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.

Investment Policies

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.

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