COST SAVINGS AND THE FREEZING OF CORPORATE PENSION PLANS* Joshua D. Rauh Northwestern University and NBER joshua
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1 COST SAVINGS AND THE FREEZING OF CORPORATE PENSION PLANS* Joshua D. Rauh Northwestern University and NBER joshua Irina Stefanescu Indiana University Stephen P. Zeldes Graduate School of Business, Columbia University and NBER October 2010 Abstract: A growing number of U.S. corporations have chosen to freeze defined benefit (DB) pension plans and replace them with defined contribution (DC) plans. A common hypothesis is that these shifts save costs for the firm. This paper examines a unique dataset of 112 pension freezes by publicly traded companies relative to a matched sample of plans at comparable firms that were not frozen. Freeze plans have older and longer tenured workforces than control plans. In particular, workers aged comprise 5 percentage points more of the workforce at freeze firms than at control firms. These ageservice patterns map into larger gross potential cost savings. Formally, for each additional percentage point of salary by which benefits would rise if a plan is not frozen, there is a percentage point increase in the likelihood that a firm will freeze its plans. In the very short term, the increase in contributions to DC plans largely offsets the cost savings of the decline in DB accruals. At the same time, the present value of pension liabilities for freeze firms falls by over 3% of book assets as a result of the freeze. Keywords: defined benefit plans, pension freezes, implicit labor contracts * The authors gratefully acknowledge the financial support from the Rotman International Centre for Pension Management (ICPM) at the Rotman School of Management, University of Toronto. We thank seminar participants at Indiana University for helpful suggestions. 1
2 1. Introduction Since the 1990s, there has been a shift from defined benefit (DB) to defined contribution (DC) pension arrangements in the U.S. corporate sector. This shift has continued markedly over the past decade. In the late 1990s, assets in private sector DB and DC plans were each around $2 trillion. By the end of 2007, DB plan assets in the private sector amounted to $2.6 trillion, compared to $3.4 trillion of DC assets. 1 The shift towards DC plans has occurred through several channels. First, the majority of new firms have favored DC arrangements. Second, some sponsors of DB pension plans have entered Chapter 11 bankruptcy and terminated their plans by transferring underfunded pension plans to the Pension Benefit Guarantee Corporation (PBGC). Finally, some firms have limited or stopped new DB accruals though a form of pension freeze. Firms undertaking a soft freeze have allowed DB benefits to continue to accrue for existing workers while offering new workers a DC plan only. Firms undertaking a hard freeze have stopped DB accruals entirely for all workers and instead covered workers after the freeze date via a DC plan only. This shift raises the question of motivation. One hypothesis is that moving from a DB to a DC plan saves firms money, on the grounds that the DB plans tend to provide more generous benefits. In a competitive, frictionless labor market, cost saving would be impossible as workers could simply demand offsetting wage increases. On the other hand, if DB plans involve some workers getting paid more than their marginal product, the firm could potentially realize savings by switching. Alternatively, if workers value DB benefits at an amount less than the costs to the firm then there would be a surplus over which employers and employees could bargain. This paper examines 112 hard pension freezes and considers their potential and actual cost savings relative to a matched sample of control plans. We test whether the extent of potential cost savings affects the decision to freeze, and then whether potential cost savings are actually realized. 1 See Department of Labor (2007), historicaltables.pdf. 2
3 The age and service distributions of the freeze versus control plans represents a reduced form picture of potential cost savings. We begin a simple non parametric comparison of the age and service distributions in the freeze and control samples. Participants in freeze plans are older and longer tenured than those in control plans. Freeze plans have 5.2% more workers over 50 and 4.4% fewer workers under age 35. They have 7.1% fewer workers with less than 5 years of service. They have substantially more mass in the part of the joint distribution with both older and longer tenured workers than control firms. This finding is interesting in the context of work that has shown that mid career employees located at the middle of a convex shaped benefit accrual function are incrementally worse off than other employees (Munnell, Golub Sass, Soto and Vitagliano, 2007). We then construct a calibrated estimate of the DB accruals that each plan in the freeze and control sample would have in the absence of freezes. This provides a more formal measure of potential cost savings excluding any labor market offsets. Under baseline parameters, freeze firms face average