Study: DB Plans on the Way Out

December 10, 2007 ( - Between the Pension Protection Act's (PPA) strict funding requirements and new pension accounting reporting mandates, traditional defined benefit pensions could well be in their death throes.

That was a key conclusion from researchers Alicia H. Munnell and Mauricio Soto at the Center for Retirement Research (CRR) at Boston College in their study, Why Are Companies Freezing Their Pensions?

“It may well be that the only defined benefit plans left standing in the private sector five years from now will be cash balance plans or some other form of hybrid (plan design),” Munnell and Soto wrote. “The age of the traditional defined benefit plan seems to be over.”

Although DB plans still cover about 21 million workers and pay benefits to 23 million retires, the proportion of the workforce covered by these plans has dropped from more than 40% to less than 20% since 1980, the CRR researchers pointed out. The rate of DB plan decline was largely driven by the PPA requirement for underfunded plans to increase their contributions and accounting changes that will force fluctuations in pension finance onto the earnings statement.

According to the PPA, plans must be 100% funded and most sponsors of underfunded plans have only seven years to pay off any existing shortfall (See Feature: Getting Prepared for the PPA – Defined Benefit ). Moreover, sponsors will have less ability to smooth the value of assets or liabilities, making cash contributions significantly more volatile.

In the next three years, the Financial Accounting Standards Board (FASB) is expected to require companies to mark-to-market the value of pension assets and liabilities, eliminating the smoothing available under current rules (See Study: New FASB Pension Rules Would Have Generated $331B in Liability ). “Given the enormous volatility in the stock and bond markets in recent years, marking-to-market could introduce significant additional volatility in reported earnings,” the researchers wrote.

Munnell and Soto said that plans where credit balances are high relative to income, legacy costs are substantial, and funding ratios are low have a higher probability of being frozen since they are likely to have the most earnings impact under the FASB's expected reporting requirements.

"The forces in place suggest that companies will continue to move away from defined benefit plans," the paper asserted, citing a McKinsey & Company report that suggested that as much as 75% of private sector defined benefit assets will be frozen or terminated by 2012 (See Consultant: DB Market Ready for Major Upheaval ).

The researchers also pointed out that when the United Kingdom adopted regulatory and accounting rules similar to those recently adopted in the United States the percent of assets in terminated or frozen status soared from 35% in 1998 to 70% in 2006.

Cash Balance Plans

The researchers also contended that some sponsors could convert to a cash balance program instead of simply freezing their DB setup.

"The fact that firms might be able to live with cash balance plans suggests that ultimately defined benefit plans could possibly look more like old-fashioned money purchase plans - defined contribution plans with required employer contributions whereemployees might be given the right to direct investments - than like the current 401(k) plans," Munnell and Soto asserted. "This would certainly represent an improvement to the U.S. retirement income system."

In terms of other identified DB plan freeze trends, Munnell and Soto said plans that cover relatively few employees are more likely to be frozen and collectively bargained plans are less likely, at least in the short term.

However, the researchers contended, freezing plans for white collar workers may mean a freeze in the union plans down the road. In fact, press releases from some of the firms in the process of freezing their plans indicate the desire to freeze union plans upon negotiation with the union.

Other trends included:

  • Firms with large legacy costs, as measured by the ratio of retired participants to total participants, are more likely to freeze their plans.
  • Scale effects exist: firms with large market capitalization are more likely to freeze their plans.
  • If defined contribution plans are prevalent in the industry, employers are more likely to freeze their defined benefit plans.
  • Industries with high R&D intensity are less likely to freeze their plans.

The study is here .