HARDEV SANDHU : Hybrid Pension Plans Can Help Guard Against Tumult of Stock Market
H ardev Sandhu is a pension and investment consultant in the Orange office of Mercer-Meidinger-Hansen, the world’s largest benefits consulting firm. Sandhu, an actuary who lives in Laguna Niguel, specializes in helping companies design retirement programs and development investment strategies for pension funds. As a result of last month’s stock market crash, Sandhu in a recent address to the Orange County chapter of the Professional and Industrial Relations Assn. advised retirement plan sponsors to consider reducing their exposure to market swings. His excerpted remarks follow.
The recent decline and continuing volatility of the stock market has focused attention on the health of America’s pension and profit-sharing plans. These plans own about 25% of all U.S. stocks. The effect of the market’s dramatic ups and downs on pension and profit-sharing plans, and on the millions of employees who are depending on them for a financially secure retirement, varies considerably.
For the millions of Americans who belong to traditional, “defined benefit” pension plans, the market crash has had little effect on their retirement benefits. These plans promise to pay benefits based on a formula that is usually related to salary and years of service with the employer.
The benefits paid are not tied to the performance of the pension plan’s investments. If the value of stocks held by these funds declines, employers may be required to make larger contributions in the future to make up for the losses.
For the millions of Americans who belong to increasingly popular “defined contribution” plans, however, the stock market crash may have significantly reduced the amount of money in their retirement accounts if they were heavily invested in stocks. In a defined contribution, or savings-type plan, employer and employee contributions are placed in an account and invested until the employee retires or leaves the company. An employee’s retirement benefits are based on the value of the account at the time of retirement.
For a defined contribution plan with 50% to 75% of its funds invested in common stocks, last month’s market crash probably reduced the value of employee accounts by up to 25%. Employees near retirement age suffered an even greater loss in the amount of retirement income that they can expect. The drop in interest rates that followed the market decline means that each dollar left in employee accounts buys less retirement income.
Some large institutions have said they are going to reassess the amount of stock market risk in their portfolios and perhaps reduce their exposure to market swings. Large institutions were sobered by the realization that on Oct. 19, the day the Dow Jones Industrial Average plunged an unprecedented 508 points, they simply could not control the amount of risk they were taking.
Long-term assets such as stocks, which may provide good inflation protection, are not going to appear as attractive if they carry the prospect of very high and sudden volatility.
Most big pension funds have not shifted their asset mix in response to the market downturn, because most big funds do not try to time the market’s twists and turns. One of the few to react was Chrysler Corp., which dumped about $500 million in stocks from its pension fund several weeks ago. The percentage of stocks held by the $3.6 billion fund was cut from 50% to 35%.
While it is distressing to an employer to see employees retire with less income than they had anticipated, it may not be possible or practical to make up the difference. If financial resources are limited, helping one group of employees may be impossible without hurting the remaining participants.
In reaction to the market crash, some observers have raised questions about the wisdom and fairness of transferring investment risk in a retirement program from employers to employees, which inevitably occurs with a defined contribution plan. They question whether defined contribution plans place too much responsibility in the hands of employees who may not be equipped to make the necessary financial decisions.
It would be a mistake for employers to rush to make major changes in their retirement programs simply because of a single major market move. However, this may be an ideal time for employers to re-evaluate their overall approach to providing retirement security.
Employers have adopted defined contribution plans in increasing numbers during the last two decades, because they are less expensive than traditional plans and because younger workers prefer them.
Younger workers like these savings-type plans because after they’ve participated for a few years, they can keep the funds that have accumulated in their accounts if they quit their jobs. Under traditional, defined benefit plans, workers don’t receive substantial benefits until they retire.
Employers could satisfy the needs of younger and older workers alike by seeking a compromise between the defined contribution and defined benefit plan.
One solution is to offer both types of pension plans. Under a dual system, workers wouldn’t accumulate as much money in their retirement accounts in their early years as they do under defined contribution plans. But the benefits received by those who stay with the same employer for 20 years or more would be less affected by and short-term market swings.
To be sure, a dual system would be more expensive for employers, but not prohibitively so. For example, if an employer is contributing 6% of pay to a defined contribution plan, a dual system can be designed so the total cost is approximately the same.
Another way to solve the problem would be to create a hybrid pension plan combining the most attractive features of both defined contribution and defined benefit plans. Hybrid plans are common in some countries, such as Canada, and have recently begun to be seen in the United States.
Hybrid plans typically contain some type of floor-offset arrangement, which specifies a minimum level of retirement income. If the defined contribution provisions of the plan are not sufficient to provide the specified level of income, the defined benefit, or “floor,” provisions make up the difference. In this case, the employer shares some of the risk of investment performance with the participants.
Employers could even make a new plan of this type retroactive to Oct. 1 to compensate for the recent market crash. With this approach, employers can help employees who are retiring now and amortize that cost into the future.
Companies with dual or hybrid plans might well enjoy a competitive edge that would easily justify the additional cost, and the additional protection will be appreciated by their employees next time the market experiences a dramatic decline.
