EBRI Studies What Workers Will Need to Offset Pension Freezes

March 9, 2006 (PLANSPONSOR.com) - The non-partisan Employee Benefits Research Institute (EBRI) has released a study on the effects of defined benefit pension plan freezes on workers and how much additional savings they will need to make up for the lost accruals.

Overall the study found that, if an 8% rate of return is assumed, the median additional annual contribution rate to a 401(k) or other savings plan needed to indemnify a worker for lost accruals is 6.6% if the worker was covered by a career-average defined benefit plan, and 8.1% if the worker was covered by a final-salary DB plan. For cash balance plans, using the current interest rate, the indemnification contribution rate is 2.7%.

Indemnification contribution rates of 14.8%, 16%, and 4.5% would cover 75% of employees who were covered by each of these plan types, respectively.

If the assumed rate of return is lower, more additional savings would be needed to make up for lost accruals from a frozen DB plan. According to the study, assuming a 4% rate of return, the contribution indemnification rate increases to 11.6% for those who were covered by a career-average DB plan, and 13.5% for those who were covered by a final-salary DB plan. To cover 75% of employees in these types of plans, rates of 18.8% and 21% would be needed, respectively.

The study results show that, not surprisingly, pension plan freezes have a greater negative financial impact on older workers than younger ones, since older workers have less time to save to make up for lost accruals. The median contribution indemnification rates ignore the impact of age for the DB participant. Using the 4% assumed rate of return, for example, the median contribution indemnification rate is 5.1% for those in the 30-34 age range who were covered by a career-average DB plan. This jumps up to 20.1% for workers age 60-64. For final-salary plans the rate jumps from 3.9% to 22.4% for these age groups.

The author of the study, Jack VanDerhei, from Temple University and an EBRI fellow, points out that many factors influence the actual additional compensation needed to replace lost accruals from a frozen DB plan. Factors such as employee tenure with the employer, employee wages, and specific plan provisions will all cause the indemnification rate to vary.

The recent onslaught of pension plan freezes by General Motors (See GM Unveils Finalized Pension Restructuring ) and other companies (See Two More Companies Join DB Plan Freezing List ) make this seem like a recent trend. However, according to the study, freezing pension plan is not new. An analysis from the Pension Benefit Guaranty Corporation (PBGC) revealed that 9.4% of private-sector DB plans were already frozen in 2003 (See PBGC Reports Pension Plan Exodus Overstated). According to the EBRI study, between 1975 and 2004, 3,400 underfunded DB plans were terminated, and 165,000 adequately funded DB plans were terminated.

Expense and funding volatility (See Expense and Funding Volatility Lead Co.’s to Ax Pension Plans ) and the effects of new Financial Accounting Standards Board rules (See Study: New FASB Pension Rules Would Have Generated $331B in Liability ) have led many companies to freeze or terminate their DB plans. A recent survey conducted by SEI indicates that recent pension reform legislation could also contribute to the ongoing trend of freezing DB plans (See Poll: Pension Reform Will Contribute to Plan Terminations).

A full analysis of the study can be found in the March 2006 EBRI Issue Brief, available at www.ebri.org .