An Uncertain Future for Defined-Benefit Plans

Proposed pension reform could add to defined-benefit-plan woes.

Economic conditions have not been kind to organizations that sponsor defined-benefit pension plans over the past several years. The high-flying stock market in the 1990s provided an extended funding holiday for many plan sponsors as returns left pension plans with more than enough money to fund liabilities and then some. However, the stock market party ended at around the same time that the interest-rate benchmarks used to calculate plan liabilities reached record lows. For the first time in years, pension plan sponsors suddenly faced underfunded obligations and rapidly growing contribution requirements.

From the CFO's perspective, it is not just the amount of plan contributions required to attain an appropriate level of funding that is the problem -- it is the volatility and unpredictability of these payments. Some companies have seen required contributions double or triple in recent years; a $100 million contribution one year suddenly became $300 million the following year. "The tipping point for many companies is the volatility defined-benefit plans can create on the plan sponsor's financial statements," says Jim Morris, senior vice president, retirement solutions, institutional solutions group, with SEI Investments, an asset management company in Oaks, Pa.

"[Lack of] predictability in plan contributions is a huge issue," agrees Judy Schub, managing director of the committee on the investment of employee benefit assets for the Association for Financial Professionals, based in Bethesda, Md. "When analysts ask CFOs about future pension funding levels, CFOs must often reply, 'I have no idea.' " Not surprisingly, this inability to project plan contribution levels does not sit well with those finance executives.

What makes these developments particularly hard to swallow for many companies is that offering a defined-benefit pension plan does not necessarily give them an edge in recruitment, retention or even employee appreciation. These plans remain perhaps one of the most valuable employee benefit programs ever offered, but they're also one of the most underappreciated. Plan sponsors have always had difficulty communicating the value of these programs, particularly to younger employees for whom retirement is a long way off. And defined-benefit plans are not very portable because the bulk of their benefits accrue in the final years before retirement. As a result, "There is no outcry from employees about wanting these plans to continue," says Kevin Wagner, retirement practice director with benefit consulting firm Watson Wyatt Worldwide in Southfield, Mich.

There is also no movement among growing companies to begin offering a defined-benefit plan -- for the same reasons. "Why should a fast-growing company that is hiring a lot of new, young employees set up a defined-benefit plan?" asks Sheldon Gamzon, a principal with PricewaterhouseCoopers HR Services in New York City. "Your average 25- to 30-year-olds don't think about a pension that they won't receive until 30 years from now. A defined-benefit plan does not help a company recruit people."

This lack of competitive benefit, as well as the ballooning costs of its plan, led high tech giant Hewlett-Packard Co., based in Palo Alto, Calif., to freeze its pension plan in December 2005 for employees whose age plus years of service equal an amount less than 62. For example, a 45-year-old employee with 10 years of service with the company cannot continue accruing benefits in the defined-benefit plan after December 31, 2005, because the worker's age plus years of service only add up to 55.

According to Ryan Donovan, an HP spokesman, the company's leadership saw the change "primarily as a way to reduce operating costs." He added that peer-company and industry benchmarking revealed that offering a pension plan was not necessary for HP to remain competitive.

The size of HP's plan contributions also varied widely from year to year. According to the company's 2004 annual report, HP expects to contribute $910 million to its pension and other post-retirement benefit plans during the 2005 fiscal year. This amount follows plan contributions of $613 million in 2004 and $1.2 billion in 2003.

HP is not the only company that is freezing or terminating its defined-benefit pension plan. According to an analysis conducted by Watson Wyatt, the rate at which Fortune 1000 companies froze or terminated these plans increased significantly last year even as the average funding level for plans grew. The analysis found that although nearly 63 percent of these companies sponsored a defined-benefit pension plan in 2004, 71 of those businesses, or 11 percent, had a frozen or terminated plan, and another 25 companies (4 percent) had pension plans that were closed to new hires. In 2003, 45 companies (7 percent) of Fortune 1000 plan sponsors had a frozen or terminated plan. (See The Big Freeze, below.)

This rise in plan terminations and freezes occurred even though the percentage of obligations actually funded in the average active pension plan increased to 83 percent last year, up from 81 percent in 2003 and 76 percent in 2002. The Watson Wyatt analysis also found that companies that froze or terminated their plans maintained plan funding at an average of 75 percent, compared with 83 percent for companies with active plans.