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Pension plans

The unprecedented economic crisis of 2008 and 2009, increased salaries of not-for-profit workers, and the implementation of certain funding provisions of the Pension Protection Act of 2006 ("PPA") created a "perfect storm" for not-for-profit organizations that maintain defined benefit pension plans.

Traditionally, not-for-profit employers offered defined benefit pension plans as a way to attract and retain valuable employees and to compensate for low salaries, relative to the for-profit sector. In the 50s, 60s, and early 70s, these plans were often contributory in nature, where the employee would have to contribute in order to be eligible for a benefit. After the adoption of the Employee Retirement Income Security Act of 1974 (ERISA), these benefit plans became non-contributory, placing the entire funding burden on the employer. During times of stock market growth and/or low interest rates, funding these plans was not a burden to the employer.

Recently, however, employers became more liberal with their investment strategies, gambling away plan assets, if you will, in the stock market, with the hope of making large returns. During the past two to three years, most employers who adopted such an investment strategy lost their investments. This left many employers with underfunded benefit plans.

Usually, having an underfunded benefit plan would not be cause for too much concern because the employer could selectively choose to fund only those liabilities that were close to coming due. For example, an employer would make sure that it could pay a benefit for a 60-year-old employee, but would not be too concerned if the benefit for a 30-year-old employee was not yet funded. Today, however, provisions of the PPA require that plans become fully funded within seven years and place very high minimum funding requirements on employers. Add to that the high salaries that not-for-profit employees can make (on which a benefit under the plan is based), and the resulting situation can be a not-for-profit employer whose donations and government grants are down and who is faced with a huge benefit plan funding obligation from under which it cannot escape (not to mention the increased need in this down economy for the services the employer provides to the public).

Some relief may be coming. In October, 2007, Congressmen Earl Pomeroy (D-ND) and Pat Tiberi (R-OH) introduced the Preserve Benefits and Jobs Act, which would provide some relief to the pension funding obligations employers are facing, while at the same time would protect workers pension benefits. Although not-for-profits are not the only group of employers impacted by this "perfect storm," their situation is unique in that most of them do not have huge resources to draw from and are limited in their ability to raise income.

Pension Regulation History

The origin of modern pension regulations can be traced to the 1960s. Prior to this period, employers and labor unions enjoyed a lot of flexibility in structuring, funding and managing pension plans.

"The history of ERISA can be said to have begun in 1961 when President John F. Kennedy created the President's Committee on Corporate Pension Plans. The movement for pension reform gained some momentum when the Studebaker Corporation, an automobile manufacturer, closed its plant in 1963; the pension plan was so poorly funded that Studebaker could not afford to provide all employees with their pensions." (Employee Retirement Income Security Act).

As a result, many employees received only a small percentage of the "actuarial value" of their pensions, and nearly 3,000 workers received none at all. The next milestone

"came on September 12,1972, when NBC broadcast Pensions: The Broken Promise, an hour-long television special that showed millions of Americans the consequences of poorly funded pension plans and onerous vesting requirements. In the following years, Congress held a series of public hearings on pension issues and public support for pension reform grew significantly." (Employee Retirement Income Security Act).

In 1974, Congress passed the Employee Retirement Income Security Act of 1974 (ERISA), designed to safeguard Americans whose retirement assets are maintained in employer-run pension plans. ERISA established minimum standards and requirements for private pension and employee benefit plans, to ensure "that funds placed in retirement plans during their working lives will be there when they retire." (U.S. Department of Labor/EBSA) The goal of ERISA was

"to protect the interests of employee benefit plan participants and their beneficiaries by requiring the disclosure to them of financial and other information concerning the plan; by establishing standards of conduct for plan fiduciaries; and by providing for appropriate remedies and access to the federal courts." (Employee Retirement Income Security Act).

ERISA also established the Pension Benefit Guaranty Corporation (PBGC), a federal corporation that provides "coverage in the event that a terminated defined benefit pension plan does not have sufficient assets to provide the benefits earned by participants." (Employee Retirement Income Security Act). Currently, the PBGC

"protects the pensions of more than 44 million American workers and retirees in more than 29,000 private single-employer and multiemployer defined benefit pension plans. PBGC receives no funds from general tax revenues. Operations are financed by insurance premiums set by Congress and paid by sponsors of defined benefit plans, investment income, assets from pension plans trusteed by PBGC, and recoveries from the companies formerly responsible for the plans." (Pension Benefit Guaranty Corporation).

