Pension Trends   Volume IX, No. 4, November 2008    

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In this issue...

A First Look at the Impact of Plunging Stock Prices on Private Pensions
          

A First Look at the Impact of Plunging Stock Prices on Private Pensions

The day this article was penned, the Dow Jones Industrial Average (DJIA) dropped another five percent. For the week not yet ended, stocks are off about ten percent. To put that in an actuarial perspective, for most of the defined benefit plans we serve, we assume that plans will earn five-point five percent or six percent per year. Daily swings now equal or even exceed yearly expectations.

What would a prolonged stock market slump mean to the private pension system and more particularly to individual participants like you and me?

1. Delayed Retirement Expectations. For baby boomers, the bottom has been pulled out from under their 401(k) retirement savings; Their retirement nest egg is too small to retire on and it will be an unknown number of years before they can again think about retiring. For many, a dream of early retirement has been lost.
    
2. Changed Expectations for All 401(k) Plan Participants. Obviously, those nearest retirement are most impacted by the drop in value of their 401(k) account. However, while younger participants hope and expect that there is time for their accounts to recover to adequate levels before they reach retirement, younger participants may also need to rethink their retirement expectations.
   
   Suppose for example, it takes three years for the DJIA to get back to its December 31, 2007 level. That would require an annual average growth rate of about twenty percent – a robust rate by any historical standard. Thus, 401(k) participants will need four years of aggressive stock market gains just to get back to where they were four years earlier. The impact of this current four-year setback is akin to giving up the last four years of investment growth. Due to the effect of compound interest (dubbed by Einstein the eighth wonder of the world), a thirty-year-old today can expect his or her retirement savings to increase forty percent in the last four years of employment before retiring at age sixty-five. So even though a thirty-year-old’s investment losses may be modest and retirement still far off, when retirement age does arrive the impact can be severe.
    
3. Renewed Interest in Small Defined Benefit Plans. Unlike their 401(k) brethren, participants in defined benefit plans do not face lower retirement expectations. Benefits in a defined benefit plan are not tied to an account balance, but are instead based on an amount promised by the employer. It is the plan sponsor (employer) who bears the investment risk, not the employee. Defined benefit plan participants don’t have to worry about what each day’s stock market result means to their financial security in retirement. Now more than ever, it is the assurance associated with defined benefit plans that make defined benefit plans attractive.
    
4. Larger Defined Benefit Plan Contributions. The benefit assurance of a defined benefit plan is a double-edged sword. Baby boom aged owners know they will be able to retire at the appointed time with the amount of retirement income intended. However, to achieve this goal, such business owners will now have to contribute more to the plan to make up for the investment losses that have occurred. On the bright side, larger contributions mean higher tax deductions.
    
5. Delayed (2009) Impact on Most Defined Benefit Plans. Most defined benefit plans are valued at the start of the plan year. So, for most defined benefit plans funding for 2008 will be based on the value of assets as of January 1, 2008. It will not be until the 2009 valuation that the precipitous drop in stock prices will impact the minimum required funding. However, defined benefit plans may be valued at the end of the year. For those plans, NOW is the time to start planning for the 2008 contribution requirement. There are actions that can be taken to help mitigate the impact of the stock market losses.
    
6. A "Mixed Bag" Impact on Large Defined Benefit Plans. For large companies that sponsor defined benefit plans, a somewhat curious result may be fewer, not more, plan terminations. This is because many large defined benefit plans will be so underfunded that the plan sponsor cannot afford the cost to make the plan whole upon termination. In the interim, however, plan benefit accruals may be reduced or frozen. FAS 158 requires that many employers report the liability for its defined benefit plan on their financial statements. FAS 158 calculations are done as of the beginning of a year, so many companies are going to take significant earnings hits related to their pension plan underfunding at December 31, 2008.

It should not be surprising that there is little silver lining associated with the 2008 plunge in stock markets worldwide. However, we believe there are actions that plan participants, sponsors and advisors can take that can mitigate damages. Our suggestions will be covered in our next newsletter.

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This newsletter has been published in order to share general information with our professional contacts. The information presented in this newsletter should not be acted upon without first seeking the advice of a CPA, attorney or other benefit professional. 

Pension Trends, Volume IX, No. 4, November 2008
Copyright © 2008 Independent Actuaries, Inc.