Why are Healthy Employers Freezing Their Pensions?

Abstract

The shift in pension coverage from defined benefit plans to 401(k)s has been underway since 1981. This shift is the result of three developments: 1) the addition of 401(k) provisions to existing thrift and profit sharing plans; 2) a surge of new 401(k) plan formation in the 1980s; and 3) the virtual halt in the formation of new defined benefit plans. A conversion from a defined benefit plan to a 401(k) plan was an extremely rare event, particularly among large plans. Historically, the only companies closing their defined benefit pension plans were facing bankruptcy or struggling to stay alive. Now the pension landscape has changed. Today, large healthy companies are either closing their defined benefit plan to new entrants or ending pension accruals for current as well as future employees. Why are healthy employers taking this action? And why now?

This brief reviews the major pension freezes during the last two years and explores the impact on employees at different stages in their careers. It then offers four possible explanations why employers are shutting down their plans. The first is that some U.S. companies are cutting pensions to reduce workers' total compensation in the face of intense global competition. The second explanation is that employers have been forced to cut back on pensions in the face of growing health benefits to maintain existing compensation levels. The third explanation, by contrast, points to the finances of the plans themselves - specifically, their market risk, longevity risk, and regulatory risk that make defined benefit pensions unattractive to employers. The final explanation is that with the enormous growth in CEO compensation, traditional qualified pensions have become irrelevant to upper management who now receive virtually all their retirement benefits through non-qualified plans. Each of these explanations contains a kernel of truth, and they all help explain the current trends.

Keywords: defined benefit plans, pensions, 401(k), pension freezes, pension coverage, company, defined contribution plans, risk, compensation, employee benefits, benefits

JEL Classification: A10, E24, G23, G28, G31, G31, G33, G34, G35, G38