Defined Benefit Plans

There are two types of pension plans: defined benefit and defined contribution. A defined benefit plan means that the participant (the employee) will receive a specified monthly benefit amount (i.e., the benefit amount is "defined) at retirement.

"The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service - for example, 1% of average salary for the last 5 years of employment for every year of service with an employer." (U.S. Department of Labor)

With a Defined Benefit Plan,

"the liability of the pension lies with the employer who is responsible for making the decisions. Employer contributions to a defined benefit pension plan are based on a formula that calculates the investments needed to meet the defined benefit. These contributions are actuarially determined taking into consideration the employee's life expectancy and normal retirement age, possible changes to interest rates, annual retirement benefit amount, and the potential for employee turnover." (Defined Benefit Pension Plans).

There are two types of Defined Benefit Plans: funded and unfunded. "In an unfunded defined benefit pension, no assets are set aside and the benefits are paid for by the employer or other pension sponsor as and when they are paid. (Defined Benefit Pension Plans). In contrast, a funded plan, collects "contributions from the employer, and sometimes also from plan members," (Defined Benefit Pension Plans) that are invested in a fund and managed by the employer or a pension fund manager.

"The future returns on the investments, and the future benefits to be paid, are not known in advance, so there is no guarantee that a given level of contributions will be enough to meet the benefits. Typically, the contributions to be paid are regularly reviewed in a valuation of the plan's assets and liabilities, carried out by an actuary to ensure that the pension fund will meet future payment obligations. This means that in a defined benefit pension, investment risk and investment rewards are typically assumed by the sponsor/employer and not by the individual. If a plan is not well-funded, the plan sponsor may not have the financial resources to continue funding the plan." (Defined Benefit Pension Plans)

Pension Fund Investment Trends

Pension funds invest the monies of their participants and manage them over the long-term in such a way as to provide a return that will guarantee future income for the employees in retirement. Traditionally, pension funds, including Defined Benefit plans, invested in vehicles that had established history and well-known risk profiles, such as equity (stocks of companies traded publicly). "In general, pension schemes around the world have historically invested in a combination of equities, high quality bonds and property." (How Will Pension Funds Manage?).

However, in the decade leading up to the 2007 recession, more and more pension funds -- like many other investors -- had begun to invest in a more "risky" vehicles, lured by the prospect of higher returns. As Stewart describes, "[f]ollowing a period of poor performance (and consequent underfunding) after the collapse of equity markets around the millennium, many pension funds adopted a new way of investing," (6) increasing the portion of their portfolios that were invested in to hedge funds "for two main, interconnected reasons. On the one hand, many pension funds [were] attempting to match assets and liabilities more closely to avoid under-funding in future (a trend which [was] being supported by regulatory and accounting changes). Hedge funds can be used to manage, reduce and indeed hedge such liability risks. Hedge funds also allow for risk reduction via increased diversification away from traditional equity market holdings (via holding in commodities, property etc.). On the other hand, this asset liability matching [provoked] a move into bonds which, coupled with the low-interest rate environment, [meant] that pension funds [were] are also been forced to think harder about how to generate return." (6).

As a result, many pension funds, including many of those of non-profit companies that in the form of Defined Benefit plans, moved away from holding traditional equity portfolios. As Stewart explains,

"[r]ather than holding traditional equity portfolios, generating most of their return from 'beta' or market return (which can be easily and cheaply obtained via passive, index products), pension funds are increasingly rethinking their investment approach and searching for 'alpha' or excess return over the market. More absolute return mandates are being given to fund mangers, who are also allowed to go short as well as long. In addition, pension funds are progressively more prepared to invest in a broader range of products -- from emerging market debt or equity, high yield fixed income, property, commodities, illiquid investments etc. Hedge funds are increasingly used as instruments to facilitate this new investment approach." (6).

Stewart outlines the various risks that pension funds were taking on with this new strategy, including

Operational Risk: "Due to the potentially risky nature of their investments, hedge funds were originally designed for high-net worth individuals," (6). However, pension funds are managed on behalf of "potentially 'subsistence' savings of…low-risk tolerance pension beneficiaries." (6).

