To freeze or not to freeze, is that a question?

The buzz about defined benefit (DB) plans has hit almost every business publication – news about their rapid decline, their financial impact and their effect on employees who must now choose some type of defined contribution (DC)-type plan for retirement security. According to a recent Mercer survey, more than half of current DB plan sponsors are considering or will soon consider freezing benefit accruals or participation under their pension plans and turning to all-DC-based retirement programs.

What’s driving this apparent reformation in corporate retirement programs? After all, many organizations have successfully sponsored DB plans for decades, using them to attract and retain employees and for workforce management. One primary reason is financial unpredictability. The economic reversal of 2001 produced unprecedented, simultaneous declines in both interest rates and stock prices. Formerly overfunded pension plans became significantly underfunded. Cash funding requirements and accounting expense charges increased and became less manageable for plan sponsors. And this situation threatens to become more severe with new funding and accounting rules.

Other reasons employers cite for moving away from DB plans are cost alignment within an increasingly global economy and the changing needs and expectations of employees. But perhaps the biggest catalyst unleashing this pent-up frustration with pension plans is the recently announced decisions by several corporate icons to move away from DB plans and implement all-DC retirement programs. Such employers include IBM, Verizon, Sears and Hewlett-Packard, to name just a few.

While the move from DB to DC retirement programs may be a sound business move for many organizations, the decision process being used by many sponsors has sometimes been myopic. Often the decisions are too strongly influenced by the conventional wisdom within the organization rather than by alignment with fact-based criteria. This narrow focus can result in unmet expectations when the new retirement program fails to deliver the desired results. From a corporate perspective, costs could be higher than expected and financial volatility may not stabilize for some time. From an employee perspective, participants could become disillusioned if they see their account balances drop – even if it’s for a short time. This means that plan sponsors need to test their premises for change very carefully before making a decision, set more realistic expectations or perhaps not make a move at all.

This Mercer Perspective on Retirement explores the DB-versus-DC issue through the eyes of two typical corporate executives who are reviewing their company’s retirement programs. They will discuss their specific situations, their thought processes and their concerns. Readers should find the conversation illuminating as well as a useful reference for their own retirement program review.

Meet the actors

Our fictional executives are Nick, a chief financial officer of a major telecommunications firm, and Nora, a chief human resource officer for a large manufacturing company. In their discussion, Nick and Nora cover many of the issues and questions we hear from real sponsors of DB plans.

Nick: So, Nora, you said your company is considering freezing your pension plans. So are we. What’s driving the change at your company?

Nora: Our board of directors asked our CEO to review our DB plan to see whether a freeze and a move to an all-DC plan would be in the best interest of shareholders. The board has heard about other large companies that have done this. We don’t feel a strong pressure to change just yet, but we need to justify continuation of our conventional DB plan. We’re just starting with our study. What’s motivating your company?

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Nick: Expense volatility. We’re very concerned about predicting our DB expenses. We have relatively large legacy costs due to recent downsizing, and a 10 percent swing in funded status can create a 25 percent earnings surprise for us. These shocks look as if they will continue, and they may be even larger as a result of the pension accounting changes that just came out.

The recent accounting changes mean that any movements in either the benefit liability or the asset values, which increase our deficit, will not only be recognized on the balance sheet, affecting shareholder equity, but may also become a charge to earnings for the year. Even though we feel earnings are more important than cash flow, we also hear that funding rule changes will soon require increased and less predictable cash commitments. We just can’t afford this much financial risk.

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Nora: We need to look at those effects more closely ourselves. Right now, our pressure point is more directly related to our competition rather than to financial issues. As of now, we know of only one competitor that has moved to an all-DC program, and that is a smaller company in some financial turmoil. But I bet that many of our other competitors are considering it just as we are. We really don’t want to be the first to close our DB plan, but we don’t think we want to be one of the last either.

Tell me, though, are the financial risks and volatility you’re describing totally eliminated with a move to an all-DC plan?

Nick: Unfortunately, financial risk and volatility are not eliminated or even significantly reduced for some time. All a freeze does is control the growth of those items. In the interim, they will still be an issue. But the structure of the program is also presenting challenges.

You see, we would probably freeze pension accruals for most active employees, but we would like to have the older, longer-service employees continue to accrue benefits in the current plan or something close to it. Right now, we’re thinking that any employee within five years of early retirement eligibility would be able to continue in the current pension plan. This is about 20 percent of our workforce, but it’s about 40 percent of our exposure.

Nora: That group would be an even higher proportion of our workforce. In fact, more than a third of our workforce will be eligible to retire within the next five years.

Nick: To add to the challenge, our retirees are 30 percent of our total liability, and older, active employees are another 50 percent. So that means we really won’t reduce our overall liability all that much if we were to move to an all-DC program … at least not for quite some time – that is, not until many new employees replace current employees who leave or retire.

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Nora: So does that mean you’re not going to change?

Nick: No, we just don’t know at this point. We may not be able to let any employees continue in the current plan if we must stop our future liability from escalating.

Nora: You mean a complete freeze for everyone?

Nick: That’s what I mean. But even if we institute a complete freeze, what we’re discovering is that to really eliminate earnings surprises, we’d have to fully fund the liability and invest much more heavily in long-term bonds. We’d need to move out of the stock market to a large extent.