annual DB accruals of 14.2% of salary compared to 13.0% of salary for control firms, a statistically significant difference of 1.2 percentage points. Within reasonable alternative parameterizations of the calibration, this effect varies from approximately 1 percentage point to approximately 2 percentage points. To measure whether potential gross cost savings affects the decision to freeze, we run probit regressions of the decision to freeze on the potential cost savings and a series of covariates, including funding ratios, whether the firm is unionized, the share of plan participants that are currently employed, and the size of the plan. We find that for each percentage point increase in potential cost savings, firms are % more likely to freeze. Finally, we measure the extent of actual short term and possible long term cost savings from freezing DB plans. In particular, we examine the extent to which the freeze firms increase their contributions to DC plans and compare it to the decline in DB accruals as a result of the freeze. At the plan level, the annual average DB service cost (the increase of the pension benefits during the year) 3
4 drops from $5 million to approximately zero in the two years immediately following the freeze. Average total firm DB service costs drop from 0.4% to 0.2% of assets, a dramatic decline but not to zero because firms often sponsor multiple plans. At the same time, average firm contributions to DC plans rise from 0.3% of assets to 0.5% of assets, fully offsetting the DB service cost in the short term. The result also holds in difference in difference specifications using the matched sample as control firms. In the short term, therefore, we cannot reject full cost offset: DB service cost declines are accompanied by DC contribution increases of similar magnitude. The median sponsor of a frozen plan generates essentially zero dollars of saving in the short term. However, firms that freeze DB plans see a decline in the present value of liabilities under a projected benefit obligation (PBO) measure of approximately 3.3% of assets compared to control firms, which opens the possibility that the anticipated cost savings are actually realized in the long run. Long run cost savings could be realized if actual DC contributions will grow less in the long run than the counterfactual DB accruals would have. Rubin (2007) found that pension freezes enhance firm market values with a lag, which would be consistent with long run cost savings if markets focus on the short run flows and do not capitalize long run cost savings until they are evident in cash flows. Furthermore, while a capitalized value of all future DC contributions could in theory offset this decline, it is important to realize that future DC contributions are not contractually obligated to nearly the same extent as future DB benefits. In many instances, the pension plan becomes a competing interest for cash within the organization. DB plans imposed large costs on many employers during the first half of this decade, as poor asset market returns combined with low interest rates led to large cash funding requirements. 2 Yet companies wishing to terminate their pension plans outside of bankruptcy needed to have enough assets to cover liabilities. By freezing DB plans and relying more on DC plans, 2 Shivdasani and Stefanescu (2010) document that the average DB contribution is around 57% of the interest payment on debt, although the distribution appears to be skewed towards large employers. In our sample of freezes the average DB contribution exceeds the interest payment on debt. 4
5 firms soften the mandatory nature of future benefit payments and give themselves greater future flexibility. 3 We organize the paper as follows. In section 2 we describe the institutional background and the evolution of different forms of private pensions. In section 3 we present the theoretical considerations and the equations for deriving calibrated estimates of cost savings. In section 4 we describe our data. In section 5 we present and discuss our main results on the determinants of pension freezes. Section 6 examines evidence on cost savings. Section 7 concludes. 2. Background 2.1. Institutional background DB plans were the predominant vehicle for retirement two decades ago. Encouraged by the tax deductibility of pension contributions in times when corporate tax rates reached historical highs, these plans were an effective tool to build and retain human capital. Their importance has steadily declined in the US with the introduction of DC plans, particularly 401(k) plans, in the early 1980s. There are many differences between the DB and the DC plans but perhaps the most important is the distribution of risk between employer and employee. DB plan sponsors promise fixed retirement income to their employees, with employers bearing all the investment risk to meet the pension liability. The risk borne by the employee under a DB plan is limited to risk of job change and risk that the pension will be reduced if their employer becomes financially insolvent. DC and hybrid plans typically give most or all responsibility to the employee for making contribution decisions, taking investment risk, and making financial decisions. The sponsor responsibility in a DC plan arrangement ends after the contribution is made. The shift towards DC plans and hybrid plans has been remarkable. A number of papers document the decline of DB pensions in general, including early work by Clark and McDermed (1990) and Gustman and Steinmeier (1992). According to figures by Buessing and Soto (2006), the number of 3 DC benefits are considerably easier to cut on an ad hoc basis in response to economic conditions. See for example the decision by FedEx Corp in 2009 to stop all employer 401(k) matches. 5
