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New pension rules are supposed to secure employees' retirement. Employers may have other ideas.
Ronald Fink, CFO Magazine
December 1, 2006
When Bemis Corp. saw the pension liability of its defined-benefit plan soar in late 2005 as a result of falling interest rates, the consumer-products packaging manufacturer decided to limit the accrual of new benefits to employees who were over 40 and had at least 20 years of service with the company. Other employees from then on would be eligible to put pretax savings into a new 401(k) plan, with Bemis contributing a share of its annual profits on their behalf.
The expectation is that the so-called soft freeze of its defined-benefit plan will halve the company's annual pension expense after eight years. In the months since the passage of the Pension Protection Act of 2006 in August, other companies have announced similar actions. DuPont, for example, plans to reduce the benefits in its pension plan for existing employees and close it to new ones as of January 1, 2008, cutting its costs by roughly two-thirds. Tenneco and Blount International plan similar changes and expect to save $11 million and up to $23 million annually, respectively.
Spurring this trend is a recent move by the Financial Accounting Standards Board, which issued the first of two sets of rules to require corporate plan sponsors to take pension assets and liabilities out of their financial-statement footnotes and include them in their reported results (see "Mismatched from the Start" at the end of this article). Taken together, the new rules enacted by Congress and FASB "will make the true cost of defined-benefit plans transparent to investors and accelerate the closing of defined-benefit plans by financially healthy plan sponsors," predicts Zvi Bodie, a professor of finance and economics at Boston University.
Indeed, that transparency may just nail the coffin shut on traditional pensions. According to Bodie, the combination of stiff new funding requirements for traditional plans and higher premiums on government pension insurance creates further disincentive for offering traditional benefits. And while the law is designed to improve the chances that companies will make good on existing pension promises, it may also encourage them to freeze or at least limit those promises and shift investment risk to employees through 401(k)s and other defined-contribution arrangements — as firms like Bemis have done. Basically, says Bemis's treasurer, Melanie Miller, "the law allows companies to do what they've wanted to do for some time."
No Real Obligation
It's no secret that defined-benefit plans have been losing favor among corporate plan sponsors. The percentage of full-time employees of large and midsize companies who take part in defined-benefit plans fell from 80 percent in 1985 to 33 percent at the end of 2003, while those in defined-contribution plans climbed from 41 percent to 51 percent. What's different now is that that shift has been further propelled by new legislation.
Sponsors now have the ability to automatically enroll employees in 401(k) plans and are protected from fiduciary liability when providing investment advice, even if it's from advisers with conflicts of interest. The law also rules that cash-balance plans are not age-discriminatory as long as they follow guidelines that were established to protect employees. As a result, says Tonya Manning of Aon Consulting, cash-balance plans are "now an option." In effect, the law reverses a 2003 court decision against IBM's conversion of a defined-benefit plan to a cash-balance plan, which cast a pall on similar moves by other sponsors. The Pension Protection Act does "a lot to make cash-balance plans viable," she adds.
Tightened funding rules for defined-benefit plans make the alternatives even more appealing. Although the new requirements will be phased in over the next five years, at the end of that period companies' plans must remain fully funded to get the backing of the Pension Benefit Guaranty Corp., the federal agency that insures defined-benefit plans. Previously, such plans needed to be only 90 percent funded at some point in the ensuing 30 years to qualify for PBGC coverage. Sponsors whose plans are considered underfunded (between 65 and 80 percent funded) face larger increases in what they must contribute, while those with plans in the worst shape (where funding is less than 65 percent and the plan is "at risk") will be subject to penalties.
To make matters worse from the perspective of costs, sponsors' ability to smooth the effects of underfunding when determining their status has been severely curtailed. The law cuts the number of years that companies register changes in the value of their pension assets and liabilities from five years to two in the case of assets and from four years to two in that of liabilities. Consequently, says Stephen Metz, a principal in PricewaterhouseCoopers's human-resources services group, "the biggest potential negative [of the law] is tremendous volatility in cash funding requirements."
What Is Fair?
For their part, most companies seem reluctant to make sweeping changes right away. A recent survey of large and midsize companies by Towers Perrin found that only 17 percent of the 126 respondents say they will close their defined-benefit plans to future hires, and only 5 percent admit they will freeze their plans as a result of the new law. Almost half intend to maintain their current plans without cutting benefits. Moreover, such companies as DuPont and Tenneco insist that their plan changes were in the works months before the law was enacted.
The sensitive nature of making any changes to retirement plans is one reason for caution. Companies that have moved away from defined-benefit plans so far contend that defined-contribution arrangements are worthy alternatives. DuPont's change is designed in part "to modernize the design of our savings and retirement plans for a new generation of employees, many of whom want more direct control and portability in their benefits," says James C. Borel, senior vice president for human resources.