Return Measurement: Hedge fund returns are only available for approximately the prior 10 years, thus real long-term return data was not available to judge the true risk of these investments. With pension funds tasked with fiduciary responsibility for their participants' lifetime investment income, this was not adequate data for pension managers to have relied on.

Diversification: One argument used to justify investment in hedge funds was that they provided diversification to a portfolio that might previously have been dominated by equity securities. However, "The claim that hedge funds reduce risk via diversification as they have low correlations to traditional assets, particularly equities, is also disputed as hedge fund returns" (7) actually mirrored global equity markets, shrinking along side.

Increasing Compensation in Non-Profit Companies

Salaries for non-profit organization rank-and-file employees has remained relatively steady in recent years (and has even declined during the recessionary period of 2008-2009, according to the latest Association of Fundraising Professionals' (AFP) Compensation and Benefits Study. "The average salary for U.S. respondents decreased by 2.0% -- from $72,683 in 2007 to $71,199 in 2008. Average salaries for Canadian fundraisers decreased from C$74,376 in 2007 to C$71,511 in 2008 -- a 3.9% decrease." (NonprofitExpert.com). Although,

"many non-profits are beginning to understand that compensation goes beyond salary, and are strengthening other offerings, including health insurance, retirement savings plans (something that was almost non-existent in the not so distant past), professional development opportunities or tuition reimbursement, performance bonuses, and flexible work arrangements." (Koya Consulting).

All of these elements of the overall compensation picture serve to increase the employee benefit costs that non-profit organizations have to bear.

More significantly, compensation for executives of non-profit organizations increased during the years prior to the recession. In fact, executive compensation increased even faster than the rate of inflation. A survey by the Chronicle of Philanthropy showed that "Chief executives at the nation's biggest charities and foundations received a median pay increase of 5%, while inflation rose by 4.1%." (Barton & Gose). Prior to 2008, 2002 also was a high water mark year for non-profit executive compensation increases, with a 7.5% median increase. One key reason for this increase is the pressure for non-profit organizations to attract top talent, often from the for-profit world. Barton & Ghose report that "[c]harity boards are increasingly recruiting for-profit executives to make the switch to the nonprofit world, and some are now sweetening pay packages to lure out-of-town candidates who may need to sell their home at a loss as part of a move." Significantly, the rate of increase for non-profit executives even "exceeded the percentage salary increase earned by executives at for-profit companies." (Barton & Gose). Although, likely this is not because non-profit executives are better paid than for-profit executives overall, but simply are enjoying a faster rise in the market as non-profit salaries race upwards to try and compete with the for-profit sector. The Chronicle survey also showed that "[t]he median salary for chief executives at the organizations surveyed was $326,500, based on information from 249 groups that provided data for both 2006 and 2007. In 2006 the median salary was $308,800." (Barton & Gose).

Pension Protection Act 2006

Among other provisions, ERISA established minimum funding requirements for defined benefit plans. Prior to the Pension Protection Act (PPA),

"a defined benefit plan maintained a "funding standard account," which was charged annually for the cost of benefits earned during the year and credited for employer contributions. Increases in the plan's liabilities due to benefit improvements, changes in actuarial assumptions, and any other reasons were amortized and charged to the account; decreases in the plan's liabilities were amortized and credited to the account. Every year, the employer was required to contribute the amount necessary to keep the funding standard account from falling below $0 at year-end."

"In 2008, when the PPA funding rules went into effect, single-employer pension plans no longer maintain[ed] funding standard accounts" leading to potential increased risk for the Pension Benefit Guaranty Corporation. Thus, "[t]he PPA's primary focus was to enhance D[efined] B[enefit] plan funding and protect the Pension Benefit Guaranty Corporation (PBGC) from additional unfunded pension liabilities." (Employee Retirement Income Security Act).

The PPA was designed to "Reform the Funding Rules for Single-Employer Defined Benefit Pension Plans" (Title I). Specifically, the Act

"Amends the Employee Retirement Income Security Act (ERISA) to repeal existing funding rules for defined benefit pension plans for plan years beginning after 2007. Establishes new minimum funding standards for single-employer defined benefit pension plans, single-employer money purchase plans, and multiemployer plans. Requires employers to pay certain minimum required contributions." (Pension Protection Act, Sect. 101).

