Defined Benefit Pension Plans May Be Financial Crisis' Next Shoe to Drop

by: Cam Hui, CFA

Recently there has been much comment about problems at defined benefit pension plans - how underfunded they are, how they are the "next shoe to drop" in the financial crisis. Here is an example from Leo Kolivakis posted at Naked Capitalism.

Here is an equally fascinating earlier analysis from Leo at Naked Capitalism:

Plan sponsors had two choices. They could retain the 60%-40% asset mix but fund at the minimum and run the risk of deficits in market down turns. Most of them never believed that their companies would ever go bankrupt and so they did not think they were putting their members’ financial lives at risk.

Or they could invest solely in fixed income assets. This removed the asset-liability mismatch and resulting windup risk but it also meant lower long-term investment returns. Lower returns meant either increased contributions in the order of 30% or 30% lower benefits or some combination thereof.

Pension plans were deliberately running asset allocation mixes of 60-40 (stocks/bonds) because it was the cheap thing to do and not for risk control (asset-liability matching) purposes.

In other words, much of the problems today at DB plans were the result of past decisions. The chickens have come home to roost.