Most companies would probably freeze their defined-benefit pension plans if the costs start eating large chunks out of corporate cash flow, a new survey of 109 senior finance executives finds.
Indeed, 60 percent of the respondents said their companies would likely deny pensions to new workers or stop adding benefits for current ones if the plans start making inordinate cash demands, according to the Towers Perrin study of mainly CFOs, treasurers, and vice presidents of finance for U.S. and U.K. companies with pension assets over $100 million.
According to Towers Perrin, 48 percent of the companies surveyed are likely to freeze their plans if they produce a hit to earnings; 43 percent are likely do so in response to a rise in cost of capital or a lower credit rating; and 33 percent will probably take action in the face of a dropping share price. Thirty-two percent of the companies surveyed had already closed their plans to new entrants. (Towers Perrin didn’t specify whether a “freeze” refers to halting current employees from receiving new credit for future benefits, refusing pension benefits to new employees, or both.)
In general, the trigger for freezing plans appears to be a drain on cash flow so severe that other cherished corporate programs are threatened with cuts. Things have gotten serious when “the pension plan becomes a competing interest for cash within the organization,” says Cecil Hemingway, who heads the pension-legacy solutions department at the actuarial and risk-management-consulting firm. In particular, pension plans would not be allowed to continue if they began to drain funds away from share buyback programs or investments in plant and equipment, he adds.
And if Congress passes a law mandating that plan sponsors fund 100 percent of pension obligations, as it’s likely to do, then many companies could be freezing their plans soon. Both Senate and House versions of the legislation reportedly demand full funding, a measure that President Bush is likely to support. Under current law, pension sponsors must fund 90 percent of their plans’ obligations.
Since pension funding can be a very volatile proposition, many plans are likely to dip below the current 90 percent level, according to other research by Towers Perrin. For example, a drop in long-bond yields drove the funded level of a hypothetical benchmark pension plan that the firm tracks down 1.4 percentage points, to 84.1 percent, in February. If the funding of real plans stayed down at that level, sponsors would have to start making contributions out of cash flow, Hemingway noted. And Congress is pushing to have a law enacted by April 15.
If Congress and President Bush do tighten funding requirements, 62 percent of the companies Towers Perrin studied would consider freezing their plans. Another point of pension anxiety is the Financial Accounting Standards Board’s current project to study — and likely overhaul — the current pension accounting system. The overhaul could include the elimination of smoothing, the practice of spreading out the estimated value of pensions over a period of time as a way to counter rate volatility. If FASB were to jettison smoothing, 72 percent of the executives surveyed would mull pension freezes.
Halting future pension benefits payouts, however, doesn’t staunch the bleeding entirely. “Freezing a defined benefit plan is only a half-measure that slows the growth of the plan, but does little to alleviate the associated market and mortality risk” thrown off by the existing plan, added Hemingway. To manage such risks, 60 percent of the executives find financial instruments such as plain-vanilla interest rate swaps attractive. Other alluring fixes were buying annuities and spinning off plans to third parties like investment and commercial banks, with 28 percent of the respondents attracted to each method.