Study: Pension Freeze is Not Total Answer

April 18, 2006 ( - Even though an employer may freeze its defined benefit pension plan, that does not mean the move meaningfully cuts down its exposure to market shifts that could generate sizable outlays of cash, a new analysis said.

A Mellon Financial Corporation news release said that its study found that freezing a plan can actually place the company at even greater risk unless management carefully addresses the remaining financial exposure.

“Freezing a plan often prompts a collective sigh of relief within the organization,” said Peter Austin, executive director of Mellon Pension Services, in the news release.  “However, the sense of relief may be premature. Freezing a plan does indeed eliminate the requirement to accrue future benefits. However, it doesn’t by itself fix what the root cause of the problem is frequently: volatility.”

Volatility results from market swings that affect the value of a pension plan’s assets and liabilities.  When such volatility results in an underfunded plan, cash contributions often are required so the plan can meet its liabilities.  Freezing is most commonly the first step toward the ultimate goal of plan termination, which relieves the sponsor of future obligations. Mellon said.

Termination worsens the shortfall for a plan that already is underfunded, Austin notes in the announcement, because a lower discount rate is used to value the liabilities. Paying employees lump sums to terminate the plan or paying insurance companies to assume the obligations are expensive options, Mellon asserted.

The Mellon analysis makes some concrete recommendations for executives who are involved in freezing their pension plans. They should ask:

  • Have we really eliminated plan risk and volatility?
  • Is termination our end goal? If so, how and when do we terminate?
  • How do we address our funding gap?
  • Should we change our asset allocation?

Austin said that asset/liability modeling and custom liability indexes are the keys to answering such questions. “The modeling examines thousands of possible economic scenarios and analyzes how various asset allocation formulas would perform relative to the plan’s liabilities,” Austin said.  “Customized liability indexes can be used to monitor the success of the investment strategy against plan-specific liability growth. Sponsors can use results of these tools to make better-informed investment decisions and more realistic assumptions about when termination can take place.”

The report is here .