The Freeze Factor

Are defined-benefit plans really on their way out? Not everyone thinks so. Ironically, the flurry of attention generated given to high-profile pension freezes has led to an increased level of interest in DB plans among many employees, some say.

Tuesday, May 2, 2006
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The long-predicted demise of the defined-benefit pension plan finally appears to be coming to pass. Each week seems to bring new headlines of high-profile companies -- IBM, Verizon Communications, Hewlett-Packard, Ford Motor Co. -- that are freezing their defined-benefit plans or closing them to new employees.

Although the majority of large U.S. companies continue to offer DB plans to at least some portion of their workforces, their numbers may eventually shrink down to zero if current trends continue. A survey of Fortune 1,000 companies conducted by Watson Wyatt found the percentage that had frozen their DB plans stood at 11 percent in 2004, up from 7 percent the previous year and 6 percent in 2002. Meanwhile, a recent Hewitt Associates survey of 220 large U.S. employers revealed that 15 percent said they were "very likely" to close their DB plans to new hires and 6 percent said they were very likely to freeze accruals for all plan participants.

Some of the companies freezing their plans, including IBM, are in good financial health, but maintain that they need to move away from these plans in order to compete with firms that only offer defined-contribution plans to their workers. Other organizations seek to escape the cost volatility associated with DB plans and the uncertainty surrounding pension-funding reform proposals in Congress.

Ironically, some observers say, the flurry of attention generated by the high-profile pension freezes has led to an increased level of interest in DB plans among many employees. Indeed, some experts say companies could end up harming themselves if they move to do away with these benefits without carefully considering all the factors. For all their faults, they say, DB plans still offer a level of security that compares favorably with 401(k) plans and other defined-contribution vehicles.

Longevity Concerns

Cost volatility is a major reason cited by employers that decide to freeze their DB plans, says Bill Gulliver, chief actuary at Towers Perrin HR Services in Stamford, Conn.

"I think almost all the companies we work with are taking a close look at their entire retirement program," he says. "The Financial Accounting Standards Board is considering changes for how companies account for retiree medical and life insurance costs, and Congress is considering changes to pension-funding requirements. Regardless of whether that legislation passes this year, minimum contribution requirements for pensions are likely to be higher and more volatile in coming years."

The cost of maintaining these plans and the volatility of such costs were the two main reasons cited by plan sponsors in the Hewitt survey who said they were likely to close their plans, says Lori Lucas, director of retirement research at the Lincolnshire, Ill.-based firm, adding that the overwhelming majority of respondents (82 percent) cited cost volatility.

However, companies that freeze their DB plan won't necessarily be shielding themselves from cost volatility, says Richard McEvoy, an analyst with Mercer HR Consulting in New York.

"Companies need to realize that freezing their DB plan is not a panacea in terms of financial management," he says. "The impact on cost volatility is fairly minimal in the short term because you're still left with the legacy liabilities. If volatility is the issue, that can be solved by a change in investment policy -- switching from equities to long-term bonds, for example, which is a far more effective solution to volatility than freezing the plan, which reduces volatility at a much slower pace."

The financial benefits of freezing a plan won't materialize until all of its liabilities are paid off, while the workforce implications could be immediate, says Stewart Lawrence, a senior vice president and consulting actuary at the Segal Co. in New York. For plans that undergo a "hard freeze," in which accruals for all plan participants are halted (as opposed to a "soft freeze," in which participants already enrolled in the plan continue to accrue benefits but new employees are barred from the plan), companies will still be required to pay out all of the benefits accrued up to the date of the freeze, a process that could take decades.

"The pain for the workforce is today, while the gain for the shareholders is tomorrow," says Lawrence. "If the pain is severe and immediate, and the benefit to the financials is deferred by a decade, freezing the plan may not be a good idea."

Volatility aside, DB plans offer an advantage over their DC counterparts in terms of employee retention and retirement security, says McEvoy.

"There's the 'mortality pooling' aspect of DB plans -- basically, participants who die early subsidize those who live for a long time, so your longevity insurance is assured," he says. "If you plan to spend down your retirement assets over your life expectancy, you have a 50/50 chance of winding up destitute, but that's not a factor in DB plans."

Then there's the fact that DB plans can serve as an inducement for employees to stick around, unlike DC plans, which are portable, says Tom Murphy, a retirement consultant at Watson Wyatt.

"With a 401(k), there are no golden handcuffs," he says.

Last year, the Aerospace Corp., a 3,500-employee nonprofit research firm based in El Segundo, Calif., unfroze its DB plan after freezing it during the early '90s in the midst of a recession. The company revived its plan primarily because it was concerned about turnover, says Vice President of Human Resources Marlene Dennis.

"We had some key people leave who said, 'You don't have golden handcuffs to keep me here,' " she says, adding that the company -- which provides aerospace-related consulting and research services to the federal government--competes for talent with much larger firms that tend to offer DB plans. "High turnover is bad for us. We need benefits that attract and keep people."