Yet DuPont saw fit to soften the blow for employees shut out of its defined-benefit plan by doubling the amount of an employee's 401(k) contribution that it will match, from 50 percent to 100 percent, up to a maximum of 6 percent of pay. Similarly, Tenneco has started a second defined-contribution plan to which the company alone contributes 2 percent to 10 percent of an employee's salary, with the percentage rising with his or her age. "Older employees suffer the most deterioration in benefits" as a result of the company's defined-benefit freeze, says Tenneco CFO Kenneth Trammell. "We wanted to offset part of that with higher contributions for them."
Still, Trammell admits, "we simply couldn't afford to pay for and continue to fund a level of benefits that was overly generous to older employees." Trammell notes that Tenneco's changes in plan design will reduce the proportion of preretirement salary that employees aged approximately 45 to 50 receive, from roughly 150 percent to 100 percent (assuming average returns).
Death Reports Premature?
How many companies will ultimately follow suit remains to be seen. In fact, some observers, such as Bill McHugh, head of the strategic investment advisory group for JP Morgan Asset Management in New York and the former treasurer of Novartis Corp., actually believe the new rules "will lead to a stronger structure" for defined-benefit plans, citing the tremendous deterioration in their financial condition in the past six years. Funding levels for the 200 largest corporate plans plummeted from 122 percent of liabilities at the end of 1999 to 86 percent at the end of last year. But as a result of the tougher funding and accounting rules, McHugh expects plan sponsors to exercise tighter control over the plan's risk exposures and their impact on the corporation's results and balance-sheet exposures. He predicts a much clearer focus on duration analysis to better match the terms of plan assets with those of their liabilities.
There's another consideration: the financial benefits of freezing traditional plans could be outweighed by the negative impact on employee productivity if companies are thereby unable to attract and retain the talent they need, warns Mike Pollack, a consultant with Towers Perrin.
To date, however, companies moving away from defined-benefit plans are confident that they can do so without losing key employees. In a statement outlining the changes to its retirement plans, DuPont suggested that the doubling of its 401(k) match "enhances the company's ability to compete for talent." Adds Mary Dineen, DuPont's manager of global benefits: "Many younger employees, particularly college graduates, are looking for portability [of benefits] and control over investments," which only defined-contribution plans provide. "They don't see value in defined-benefit plans," she asserts.
Still, any accelerated trend away from defined-benefit plans doesn't solve the larger issue of who should pay for retirement. Despite or perhaps because of the new rules, U.S. Comptroller General David M. Walker recently complained that "issues of coverage and plan design remain largely unanswered, and the appropriate balance of responsibility for retirement among employers, government, and workers remains unclear."
Ronald Fink is a deputy editor of CFO.
Mismatched from the Start
One issue that the Pension Protection Act of 2006 doesn't address is the asset-liability mismatch that exists in most pension plans. Such experts as Boston University finance and economics professor Zvi Bodie, charge that there is a mismatch between the benefits promised to employees and the pension asset portfolios used to finance them. The law, he wrote in an open letter after it was passed in August, "does not even acknowledge" that the problem exists.
In fact, Bodie has long favored action to charge companies higher government insurance premiums if they do not match their pension assets to their liabilities. He also favors a change in the rules for reporting pension expense to prevent companies from using expected rather than actual returns on pension assets.
Bodie isn't alone in worrying about this mismatch. "The concern is that companies can't constructively use the surplus from equities," observes Mike Pollack, a consultant with Towers Perrin. And in an October speech at a meeting of the International Foundation of Employee Benefit Plans, U.S. Comptroller General David M. Walker went so far as to say that by ignoring the fundamental mismatch between defined-benefit plan assets and liabilities, the act "will likely not reverse long-term decline in the defined-benefit system."
Yet it's possible the law will encourage plan sponsors to invest more in debt and less in equity when funding their plans. That's because it requires companies to discount defined-benefit plan liabilities based on the rate of cash flow from an index of corporate debt of varying terms, rather than from an index of 30-year Treasuries.
The effect, say some observers, is to encourage a shift to less-risky, shorter-term investments (that is, bonds). While Bemis Corp., for one, currently invests 80 percent of its plan assets in equities and 20 percent in bonds, treasurer Melanie Miller says the company may revisit its investment policy in light of the new law, and consultants expect other companies invested heavily in equities to do the same. Meanwhile, the second phase of FASB's pension-accounting project will address such issues as whether to deconsolidate plan assets and liabilities, which would mean that gains and losses on assets may no longer be included in corporate income and cash flow. — R.F.