NCPA - National Center for Policy Analysis


December 21, 2005

America's defined benefit pension plans are in crisis. Traditional defined benefit (DB) pensions are usually paid to retired employees based on years of work and final salary. Although still common at large companies, they have fallen out of favor at small and mid-sized firms, which have shifted to defined contribution (DC) plans, such as 401(k)s, says William B. Conerly, a senior fellow at the National Center for Policy Analysis.

The majority of existing DB plans are significantly underfunded. The crisis stems from the growing number of retirees receiving DB pensions and the growing number of companies forced into bankruptcy due to benefit costs. When companies default on their obligations, workers receive benefits from the federal Pension Benefit Guaranty Corporation (PBGC).

The problem stems from built-in incentives for corporations to underfund their pension plans, explains Conerly. The law requires companies to put aside funds to meet their promises to workers, but the law lacks teeth. For instance:

  • Companies can average their investment results so they have years to make up bad stock market returns.
  • DB plans mostly pay a fixed tax per employee, meaning workers entitled to the maximum guaranteed annual pension of $38,000 cost as much as workers entitled to less than $10,000.

Although severely underfunded plans must pay a penalty tax, it is trivial. A company underfunded by $5 million faces an extra tax of just $45,000. As a result, companies leave their pension plans severely underfunded for many years.

The present crisis shows that DB plans are risky and the PBGC is fundamentally unsound. Employers are already making the transition to DC plans voluntarily. A transition from PBGC to private insurance will put employee pension benefits on a sound footing, while eliminating risk to taxpayers, says Conerly.

Source: William B. Conerly, "The Defined Benefit Pension Crisis," National Center for Policy Analysis, Brief Analysis No. 540, December 21, 2005.

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