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.
A Regulatory Deathblow?
Proposed regulatory changes could add to the momentum against defined-benefit pension plans. Ever since the federal Pension Benefit Guaranty Corporation (PBGC) took over the pension plans of bankrupt United Airlines Inc. and guaranteed about $2 billion in unfunded benefits, there has been growing concern in Congress about the PBGC's future solvency.
"Proposed pension reforms seem to be more about protecting the PBGC from insolvency than convincing companies to keep their defined-benefit plans," says Morris. "The CFOs of healthy companies with healthy plans are concerned that they will be left holding the bag for the PBGC's problems."
The suggested reforms would sharply increase the annual premiums plan sponsors must pay to the PBGC and require companies with a credit rating below investment grade to maintain a higher level of plan funding. "These companies would have to fund their plans as if they were going out of business tomorrow," says Schub. "This would require these companies to put a lot of money into the plan -- for example, $400 million instead of $50 million. Frankly, if some of these proposed reforms go through, there is likely to be some hard-core freezing of benefits among existing plans."
Some benefits observers question whether reformers have considered the impact of the proposed changes. "There should be a balance between the need to get plans funded and the fact that any reform that is too strong will kill the patient," says Schub. Analysts seem to agree that some level of defined-benefit pension reform is necessary. The question is, how far-reaching should that reform be?
As the regulatory climate turns against them, many plan sponsors are questioning whether defined-benefit plans are worth the effort, given the costs and funding volatility associated with them. "At some point, plan fiduciaries will no longer be able to hold off corporate people" who want to freeze or terminate the plan, says Schub.
A Dearth of Options
The problems associated with defined-benefit plans are occurring at a time when there are few alternatives. Cash balance plans -- the most visible -- are hybrid plans designed to ensure stable and predictable plan costs with no risk of large, unfunded liabilities for sponsors. These programs provide participants with a defined dollar amount (usually a percent of pay) for each year of service, and these benefits then earn interest, usually based on the yield on government bonds. The problem is, cash balance plans have been hovering in legal limbo since a 2003 court ruling that implied such plans violate the mandates of the Employee Retirement Income Security Act (ERISA).
In this environment, "we are seeing a flight back to standard plans," says Wagner. "Plan sponsors don't want leading-edge plan design." Instead, companies and pension plan consultants are looking for new plan designs based on older types that have been available for decades. Variable retirement plans, which date back to the 1950s, represent one such design option. Relatively few organizations other than nonprofit organizations and universities currently use these plans.
Among consultancies that have been developing new plans based on traditional designs is Mercer Human Resource Consulting, which in July introduced its retirement shares plan, a product that's similar to a variable benefit plan. Like cash-balance plans, the retirement shares plan promises sponsors the stability and low risk missing from defined-benefit plans.
According to Don Fuerst, a worldwide partner in the Denver office of Mercer Human Resource Consulting, the retirement shares plan credits each participant's account with a certain amount of retirement benefits just like a defined-benefit plan, but these benefits accrue in the form of retirement shares. For example, a plan with a benefit formula that awards benefits equal to one percent of pay uses that amount to purchase retirement shares in the plan at their current value, which is based on the value of the plan's assets on a particular date. An employee paid $50,000 would receive a $500 benefit credit. If retirement shares are valued at $10, the employee would purchase 50 retirement shares. The retirement shares change in value based on the investment return of the plan's assets. "This is a viable alternative to freezing a defined-benefit plan and only having a defined contribution plan," says Fuerst.
The retirement shares plan places the investment risk on participants and does not guarantee a specific level of retirement income from the value of a participant's retirement shares. "Investment risk represents 90 to 95 percent of the risks plan sponsors face with a defined-benefit plan," says Fuerst. "The retirement shares plan transfers investment risk to employees." Some risks to the plan sponsor remain, including demographic risks (when individuals retire) and mortality risk (how long participants live), but they are far smaller than investment risk.
The plan also offers two classes of shares -- stable value shares and equity shares. Participants can choose between them, considering growth potential and the amount of risk they are willing to assume.
Because the retirement shares plan transfers investment risks to employees, predictability of required employer contributions is more assured. At the same time, this consistency means that plans will never be overfunded and "plan sponsors cannot expect funding holi-days like the ones they enjoyed with their defined-benefit plans in the 1990s," says Fuerst.
Despite the promise of new plan types on the horizon, it is unclear whether companies will find a viable alternative to defined-benefit plans that provides greater funding predictability and lower costs than defined-benefit plans but greater retirement security than 401(k) plans alone can offer. "There is a huge need for retirement income that defined-benefit plans are unique in fulfilling," says Wagner.