[quote=harvey]
The use of the term “funding” is unclear to me here. Are we talking about making the required contributions? (I thought you were.)
[/quote]
A little lesson on the difference between defined benefit plans and defined contribution plans…
DC plans are pretty simple. A specific dollar amount based on compensation is contributed to the plan each year. Each employee has an account balance. Risks of investment loss flow to participants.
Defined benefit plans (also sometimes referred to “target benefit” plans) provide a stream of annual pension payments to retirees at a specific retirement age. Funding is based on actuarial and other assumptions required to reach that target benefit.
Example: 30 year old employee earning $50K a year, with a target annual benefit of 2% of comp at 65 years of age. Actuaries compute how much is needed today in order to fund a $1,000 a year, 35 years from now, over the employees expected life. Assumptions have to be made about life expectancy, and pre and post retirement rate of return. Sounds a bit complicated, but it’s not, and annuity companies do this all the time, they’re very good at it. This amount would be the annual “normal cost”.
Where it gets a little more complicated is where the target benefit is based on final year of pay, and has COL adjustments, and vesting schedules. Employees do not have accounts, the fund, in total, needs to be sufficient to fund retirement benefits for all employees.
Each year, the total required to fund all current employees is computed. The difference between funds in the plan and the required funds is the pension liability for the year. (I won’t get into the details here, but some of that pension liability flows to the P&L, and some may not flow to the current P&L, as in cases of funding based on changes to plan design. Those changes may result in required funding for past service costs, which normally get amortized.)
If there are no changes to the plan, and the plan investment scheme meets the expected rate of return, generally the funding for the year will be the normal cost. That’s the amount the employer is required to contribute for the year. It is not a precise number, but actuaries really do know what they’re doing. It will be pretty damn close.
If investment results vary from the expected rate of return, the current required contribution will vary accordingly. During the roughly 15 years from 1990 forward, investment returns were generally significantly higher than expected, resulting in required contributions being significantly lower than normal costs. Employers (cities, counties, police departments, etc, in addition to private companies) had lower, sometimes significantly lower, current costs as a result of these higher returns. In some cases, some employers had no required contributions.
In other words, the annual costs for defined benefit plans were as low as zero. That’s significant savings versus defined contribution plans. Employers did NOTHING wrong by contributing zero. They didn’t skip required contributions. There were NO required contributions. The plans were fully funded. Plan sponsors saved millions of dollars as a result of these higher investment returns. Employees got nothing extra.
Then the shit hit the fan a few years ago, when investment returns were sharply negative. The required amount to fund all future payments was computed just as it had been in the past, but the fund balances at year end were signficantly lower than the required funding. Employers (plan sponsors) were required to make up that difference. That’s what caused the crisis.
There are all kinds of peripheral stuff that has also happened. For instances, plan sponsors at times negotiated retirement plan benefit increases, in leiu of current comp increases (See SDPD), which was easy since plans were already over-funded, those benefit increases were almost free. Seemed like a good idea at the time. But when investment losses hit the funds, those previously free or low cost increases, exacerbated the underfunding problems.
I hopefully didn’t skip anything terribly important. I think I hit most of the basics on how the plans work. Please excuse typos, if any, it’s a bitch typing all this crap on my phone.