6 individuals with only a DB plan fell from 9.6 million in 1990 to 6.6 million in 2003, whereas the number of individuals with only a DC plan rose from 11.5 million to 30.1 million over the same time period. The most cited reason behind the shift is the significant increase in pension costs and risks to the employer. The employer bears the risk of DB plan investments. It also bears interest rate risk, which affects the present value of the pension liability and therefore the mandatory funding requirements. The sponsor faces larger worker life expectancy rates compared with years ago when the plans were adopted. Changing legislation has also altered the expectations about costs. The Pension Protection Act (PPA) of 2006 has tightened the funding requirement and the new accounting standards (FASB 158) have moved some liabilities onto the balance sheet that were previously off the balance sheet. Another reason for the shift is the desire to align employee compensation with the lower labor cost of the global competitors. In equilibrium, the sum of cash wages and fringe benefits declines with competition, and employers find it easier to cut pension benefits. Facing all these challenges, corporate DB sponsors may prefer the less costly and more manageable structure of DC plans, other things equal. However, the termination of a DB plan is often costly and in many cases not possible. Unfunded pension liabilities can be taken over by PBGC only when the sponsor has filed for bankruptcy and reorganization is unavoidable in the absence of the pension takeover. Under normal business conditions, plans can only be terminated if they are fully funded and any excess assets are heavily taxed at a 50% rate. If they decide to proceed, sponsors pay off beneficiaries by purchasing annuities. Most of these standard terminations have been implemented for small single employer plans. 4 The number of distress terminations is also small, but the large ones have been highly publicized (for example United Airlines). The most common strategy implemented by DB sponsors has been a freeze of the pension plan. While there are several types of freezes, all involve the reduction or the cessation of new accruals. A 4 According to Belt (2005), during the period, 99,000 of the 101,000 single employer plan terminations fell into the category of a standard termination, with only 2,000 being distress terminations. 6
7 hard freeze eliminates all future accruals, the benefits will not grow from the level they reached at the time of the freeze. A soft freeze typically eliminates new accruals based on years of service, in particular by closing the plan to new employees. Most often, sponsoring companies compensate workers by allowing them to participate into either an existing or a new 401(k) plan. 5 Many large companies sponsor more than one plan, and firms frequently decide to freeze plans on a selective basis Literature Review While the benefits and the costs of sponsoring defined benefit plans are relatively well understood in isolation, the reasons behind freezing or terminating a DB plan under normal business conditions (no financial distress) remains an open question. Previous literature has focused either on work incentives (Ippolito (1985)), tax benefits (Black (1980), Tepper (1981), Petersen (1992), Shivdasani and Stefanescu (2010)), earnings manipulation incentives (Bergstresser, Desai, and Rauh (2005)) or financial slack (Ballester, Fried and Livnat (2002)). Corporate pension plans have a significant impact on the investment policy of the company (Rauh (2006)) and in some pension systems, significant agency conflicts could exist between the insider trustees and plan members (Cocco and Volpin (2006)). The literature has also succeeded in modeling some of the potential macroeconomic forces behind the DB to DC shift, such as declines in the value of existing jobs relative to new jobs (Friedberg and Owyang (2004)) and reduced search costs (Friedberg et al (2006)). Studies by Kruse (1995) and Ippolito and Thompson (2000) examine the periods and and generally find that the growth in DC plans over those periods was more the result of compositional effects than the result of terminating DB plans and DC conversions. However, these studies came before the hybrid conversions and pension freezes of very large employers. Pension freezes became common in the early part of the current decade. In 2005, pension freezes were announced by IBM, Hewlett Packard, Sears Holding, and Verizon. Reports issued by the 5 The PBGC has calculated that as of 2003, 9.4% of DB plans were frozen (PBGC (2005)), and other studies have calculated that the occurrence of plans being frozen to new participants is even more prevalent than the PBGC suggests (VanDerhei (2006)). 7
