Do the Math For Lost Pensions

By Albert B. Crenshaw
Sunday, March 12, 2006; F08

As company after company across the country freezes or terminates traditional pensions, typically at the same time shifting to new or sweetened 401(k) plans, workers face a new and very important question:

How much do I need to save to make up for pension benefits I was expecting and now won't get? The answer, for tens of thousands of mid-career workers, is a lot.

Exactly how much depends on so vast a number of variables -- including the worker's age, the generosity of the original plan, the rate of return achieved under the 401(k) -- that no rule of thumb can be reliable.

But a study by pension expert Jack L. VanDerhei of Temple University and the nonprofit Employee Benefit Research Institute (EBRI) finds that middle-age workers who had generous pensions and who don't get particularly high 401(k) returns would have to sock away 20 percent of pay to save enough to buy an annuity to replace lost pension benefits.

The money doesn't all have to come from workers. It could be contributed by employers or could come from a combination of employee contributions and employer match, as is common today. But, since the cost of traditional pensions is commonly borne entirely by employers, whatever additional money a worker has to put in represents a pay cut.

That cut can come today, if the worker ponies up to have more retirement income, or later in the form of reduced retirement income. But either way, it's a cut.

How much?

Let's look at a specific example that VanDerhei worked out.

Assume a worker joined a company as he turned 30, expecting to work to age 65. Assume further that the company has a "final-average defined benefit" pension plan, a common type for middle managers, and that the plan promised a benefit calculated by multiplying the number of years worked times the average of the three highest years of pay times 1 percent.

Now assume that the worker reaches age 50 this year and is earning $70,000. If his pay goes up 3 percent every year, at 64 he will make $105,881, and the average of his "high three" years will be $102,827.

If the pension plan remained in place, his annual benefit would work out to:

$102,827 x 35 x 0.01 = $35,989

But look what happens if the plan is frozen this year, making his high-three average $67,980 and his years of service 20. His annual benefit, beginning at age 65, would be:

$67,980 x 20 x 0.01 = $13,596

This would leave him with $22,393 a year to make up out of his 401(k). VanDerhei figured that the worker would have to accumulate $299,536 in his 401(k) to buy an annuity "to fill in the gap created by the pension freeze."

To get there, assuming the asset allocation common for someone his age -- about 63 percent stocks at age 50 and declining to about 55 percent at retirement -- and a 10.5 percent return on stocks and 5.5 percent on bonds, he (and/or his employer) would have to contribute 12.87 percent of his pay for each of the succeeding 15 years.

If he gets only 8 percent return on his stocks, though, the required contribution rises to 14.3 percent of his pay.

Looking at hundreds of plans for his study, which was published last week by EBRI, VanDerhei found that to make up for a frozen final-average plan -- and such plans vary widely in their generosity -- the additional share of pay that workers and/or employers in the median plan would have to contribute to make up for lost benefits would be 8.1 percent if their 401(k)s were assumed to earn an 8 percent return. To make participants in three-quarters of all final average plans whole, the contribution rate on average would have to be 16 percent of pay.

If their 401(k) plans earned only 4 percent, however, a contribution rate of 13.5 percent would be necessary to cover participants in the median plan, and 21 percent to cover workers in three-quarters of such plans.

Other types of pension plans with less-generous benefit formulas would require lower contributions. Cash-balance plans, in which workers have a hypothetical account that is credited with a percentage of pay each year along with interest, would under some scenarios require new 401(k) contributions as low as 2.7 percent of pay to offset a freeze.

The good news, if you want to call it that, is that younger workers could, in theory, make up for their lost pension benefits with fairly modest 401(k) contributions. That is because they would have many years for their k-plan balances to compound.

But even those workers would have lost something: risk protection.

In a defined-benefit plan, the investment risks are borne by the employer, which is given tax benefits to pre-fund its pension obligations but is required to make up for deficit if the investment returns fall short.

When a company shifts to a 401(k), the risks don't disappear; they are simply shifted to the worker. General Motors Chairman Rick Wagoner acknowledged as much as the company announced the freezing of its pension plans for white-collar workers. "These changes will reduce financial risks . . . for GM," he said.

Further, there is no guarantee that the improved 401(k) matches that have accompanied pension freezes at GM, International Business Machines and elsewhere will continue through an employee's career. Generally, companies are free to raise, lower or eliminate their matching programs as they see fit.

And finally, the increased limits that allow workers to contribute as much as $15,000 to their 401(k) plans this year -- plus $5,000 for workers 50 or older -- are scheduled to expire at the end of 2010. At that point, unless Congress acts, the limit would revert to $10,500 plus inflation adjustments, meaning that to contribute the amounts VanDerhei's study indicates are needed, workers would have to make a portion of their payments in after-tax dollars.

Today, the private pension system provides about $120 billion to retirees and their families each year, the fruit of years of contributions and investments by employers.

Some big pension plans are in trouble, but most are not. Nonetheless, companies, including healthy ones, are shedding such plans wherever they can to rid themselves of the risk and expense. So workers are left to cast about for a system that decades from now will provide the equivalent of $120 billion a year, or see their living standards slide toward poverty.

What's it gonna be, folks?

* * *

The U.S. Circuit Court of Appeals for the 4th Circuit last week sent a sigh of relief through the life insurance industry in Maryland and states with similar laws by vacating a judge's ruling that a trust cannot have an "insurable interest" in a person. That would mean, in effect, that a trust couldn't own life insurance, potentially upsetting one of the prime estate-planning devices in today's financial marketplace.

Since life insurance death benefits are not subject to income tax but are included in the insured's taxable estate if he owned the policy, it has become common to set up irrevocable life insurance trusts to own big policies. When everything is done right, the policy proceeds escape tax altogether at the death of the insured.

But, in a case involving a trust as well as allegations of fraud, U.S. District Judge Claude M. Hilton ruled that the Transamerica Occidental Life Insurance Co. did not have to pay on the policy it sold on the life of Harald Giesinger not only because of misrepresentations in the application but also because the trust couldn't have had an insurable interest in Giesinger's life.

A three-judge panel of the appeals court sustained Hilton on the issue of misrepresentation, rejecting arguments by the trustee Vera Chawla that Transamerica ignored obvious evidence of Giesinger's poor health and therefore should have known about it.

But it set aside Hilton's ruling on the insurable interest question, saying it "appears to have unnecessarily addressed an important and novel question of Maryland law."

While Hilton's ruling is void and not available as a precedent, the appeals court did not say that his reasoning was wrong, merely that it was a thicket into which he needn't have plunged.

Maryland legislators are working on a fix that might resolve the issue, but in the meantime, insurance buyers and sellers are left to wonder what the court would have decided if it had addressed the question.

Chawla's attorney, William H. Crispin of Washington, also said the misrepresentation ruling will make it much easier for insurers to sell policies without paying too much attention to the insured's health and then rescinding them if the insured dies within two years.
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