (954) 916-1232 (FAX); bob@robertdklausner.com; WEBSITE :www.robertdklausner.com

¹ This lecture was delivered by the author at Harvard Law School Worklife Program on January 19, 2006.