In the latest piece of bad news regarding traditional pen- sion plans, Verizon Communications Inc., the $71.2 billion phone company, announced that it is freezing its defined benefit (DB) pension plan for 50,000 management employees. Verizon is just the latest in a line of U.S. companies backing away from DB plans. According to a Watson Wyatt study, 11% of Fortune 1,000 companies with DB plans had frozen or terminated their plans in 2004, up from 7% in 2003. The trend reflects in large part the financial market swings that left many plans severely underfunded, wreaking havoc on corporate bottom lines. Companies may see freezing the plan as a way out of the maelstrom, but benefits consultants warn that it solves only part of the problem: While freezing a DB plan reduces costs, it has little immediate effect on the financial risks associated with the plan.

"What's surprising is how long it takes most typical plans after they're frozen to achieve a reduction in financial risk," says Alan Glickstein, a senior retirement consultant in the Dallas office of Watson Wyatt. "You're talking decades in many cases before there's an appreciable drop in the liabilities and the exposure to risk." Jim Morris, a senior vice president at SEI Retirement Solutions, argues that the financial risks of a DB plan may be even greater after the plan is frozen. For one thing, companies tend to put frozen plans on the back burner, and that lack of attention can be dangerous. "A frozen plan has to be managed just as actively, if not more so, than an active plan," Morris says. "We like to say that when you freeze, you're really just starting a new process, you're not finishing." In an illustration of the risks involved, he notes that some companies that froze well-funded plans years ago were disconcerted to see those plans become underfunded when financial markets fell, resulting in stepped-up contribution requirements. Glickstein says companies should be aware that frozen plans behave differently and must be managed differently. "So the sensitivity to interest rates should change, the investment strategy should change, [and] there should be greater interest in liquidity, since more benefits are being paid out than earned," he says. Morris says that's particularly true if the company plans to terminate the plan. "If your business is on a five-year cycle to terminate the plan, you're trying to take risk off the table as fast as you can," he says. "If you get a spike in interest rates, the organization may want to lengthen the duration of its bonds and pull back on its equity commitments."

Companies could eliminate financial risks by terminating their DB plans. But that's an expensive option, because it requires either paying a lump sum or buying an annuity for each plan participant. With interest rates still relatively low, Morris estimates that termination costs could be up to 20% higher than full funding. Of course, that cost will decline if interest rates continue to rise. Meanwhile, though, the number of companies freezing their plans is likely to rise. "More and more of our current clients as well as the folks we're talking, to are either freezing or about to freeze," Morris says. Glickstein also sees "a significant risk" that going forward, plan freezes could "continue or accelerate." The Financial Accounting Standards Board's proposed changes to the way companies account for pension plans could encourage companies to freeze, he says, as could the pension financing reform legislation currently before Congress. Glickstein cited the elimination of smoothing as one provision that could encourage more freezing of plans, but added that the legislation could actually prevent plans from being frozen if it clears up the legal confusion about cash balance plans, also known as hybrid plans. "In many cases, we think the closing or freezing could be eliminated if that choice that many companies want, of the hybrid plan, were available," he says.

Continue Reading for Free

Register and gain access to:

  • Thought leadership on regulatory changes, economic trends, corporate success stories, and tactical solutions for treasurers, CFOs, risk managers, controllers, and other finance professionals
  • Informative weekly newsletter featuring news, analysis, real-world cas studies, and other critical content
  • Educational webcasts, white papers, and ebooks from industry thought leaders
  • Critical coverage of the employee benefits and financial advisory markets on our other ALM sites, PropertyCasualty360 and ThinkAdvisor
NOT FOR REPRINT

© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.