For many people, having an old-fashioned, defined benefit pension is a real retirement planning advantage. People who have them feel much more financially secure, both as they plan for retirement and after they actually pull the trigger.
But in the last 20 years, the number of workers with defined benefit pensions has declined, in large part because companies have been unsure about their ability to pay for them as retirees live longer. Plus, returns on fixed-income investments, which have been considered key to funding these plans, have been historically low, at least for the last half-dozen years.
That's all likely to change and defined benefit pensions will make a comeback, predicts Rich Rausser, senior vice president of client services at Pentegra, a retirement services company. Rausser wrote in a white paper: "Underlying macroeconomic trends such as the 30-year bull market in bonds, the decade-long stagnation in the equity markets and the lack of viable options to extend duration for pension investment managers all exhibit signs of changing for the better."
Rausser says that in the current low-interest rate environment, the typical defined contribution plan -- such as a 401(k) -- costs an employer about 6 percent of payroll. Meanwhile, the typical defined benefit plan today costs 17 percent of payroll. But it doesn't take very long for the situation to change if interest rates rise.
For instance, if interest rates go back to where they were in 2006 and 2007, the typical defined benefit plan would have a surplus of 115 percent to 125 percent, Rausser calculates. That would allow plan sponsors to use these excess dollars to fund the plans for several years without having to contribute anything additional. That makes a defined benefit plan much cheaper than a defined contribution plan where annual employer contributions are locked in.
So when will rates turn around and defined benefit pensions roar back? Rausser doesn't have a crystal ball, but he says some companies are already anticipating that day. At least one of his large company clients recently re-opened its frozen defined benefit pension plan. The company made that decision after running the numbers and concluding that any expansion of a 401(k) was already going to be at best cost neutral and possibly more expensive than offering a defined benefit plan, especially when the company took into account the cost of employee turnover, which defined benefit plans tend to reduce.
"The whole point of the white paper is that things are going to change dramatically once rates go up, and we shouldn't forget the impact of those changes on pension funding," Rausser says.