Has the US got over the worst when it comes to the freezing of defined benefit (DB) schemes? Perhaps yes, according to a recent report by consulting firm Watson Wyatt Worldwide, which during the last 10 years, has been tracking whether US firms have frozen DB plans or are in the process of freezing and terminating a plan. While the trend had been upward until last year, for the first time in 2007 the percentage of plan sponsors that have frozen their pension plans has dropped, declining to 4% from 7% in 2006.
Alan Glickstein, the national practice leader for policies and processes at Watson Wyatt, says: "59% of large companies that still have DB plans are committed to keeping them. There undoubtedly will be more DB plan freezes and closes in the future, because pension changes happen slowly and decisions take a long time to be taken and implemented. But the rate is going down and we are pretty optimistic that employers will react positively to the Pension Protection Act (PPA) and the new economic environment."
The PPA became law in August 2006 and will take effect only in 2008, but it has already helped in two ways, explains Glickstein: "First, it has given certainty about the funding rules, making costs more predictable for all plans and stabilising the system. Second, it has provided new clarity for hybrid plans, which used to be very popular in the 1980s and 1990s, but then they stopped growing because of legal problems. We already see large companies, such as Dow Chemical, MeadWestvaco and SunTrust Banks, which have announced new cash-balance plans, while FedEx has expanded its existing cash-balance plan."
Hybrid plans - typically cash-balance plans - are DB schemes for tax, accounting and regulatory purposes, with the sponsor company deciding how to invest the assets and bearing the investment risks. At the same time they look like DC schemes because each employee has his own notional account balance that grows by some defined rate of interest and annual employer contribution. Cash-balance plans were hit by a wave of lawsuits claiming they violated age discrimination laws, but now the PPA and two appeals courts have established they are acceptable.
"Before the PPA and the court ruling, companies thought they could only switch from DB plans to 401(k)s, they had no alternative," says Glickstein.
"Now, judging from our experience, many companies are re-evaluating their retirement schemes and thinking of hybrid plans because they are cheaper: in the long term they may provide the same level of benefits with lower costs. In fact, the plan may be designed to lower volatility and, being managed by professionals, it should perform better than 401(k)s, where investment decisions are made by employees. A cash-balance plan also gives a company a way to use any surplus in its current DB plan. Besides, a company that freezes its DB scheme and opts for a 401(k), has still to manage the frozen plan and bear its risks."
The Dow example corroborates Glickstein's thesis. The company said it decided to launch a cash-balance plan after it reassessed its retirement benefits in the wake of the PPA. Dow managers believe that, in the long term, the use of a cash-balance plan will reduce the company's pension expense volatility, and it will also attract young workers because, after a three-year vesting period, employees can take their assets with them if they leave the company.
On the other hand, another Wall Street blue chip, IBM, will stop contributing to its DB pension fund at the end of the year, freezing it and shifting employees to an expanded 401(k). IBM made the decision at the beginning of 2006 after years of fighting in court against a lawsuit from a group of workers over its 1999 switch to a cash-balance plan, even if the company won the case eventually.
"Another important reason why DB plans should get new traction is the economy," says Glickstein. "In past years they incurred funding problems - their asset growth didn't match their liabilities' expansion - because interest rates became extremely low, while stock market returns were bad. Now that interest rates have stabilised and asset returns are positive again, companies don't face a funding crisis anymore."
Watson Wyatt's research focuses on the Fortune 1000. The number of firms in this list that sponsored one or more frozen DB plans rose from 45 in 2004 to 113 in 2006, and to 138 in 2007, while the percentage of plan sponsors freezing their plans rose from 1% in 2004 to 4% in 2004 and 7% in 2006; since then it has dropped to 4% this year. During the last six years, DB sponsorship has stayed fairly steady at around 63%.