8 Pension Benefit Corporation (2008) and Government Accountability Office (2008) show that the majority of the freezes affect small plans. They show that about 21 percent of all active participants are affected by a freeze and that almost half of all sponsors have at least one frozen plan. It has been suggested that the incidence of freezes is less likely in collectively bargained firms. Given the relatively recent wave of freezes (and the lag with which this information becomes available at the plan level), the decision to freeze the DB plan has not been completely understood and the cost savings and the implications have not been quantified. To our knowledge, Munnell and Soto (2007) is the only paper that carries out an analysis that combines both the sponsor and the plan level characteristics. Their analysis covers only year 2005 and therefore explores cross sectional differences. In contrast, our analysis has a time dimension to the pension liability that allows us to estimate the actual cost savings at the plan level, in absolute value and also relative to a sample of control plans. They find the plan characteristics (underfunding level, size, large credit balances, bargaining power) play a role in the firm decision to freeze, although some of the coefficients are only marginally significant. They also find that the financial health of the company has a small economic impact on the decision to freeze. In contrast, Beaudoin and al. (2009) find that the profitability of the sponsor is important. In addition, they show that the balance sheet impact of SFAS 158 is associated with the decision to freeze. 3. Theoretical Considerations and Measuring Potential Cost Savings 3.1. Theoretical Considerations In a competitive and frictionless labor market equilibrium, a worker s total compensation must equal his or her marginal product of labor. Economic theory has posited a number of reasons why compensation may deviate from a worker s outside option. For example, efficiency wages may be paid to encourage effort (Shapiro and Stiglitz (1984)). Implicit contracts in which workers are paid less than their marginal product at the beginning of their career, and more than their marginal product late in the career, may discourage worker shirking (Lazear (1979)). 8
9 In most DB pension plans, accruals are larger for older workers than for younger workers. This arrangement may arise because a firm s older workers are more productive than younger workers, or it may be that the firm is using the implicit contract of the pension plan to reduce turnover or agency problems. A freeze of DB pension accruals can be thought of as having three sets of effects. First, the freeze in isolation with no offsets would be a cut in employee compensation; this cut is larger for longertenured employees whose annual accruals are larger. Hence, when considered in isolation, freezes lower DB pension accruals to zero and reduce the extent of seniority compensation. Second, the firm may need to compensate employees affected by the freeze. The firm may do this by raising salaries or contributions to other benefit plans, including defined contribution pension arrangements. In a perfectly competitive labor market in which employees and employers valued the pension benefits identically, the change in non pension compensation should exactly offset the reduction in pension benefit accruals. All potential cost savings for the firm would be offset, and relative total compensation among young and old workers would be the same as they had been before the freeze. In contrast, these offsets will be small if workers were compensated more than their marginal products before the freeze. Alternatively, if workers had valued the pension benefits at an amount less than the cost to the employer of providing those benefits, freezing the pension plan would generate a surplus over which employers and employees could bargain. Third, workers themselves may respond to the changed compensation package by pursuing outside options. If the total compensation of some workers relative to their outside options has decreased, then turnover would be expected to increase. Given these effects, there are several sets of conditions that would induce a firm to freeze DB plans. For example, a firm whose longer service workers were being compensated more than their marginal product under the DB plan in the context of some type of wage rigidities might attempt to freeze the plans to restore their competitive position. Firms that are in a weak financial position might 9
