Pensions: Financing and Regulation

The development of a pension funding or budgeting plan starts with the economic and demographic characteristics of the group to be served. These characteristics can be observed, but the level of retirement benefits to be provided is an important decision that is influenced by the human resource management philosophy of the sponsor. The benefit level decision may also be influenced by the members, sometimes expressed through collective bargaining. The benefit level is often studied by using replacement ratios. The replacement ratio is (income rate after retirement/income rate before retirement).

After the qualitative decision on benefit level is made, the decision is quantified as a formula for benefits that may depend on age, service, and salary history. The cost and liabilities of a pension plan are derived by calculating actuarial present values (APV) of future possible payments. An APV is the product of an expected payment amount and the probability that the amount will be paid, and a discount factor that recognizes that, because of investment income, a dollar today is worth more than one due to be paid in the future. For example, suppose $1,000 will be paid in ten years to a person now age sixty-five if the person is then alive. The APV of this contingent payment at age sixty-five is: The probability of survival from age sixty-five to seventy-five in this example was taken from the 1983 Group Annuity Mortality Table (Females) and an investment return rate of 8 percent per year was assumed. In valuing the liabilities of a pension plan—the actuarial present value of future promises—many calculations of this type are required.

The next decision in constructing a pension plan is to select one of two broad classes of plans, defined benefit (DB) and defined contribution (DC). In the 1990s hybrid plans with some of the characteristics of both types of plans were introduced.

DB plans specify the benefit formula and it becomes the foundation of the funding plan. The sponsor may have a great deal of freedom in funding the plan. DB plans reduce the risk, the possibility of unfortunate events, for plan participants and allow sponsors some flexibility in making contributions to the pension fund. It is also fairly easy to include benefits for members near retirement age and the higher liability for these older members as part of the general liability of the plan. The members, however, will not have the satisfaction of watching an individual account balance grow, and the fixed nature of benefits causes the sponsor to manage the consequences of adverse experience as well as to benefit from favorable experience.

In a DC plan a set of defined contributions for each participant is determined with the objective of achieving the replacement ratio goal set in the initial planning. Each member can have the satisfaction of watching an individual asset account grow. The management of early withdrawals from the plan is easy because of the individual nature of the funding. From the sponsor's viewpoint, DC plans may reduce the flexibility in making annual contributions, but required risk management is far less because the pension obligation is met once the budgeted annual contribution is made.

During the period of rapid growth of private pension plans in the United States following World War II, DB plans were more common. Since the 1980s, DC plans have increased in importance. The early preference for DB plans can be attributed to pressure from organized labor to include workers near retirement age and to have the risk of deviations from expected experience managed by the sponsor. In addition, plan sponsors valued the ability to make actual contributions within a wide range. The shift to DC plans can be attributed to the satisfaction of members in observing an individual account grow, especially in periods of high investment returns, and the ease of managing the transfer from one pension plan to another in a period of high labor mobility. To sponsors DC plans seem to minimize their risk. Within a few years in the late 1970s and early 1980s, real rates of investment return (investment return rate - price inflation rate) went from negative to historic highs. This roller-coaster experience brought home to sponsors the financial risks of DB plans. The mounting costs of compliance with tax regulations and accounting standards also discouraged sponsors from adopting DB plans.