Pensions Are Dying; Long Live Pensions”…At present, the only way a company can manage the risk of long-lived workers is to work them so hard that they die within a few years of retirement; this is not a good way to retain staff….”Financial Times, editorial, September 30, 2006
On Tuesday, March 7, 2006, General Motors (GM) issued a press release that was distributed to newswires and the usual business channels. In a briefly worded statement, it announced that all new employees hired by GM after January 1, 2007, would no longer be entitled to enroll or participate in the company’s traditional pension plan. The plan was being closed and frozen to all entrants. Instead, new GM employees would be given the option of participating in the company’s enhanced salary-deferred, tax-sheltered savings program, also known as a 401(k) plan. Employees who elected to join the 401(k) plan would have their contributions or savings matched by GM, up to a limit, as is usually the case with these ubiquitous plans. They would be given the ability to manage and diversify their investments across a wide range of stocks, bonds and other funds. In a sense, they would all become personal pension fund managers.
In the technical language of pension economics, GM had replaced its guaranteed defined benefit (DB) pension plan with a defined contribution (DC) pension plan. Like many other companies before it, and many others since, GM “threw in the towel” and went from a DB to a DC plan.
Oddly enough, despite the rather arcane nature of the news, GM’s stock, which before the announcement on Monday afternoon was trading around $19.80 per share, jumped up just as soon as the press release hit the newswires. By the end of trading on Wednesday, it settled at almost $21.30 per share. Clearly then, the shareholders and the market liked the news and rewarded GM by bidding up its share price.
Hundreds of companies have made the same move as GM in the last few years, and most of them have been similarly cheered on by the market. Major corporations are basically moving away from providing pension income for life. They are shifting the responsibility to you personally. This is why it is now more important than ever for you to take a very careful look at the myriad of assets on your personal balance sheet and answer this question: Are you a stock or a bond?
How Do Pensions Work, Exactly?At its essence, a traditional defined benefit (DB) pension plan is the easiest way of generating and sustaining a retirement income. When you retire from a DB plan, the employer via the pension plan administrator uses a simple formula to determine your pension entitlement. They add up the number of years you have been working at the company — for example, 30 years — and they multiply this number by an accrual rate — for example 2 percent. The product of these two numbers is called your salary replacement ratio, which in the preceding example is 2%x30 = 60%. And so, your annual pension income, which you will receive for the rest of your life as long as you live, is 60% of your annual salary measured on or near the day you retired. In the preceding case, if you retired at a salary of $50,000 per year, your pension would be 60% of that amount, which is $30,000 of pension income as long as you live.
Now sure, a number of DB pension plans have slightly more complicated formulas that are used to arrive at your pension income entitlement. The accrual rate of, say, 2% might vary depending on when you joined the plan, how much you earn, and perhaps even your age. In some cases an average of your salary in the last few years or perhaps your best year’s salary is used for the final calculation. Some pension plans adjust your annual pension income every year by inflation, whereas others don’t, which then results in the declining purchasing power of retirees over time. Nevertheless, regardless of the minutia, your initial income under a DB pension plan is computed by multiplying three different numbers together. The first number is the accrual rate, the second number is the number of years you have been part of the pension plan, and the third and final number is your final salary, or the average of your salary during the last few years of employment. Hence, the term, “defined benefit.” Here is the key point: You know exactly what your income benefit will be as you get closer to the golden years. This knowledge provides certainty, tranquility, and predictability. This arrangement was the norm for most large North American companies and their employees for more than 50 years. In fact, the earliest defined benefit pension plans have more than a 100-year history.