Prior to unfreezing its plan, Aerospace Corp. contributed an amount equal to 8 percent of employees' pay to its defined-contribution plan, which had replaced the old pension benefit in 1993. When the DB plan was unfrozen, employees were given the option of staying exclusively with the DC plan or enrolling in the DB plan and having their 8-percent company contribution split between both plans. Nearly half of the DC-plan participants elected to join the DB plan, says Dennis, adding that the expense of reviving the benefit was less than initially feared because the demographic makeup of the new enrollees is spread out among different age groups.

Increased Awareness

Companies deciding whether or not to freeze their plans should first examine their workforce demographics and their business goals, says Watson Wyatt's Murphy.

"A key element of this is objective setting," he says. "If you have an organization in which the DB plan is considered to be a key part of the compensation package, and your workforce is such that you realize the value of DB plans in providing security -- that it has value as a workforce-management tool -- then that would be a reason for retaining the DB plan."

The spate of publicity surrounding pension freezes, along with growing concerns about the future of Social Security, has given pensions a much higher level of visibility among Americans in general, says Lawrence.

"Five years ago, the lay readers of USA Today and Money magazine had no clue what a defined-benefit plan was," he says. "But as more employers do things to their DB plans, sensitivity is raised and the way folks value these plans is increased."

At Columbus, Ga.-based Aflac, a growing number of employees are asking about the firm's defined-benefit plan, says Rena Lane, senior manager for benefits and payroll.

"I think the recent media attention to Social Security and concerns about whether it will still exist when our younger employees retire has really put our DB plan on their radar screens," she says, adding that Aflac offers both a traditional pension benefit and a 401(k).

"We get a lot more questions about how the DB plan works, what their benefits will be when they retire, how it interacts with the 401(k) plan, and so on."

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In response to the increased interest, the company has beefed up its pension-related communication efforts, which have included adding "pension estimators" to employees' quarterly 401(k) statements that show them what they'll receive in monthly pension benefits if they remain with Aflac until age 65, says Lane. Both the pension and the 401(k) are administered by Boston-based Fidelity Investments, she says.

"Every year, when the valuation is done, they'll see the amount they'll be eligible to receive grow and it will give them a better appreciation for the DB plan," says Lane.

Aflac has no plans to freeze its DB plan at this point, she says, adding that she's also noticed an increase in the number of job applicants who ask about the company's pension plan.

"I don't know if the DB plan is a major selling point in them coming to work for us, but we certainly are asked about it by applicants," she says.

Making the Transition

Regardless of their appeal to employees, defined-benefit pensions are increasingly a thing of the past -- and not just in the United States. "There's a clear shift away from the DB model to the DC model in all parts of the world -- in Singapore, Australia, the United Kingdom," says Troy Saharic, an investment analyst at Mercer HR Consulting. "It's a global issue."

Traditional pensions tend to be less attractive to today's job-hopping younger generation, he adds, while DC plans offer a portable alternative that many find appealing. Nevertheless, most studies indicate that the majority of Americans enrolled in DC plans are woefully unprepared for retirement. The latest Retirement Confidence Survey from the Washington-based Employee Benefits Research Institute found that more than two-thirds (68 percent) of current workers say they and their spouses have accumulated less than $50,000 in their retirement savings.

"If you take a look at wealth accumulation in 401(k) plans, it's not a great story," says Saharic. "Retirement readiness is a big problem, which is why you've got the IRS and the Department of Labor being so active in auditing these plans and making sure plan fiduciaries are making good investment decisions, because they know in 20 years, we're going to have a big issue on our hands."

Matters aren't helped by the nation's spending habits, says Hugh Bromma, CEO of the Entrust Group, a financial-advisory firm in Oakland, Calif.

"We Americans tend to want to spend and consume rather than save," he says. "Our national savings rate is at a negative level. People need to understand that cutting out hamburgers and milkshakes isn't going to cut it; instead, they need to cut back on large consumption expenditures."

Most experts say companies that decide to make the transition from defined-benefit to defined-contribution plans should do everything they can to help their employees adjust to a new, less-certain environment in which the key to whether they'll enjoy a decent retirement lies with the actions they take -- or fail to take.

IBM launched an intensive communications effort in conjunction with its announcement, made last January, that it would freeze all accruals to its DB plans by 2008, says spokesman Todd L. Martin.

"We put together a major outreach around the initial announcement, including in-person meetings with thousands of employees and managers," he says. "We're also planning a very robust financial-planning and education campaign for later this year."

IBM plans to replace its DB plans with a "401(k) Plus Plan" that will provide former pension-plan participants with a dollar-for-dollar match of up to 6 percent of their pay and a 4 percent automatic company contribution, while nonexempt participants will receive an additional "special savings award" equal to 5 percent of pay, according to the company. All new employees will be automatically enrolled in IBM's 401(k) plan and will receive a company match of 5 percent of pay and an automatic company contribution of 1 percent of pay after one year of service, for a total of 6 percent of pay. 

Features such as automatic enrollment and automatic company contributions tied to annual raises, along with a clear focus on helping 401(k) plan participants as much as possible, have become increasingly common among employers that offer defined-contribution plans, says McEvoy.

"It's as if a new form of paternalism is emerging," he says.

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