Defined Benefit Pension Plans and the Financial Crisis: Impact and Sponsors and Government Reactions

The global financial crisis of 2008-9 hit corporate defined benefit (DB) plans just as the new funding and other provisions of the Pension Protection Act of 2006 were being implemented. Both sponsors and the federal government reacted to the large shortfalls that developed. In this paper, the impacts and reactions are documented and the implications are evaluated. In particular, plans’ funding status dropped dramatically, sponsors reduced risk in investments, increased contributions, and changed plan design, while premiums paid to the PBGC nearly doubled, and the federal government, through regulations and legislation, provided some temporary and/or conditional funding relief. Because the relief is temporary, and discount rates are projected to remain low, the shortfalls largely remain, dependent on future developments in financial markets. For the longer-term, the heightened appreciation for risk, as affecting both DB and defined contribution plans, has led to proposals for a new, more flexible, DB-like plan type called the flexible structured plan and other changes in government policies

The New Pension Law and Defined Benefit Plans: A Surprisingly Good Match

Much of the commentary on the new pension reform law suggests that it will be deleterious to defined benefit plans. We describe the economic policy background leading to the new law, the law’s main funding provisions, and analyze the volatility of required minimum contributions, leading us to the opposite conclusion. The new law should improve benefit security, reduce contribution volatility, and encourage responsible management and creative plan design, thereby improving the environment in which defined benefit plans are sponsored by employers and retirement benefits are earned by workers

Life-cycle saving, limits on contributions to DC pension plans, and lifetime tax benefits

This paper analyzes questions related to defined contribution (DC) plans. For what types of households are statutory contribution limits likely to bind? How large is the lifetime tax benefit from participating in a DC plan and how does it vary with lifetime income? The authors find that contribution limits bind for households that begin their plan participation late in life or wish to retire early, single-earner households, those who are not borrowing-constrained, those with rapid rates of real wage growth, and those with high levels of earnings regardless of age. Setting contribution rates at the average maximum level allowed by employers and assuming a 4% real return on assets, the lifetime benefit rises from 2% of lifetime consumption for households earning $25,000 per year, to 9.8$300,000 per year. Contribution ceilings limit the benefit for high earners and are sensitive to the assumed rate of return.Saving and investment ; Retirement

Comparing the Economic and Conventional Approaches to Financial Planning

The conventional approach to retirement and life insurance planning, which is used throughout the financial planning industry, differs markedly from the economic approach. The conventional approach asks households to specify how much they want to spend before retirement, after retirement, and in the event of an untimely death of the head or spouse. It then determines the amounts of saving and life insurance needed to achieve these targets. The economic approach is based on the life-cycle model of saving. Its goal is to smooth households' living standards over their life cycles and to ensure comparable living standards for potential survivors. In the economic approach, spending targets are endogenous. They are derived by calculating the most the household can afford to consume in the present given that it wants to preserve that living standard in the future. Although spending targets under the conventional approach can be adjusted in an iterative process to approximate those derived under the economic approach, there are practical limits to doing so. This is particularly the case for households experiencing changing demographics or facing borrowing constraints. This paper illustrates the different saving and insurance recommendations provided by economic financial planning software and the practical application of traditional financial planning software. The two software programs are Economic Security Planner (ESPlanner), developed by Economic Security Planning, Inc., and Quicken Financial Planner (QFP), developed by Intuit. Each program is run on 24 cases, 20 of which are stylized and 4 of which are actual households. The two software programs recommend dramatically different levels of saving or life insurance in each of the 24 cases. The different saving recommendations primarily reflect ESPlanner's adjustment for household demographics and borrowing constraints. The different life insurance recommendations reflect these same factors as well as ESPlanner's accounting for contingent household plans and for Social Security's survivor benefits. The less detailed tax and Social Security retirement benefit calculations used in our implementation of QFP also explain some of the differences between the two programs.

Longevity-Insured Retirement Distributions from Pension Plans: Market and Regulatory Issues

This paper explores the extent to which retirees can and do insure themselves against longevity risk in private pension plans. We first review the theoretical and empirical results on the value of annuities, and discuss reasons why households may choose not to further insure themselves against longevity risk. We then analyze current trends in the private pension market, and find that the shift from defined benefit plans to defined contribution plans is likely to reduce annuitization rates among future retirees. This is driven primarily by the fact that the majority of DC plans, such as 401(k) plans, do not even offer participants a life annuity option at retirement. Thus, individuals who wish to annuitize generally must do so in the individual market where payouts are lower due to a healthier mortality pool. Hence, we can forecast that in the coming decades, absent institutional and regulatory changes, overall annuitization rates may fall and households may be increasingly exposed to the risk of outliving their financial resources, while the currently small private individual annuity market may witness significant growth. Finally, we discuss several policy options designed to increase annuitization of retirement resources.

Taxing Retirement Income: Nonqualified Annuities and Distributions from Qualified Accounts

This paper explores the current tax treatment of non-qualified immediate annuities and distributions from tax-qualified retirement plans in the United States. First, we describe how immediate annuities held outside retirement accounts are taxed. We conclude that the current income tax treatment of annuities does not substantially alter the incentive to purchase an annuity rather than a taxable bond. We nevertheless find differences across different individuals in the effective tax burden on annuity contracts. Second, we examine an alternative method of taxing annuities that would avoid changing the fraction of the annuity payment that is included in taxable income as the annuitant ages, but would still raise the same expected present discounted value of revenues as the current income tax rule. We find that a shift to a constant inclusion ratio increases the utility of annuitants, and that this increase is greater for more risk averse individuals. Third, we examine how payouts from qualified accounts are taxed, focusing on both annuity payouts and minimum distribution requirements that constrain the feasible time path of nonannuitized payouts. We describe briefly the origins and workings of the minimum distribution rules and we also provide evidence on the fraction of retirement assets potentially affected by these rules.

A Regulatory Framework for Strengthening Defined Benefit Pensions

Recent financial market and plan termination experiences have exposed the shortcomings of existing funding, disclosure, and premium rules governing private single-employer defined benefit pension plans in the United States. These rules were designed to provide predictability for plan sponsors and administrators, by insulating pension plans from the realities of economic and financial market fluctuations. Unfortunately current practice often overlooks key financial principles that arguably should inform a responsible set of pension rules and the insurance system backing the plans. We outline the key characteristics of pension plans needed to beneficially guide rule-making and offer examples drawn from proposed funding and premium rule