contributions directly into assets that are owned by the employees. In
these plans, the firm does not guarantee any benefits. In contrast, in de-
fined benefit plansthe employer spells out the income and healthcare ben-
efits that will be paid, and the assets backing these plans are not chosen
by or directly owned by the employees.
Under government regulations, DB plans must be funded—that is,
the firm must place assets in a separate account that will cover the ex-
pected benefits associated with these plans. In DC plans, the risk that the
value of the plan at retirement will not cover retirement expenses is
taken by the employees instead of the employers, and it is the employ-
ees who must decide where to place their investment dollars.
There were two reasons for the tremendous increase in the popularity
of the DC plans over the past two decades. One was the great bull market of
the 1990s that made many employees believe that they could obtain a better
return on their own investments than the returns promised by the firm.
The second reason was that contributions in a DC plan were imme-
diatelyvested—that is, they became the property of the employee. If an
employee left the firm, he could take his DC assets with him. In contrast,
it takes a number of years before the benefits of a DB plan belong to the
employee. If an employee leaves the firm before these benefits become
vested, then the employee receives no benefit.
Problems and Risks in Defined Benefit Plans
Current rules for calculating the returns on the assets backing DB plans
are generous to the corporations. The FASB allows firms to choose their
own estimate of the rate of return on the assets in their portfolio, and
often these estimates are too high. Furthermore, if the value of the assets
falls below the pension liabilities (and the fund is called underfunded),
the FASB allows firms to close this gap over a substantial period of time.
Although the government shortened the period over which firms must
restore underfunded pensions in the Pension Protection Act of 2006,
firms are still allowed to choose their own return estimates.
While the government requires firms to build a fund for retirement
income benefits, it does notrequire them to fund other pension-related
benefits, particularly health benefits. In 2003 a Goldman Sachs analyst
estimated that the healthcare liabilities of the three Detroit automakers
amount to $92 billion, roughly 50 percent greater than their combined
market capitalizations.^17
106 PART 2 Valuation, Style Investing, and Global Markets
(^17) David Stires, “The Breaking Point,” Fortune, February 18, 2003.