10 also be induced to freeze plans in order to save costs, but only if actual cost savings could be achieved through the freeze. Freezing is likely to be more costly for firms facing stronger employee representation in the form of unions. 3.2 Measuring Potential Cost Savings In the absence of any offsets, the potential cost saving from freezing plans is the value of the cost accruals that the firm would incur if the plan continued to run. The present value of accrued pension liabilities is a function of the benefit formula, the years of service of each employee, the salary of each employee, and the present value of an annuity beginning in each employee s retirement year. The expected cost accruals are simply the expected change in the present value of the liability in the absence of a freeze. These potential accruals could in theory be measured over a window of any length of time. Suppose the firm is considering a freeze at time t, and then consider the accumulated benefit obligation (ABO) liability at time s>t. The ABO liability at time t for one worker is given by, 1 (1) where k is the pension plan s benefit factor, N t is the number of years the employee has worked as of time t, Y t is the employee s salary as of time t, P s,r is the probability the employee lives from time t to retirement date R, and V R is the value of an annuity for this employee beginning at R. To measure maximum potential cost savings from freezing, we need to compare what the ABO will be at time s>t if there is a freeze with its value if there is not a freeze. Formally the comparison is between the following two formulas., 1 (2), 1 (3) 10
11 Defining the term in brackets in the above two formulas as Z s, we can calculate Δ t, the maximum potential cost savings from freezing at time t: (4) It is convenient to express this quantity as a fraction of Y t or the employee s current year salary. It can be shown that for a one year window (i.e. s=t+1), the maximum potential cost saving as a fraction of Y t is given by: 1 1. (5) This shows that the potential cost savings at time t as a share of time t salary can be expressed as a function of four simple quantities: the benefit factor k, the present value factor Z s, the rate of salary growth, and the current number of years service (N t ). The quantity δ t /Y t can then be aggregated across employees with different characteristics. As explained in the following section, our data allow us to measure the distribution of workers by age and service in each plan. We therefore aggregate over employees in these different cells, using the appropriate number of years of service and present value factors Z s for each. To aggregate across ageservice cells, a weighted sum must be taken over age (a) and service (s):, (6) where w a,s is a weight specific to the age service cell that depends on the share of that cell s salary in total plan salary (Y t * ):,. (7) We name the quantity gross potential cost savings. It reflects the percent of salary a firm could realize from freezing plans at time t if there are no offsets to other aspects of employee 11
12 compensation. We assume several variables in equations (5) (7) are constant across cells and plans, namely the benefit factor and annual salary growth, but we examine the sensitivity of the calculations to different assumptions. Gross potential cost savings will generally be larger when employees are older and have longer service, as additional years work under the plan happen at a part of the benefit accrual path that is very convex. However, once employees are very close to retirement, gross potential cost savings will decline. 4. Data and Empirical Strategy 4.1 Data We collect our sample of plan freezes from IRS Form 5500 filed at plan level with the Department of Labor (DOL). Starting with 2002, the form requires the sponsor to disclose whether the plan was frozen or not during the reporting year. The disclosures apply only to hard freezes. Starting from the first year when the plan is frozen, all subsequent filings will have this annotation. We note that most freezes that were implemented prior to 2002 clustered during this first year of the disclosure. In order to capture the year of the announcement we only allow in our sample those freezes that were first disclosed in The only instance when the year of the freeze is 2002 or 2003 is when we are able to identify the event in Factiva news. Our sample of plan freezes spans therefore the period Electronic versions of IRS 5500 filings are available from 1991 to However, starting with 1999, Form 5500 is missing key information (the CUSIP identifier of the parent company). The only variables that allow us to link the plan to the actual sponsor is the employer identifier number (EIN) and the plan stated sponsor name (which in most cases is the name of a subsidiary). The CUSIP identifier of the parent was therefore critical for automatic matching. The EIN (also referred to as the IRS identification number) of the subsidiary is in many cases different for the EIN of the parent. Subsidiaries that are at least 80% owned by the parent have the option to file for taxes separately, while still remaining consolidated with the parent company for financial purposes. 12