Nora: Why? What does that do?

Nick: Moving out of the stock market would allow us to structure our plan so that when liabilities move up or down because of changes in interest rates, the assets will do the same. The only problem is that this matching structure will require that we contribute more than the minimum over the next five to 10 years in order to match all or most of the liability. And we’re going to give up some long-term investment return in the process. But at least it will make the financials predictable.

Other investment policy options to consider Some DB volatility can be controlled by hedging a portion of the asset interest rate risk in swaps. An interest rate swap is an agreement between two parties to exchange cash flows in the future – essentially trading a variable stream of payments for a fixed stream, which can be used to pay fixed benefits.   Alternatively, plan assets could be invested in fixed income assets with payments that match the benefit cash flow, like a bond portfolio, which would reduce interest rate volatility.   By matching the duration and payment streams of bond maturities with the pension plan benefit payments, the funded status of the plan would no longer be sensitive to interest rate changes. Other sources of volatility exist, but interest rate changes by far have the most impact on a frozen plan.   A strategy can be designed to fund a plan within a specific time frame to reach a point where funding and expense requirements are minimal. At that point, the plan can be allowed to wind down over time or additional cash can be used to terminate the plan sooner.

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Nora: So it sounds like the cost of a frozen plan can be higher than you think.

Nick: Yes, I think that’s right. But we would still save money by eliminating future pension accruals for active employees.

Nora: But aren’t you going to replace pension benefits with additional DC benefits?

Nick: Yes, but we don’t want to end up spending more money. We plan to have a reasonable benefit replacement, but not one that is so generous as to increase our costs. The Employee Benefit Research Institute study that I just read said that, on average, it would take an 8-percent-of-pay contribution to replace the economic value of a typical final-average-pay pension benefit. I don’t know what it would cost us, but 8 percent is more than we could afford.

Let me ask you a question: Why are you afraid to make a move in advance of your competitors? What harm would it really do? Don’t you feel the same financial pressure to move quickly?

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Nora: I don’t think our plan affects earnings as much as yours does, so we’re really thinking carefully about whether an all-DC program will help us with our people needs. One of our biggest concerns is our long service employees. We have many in our company, and they are expecting that pension benefit. These folks are critical to our innovation cycles; our production processes; and, perhaps most important, to our customer relations. I don’t think we have the option of just freezing pensions for these employees such as what you are considering. We’re afraid it could be a catalyst for unplanned or mass early retirement or, worse yet, a move to a competitor.

If we do decide to freeze, we might adopt transition provisions or “grandfather” clauses to help protect future benefits for these employees.

Nick: We have some of those same concerns as well, so we are also considering “grandfathering” certain employees. I’m just not sure we can do it and meet our financial objectives too.

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Nick: But wouldn’t you agree that newer employees are interested in a DC plan only?

Nora: That’s true with the younger employees who are new to our company, but not all new employees are recent graduates. We hire quite a few mid-career employees directly from competitors, and we want to persuade them that if they perform well, they can complete the remainder of their careers with us. As long as our competitors have pension plans, we think it is important for us to also have a pension plan to support that strategy. On the other hand, if all our competitors shift to all-DC programs, we don’t think that a pension plan will have the same recruiting power, even for mid-career employees. And we still have a competitive 401(k) plan to help recruit younger employees.

Nick: I’m not sure that we’ve looked at all those issues carefully enough yet.

Nora: We’re also very concerned about whether an all-DC retirement program will work effectively in the future. Our business will continue to need professional and technical employees who will learn our systems, our processes and our products. So we want them to stay with us as long as they continue to perform well. But we also want them to be able to afford to retire at a time that’s right for them and for us. We’ll rely on our performance management system to determine that time, but it still depends on employees having enough money to retire.

We’ve looked at the benefit implications of DC plans, and it costs a lot of money to provide the same level of retirement benefits as our DB plan for longer-service employees. Don’t you share these concerns?

Nick: I don’t think our business relies as much as yours does on longer-service employees. We are changing so rapidly that we usually look for new employees with new knowledge. I think our workforce is more mobile than yours.

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Nora: We have another issue that we need to think about very carefully: Many of our employees are nonunion hourly and work at production sites surrounded by employers that are unionized and that offer pensions for comparable jobs. These employees have always been covered in our pension plan, and we’re very reluctant to put them into an all-DC program. We may need to consider keeping a DB pension plan, at least for them. But this will complicate matters for us.

Nick: Thanks for your time, Nora, you’ve given me a lot to think about as our organization begins to evaluate this important decision.

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A balancing act

While freezing a plan will help reduce costs and may seem like an escape from a financial black hole, it will not immediately reduce risk. Frozen plans must be actively managed, and they are subject to the same financial pressures and market vagaries as open plans: falling interest rates, poor market performance, etc. And then, of course, there are the HR implications of freezing a plan, such as managing and attracting the right talent; optimizing the timing of retirement for employees, in conformity with company goals; and creating a workforce profile responsive to competitive needs, among others. So before you decide to alter your retirement plan, you should ask yourself some critical questions.

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About the author

Bruce R. Nordstrom, EA, MAAA, is a principal in Mercer’s Dallas office. He has more than 20 years’ experience in pension planning and works primarily with large corporations on mergers and acquisitions, on design and setup of new retirement programs, and in other related areas.