Additionally, the Act

"Amends ERISA to set forth funding rules for single-employer defined benefit pension plans. Makes the minimum required contribution for single-employer plans the sum of the target normal cost of the plan for the plan year, the shortfall amortization charge, and the waiver amortization charge. Allows funding shortfalls to be amortized over seven years." (Pension Protection Act, Sect. 102).

The PPA accomplished a number of valuable goals; namely, as Macey describes, it has "improve[d] the funded status of chronically underfunded plans (e.g., faster funding, benefit restrictions)," provided "greater transparency regarding Defined Benefit…plan funded status" clarified "some of the key uncertainties regarding cash balance plans, and enhanced opportunities for employers to design and implement automatic 401(k) enrollment provisions to improve employee retirement security." (1). With respect to the funding of defined benefit plans under the PPA, the requirement

"is simply that a plan must stay fully funded (that is, its assets must equal or exceed its liabilities). If a plan is fully funded, the minimum required contribution is the cost of benefits earned during the year. If a plan is not fully funded, the contribution also includes the amount necessary to amortize over seven years the difference between its liabilities and its assets. Stricter rules apply to severely underfunded plans (called "at-risk status")." (Employee Retirement Income Security Act)

The PPA also introduced some provisions that can become challenging for plans to follow when economic conditions are not favorable. As Macey describes, "[t]he PPA imposes new restrictions on a variety of benefit design and administrative aspects of pension plans and does so in a manner that is difficult for sponsors to deal with." (9). For example, by April 1 of each year for that calendar year's plans,

"the plan's actuary must certify that the plan's funded status at the beginning of the year is in excess of 80% in order to avoid restrictions on paying lump sums (and Social Security leveling benefits -- paying a temporarily higher amount until Social Security commences)." (9-10). Macey also points out that "[f]or severely underfunded plans that are less than 60% funded, the restrictions become more severe (freeze of further accruals, no lump sums, no payment of plant shutdown and other contingent event benefits, etc.). As a practical matter, development and submission of this certification within a short time period (i.e.,in the first quarter of the plan year) may be difficult because of data and other issues that the plan's actuary must address."

Plan sponsors have the option, in lieu of an actual certification by April 1st, instead "the application of the benefit restriction rules can be determined by subtracting 10% from the funded status as of the immediately preceding year." (Macey, 10). However, this provides only temporary relief.

Economic Crisis of 2008-2009

In 2007, a financial crisis in the United States began to emerge. "Beginning in the United States in December 2007… much of the industrialized world has been undergoing a recession, a pronounced deceleration of economic activity." (Late-2000s Recession). What precipitated the financial crisis was a range of factors, in particular the long real estate bubble that had pushed Americans into debt and reckless mortgage practices over the previous decades. The problems have

"been linked to reckless and unsustainable lending practices compounded by government intervention and the growing trend of securitization of real estate mortgages…The U.S. mortgage-backed securities, which had risks that were hard to assess, were marketed around the world. A more broad-based credit boom fed a global speculative bubble in real estate and equities, which served to reinforce the risky lending practices.]The precarious financial situation was made more difficult by a sharp increase in oil and food prices. The emergence of Sub-prime loan losses in 2007 began the crisis and exposed other risky loans and over-inflated asset prices. With loan losses mounting and the fall of Lehman Brothers on September 15, 2008, a major panic broke out on the inter-bank loan market. As share and housing prices declined many large and well established investment and commercial banks in the United States and Europe suffered huge losses and even faced bankruptcy, resulting in massive public financial assistance." (Late-2000s Recession).

These factors led to a global recession and economic decline, that "has resulted in a sharp drop in international trade, rising unemployment and slumping commodity prices." (Late-2000s Recession).

The non-profit sector of the market was not immune from these same pressures. As the nation and the world went into recession, companies began to experience declining revenues, leading to budget cuts in many "non-essential" areas, for example, charitable giving. Layoffs and employment cutbacks also led to a decline in incomes for many Americans (Boushey), which also decreased giving to non-profit organizations. In fact, charitable giving declined in 2008 by the largest margin in more than 50 years (Smith A16). According to a report issued in June 2009 by the Giving USA Foundation, "[i]ndividuals and institutions made gifts and pledges of $307.65 billion" in 2008, "a decrease of 5.7% on an inflation-adjusted basis over the $314 billion given in 2007." (Smith A16).