13 Identifying plans is further complicated when plan sponsors are acquired, sold, or merged. Tracking the plan over time can be challenging. These difficulties are all documented by other researchers in the area (see for ex. Munnell and Soto, 2007). To overcome these problems we manually collect the list of subsidiaries for all sponsoring companies during this time period (10 k filings, Exhibit 21). We identify sponsors in COMPUSTAT based on the availability of data on pension assets and liabilities. We then match Form 5500 with the list of subsidiaries on several dimensions: EIN numbers, sponsor names, subsidiaries names. This process allows us to obtain a very close match between sponsors and plans. A more detailed description of our final sample is included in Appendix Table 1. We identify about 9600 plan freezes in Form 5500 but most of them are very small plans, with less than 50 active employees. Only 719 plans are reliably matched with COMPUSTAT. We further eliminate from this sample all plans for which information is not available in the three years surrounding the freeze. This procedure automatically eliminates year 2007 freezes and yields 139 plan freezes. Finally, we condition on the availability of the age service matrix, which leaves us with a sample of 112 freezes. The industry distribution of these freezes is shown in Panel A of Table 1. The most represented industries are chemicals (7), business services (10), and depository institutions (12). A further sample on which we perform some analysis is the subsample in which we have both pre freeze and post freeze data for all of these items. This subsample and its industry distribution is shown in Panel B of Table 1; the subsample consists of 76 freezes Empirical Strategy A key feature of the empirical strategy is that we compare plans that sponsors decided to freeze with similar plans sponsored by other firms who did not enact pension freezes. In order to examine whether the variation in gross potential cost saving is associated with the probability of freezing plans, some control sample is required. Using a matched sample also allows us to eliminate any secular trends in the data during the sample period in considering whether cost savings were in fact achieved. For example, it might be the case that during this time period, contributions to DB plans were falling and 13
14 contributions to DC were rising for all firms; without a control sample it would appear that cost savings were being achieved through the freeze when in fact this trend was occurring at all firms. A further concern is that there were some changes in regulation during the period. In anticipation of the Pension Protection Act of 2006, sponsoring companies could have changed their behavior in a way that would be hard for us to capture empirically. On the presumption that the reaction was similar across similar plans, the matched pair research design will allow us to separate the effects of the freeze. Our matching relies on a matching of propensity scores, originally developed by Rosenbaum and Rubin (1983, 1985) and Heckman et al. (2007). The propensity score is the conditional probability of treatment assignment given ex ante variables. We limit the set of potential control plans to plans in the same industry and year as the firm observation undertaking the freeze. Industry is measured at the narrowest SIC level for which a set of at least two possible control plans exist, up to 4 digits We then calculate propensity scores based on the size of the individual plan liabilities (accumulated benefit obligation current liability from the IRS 5500), and the number of participants, using only plans with sponsors in the same industry as possible controls. 6 We focus on plan level variables, based on the intuition that pension related changes in regulation and accounting will impact these plans in a similar way. Additionally, we manually collect the age service compensation matrices that are filed as paper attachments to Form 5500 with the DOL. An example of such a matrix, for one of the pension plans from Xerox is provided in Appendix Table 2. Once a matching sample is obtained, we compare changes in plan and sponsor level variables before and after the freeze and for the comparable time period for the matched firm. We can also 6 Operationally this means that we run the propensity score matching four times: once at the four digit SIC level, once at the three digit level, once at the two digit, and once at the one digit. Where a plan has sufficient control plan candidates at the four digit level, we use the result of the four digit match. If not, we look at the three digit match, and so on. 14
15 examine the differences between freeze and control firms ex ante, particularly as regards to funding ratios, unionization, leverage, and profitability. A critical variable we hypothesize might affect the decision to freeze is gross potential cost savings from the freeze. The empirical strategy proceeds with a measurement of gross potential cost savings by applying equations (5) (7) in Section 3.2. In particular, the gross potential cost savings as a fraction of current year salary is calculated using equation (5) for each cell of the age service matrix. This gross potential cost savings is then aggregated across all participants in the plans using equations (6) (7). The plan specific information in this calculation is the age service distribution. The other parameters are calibrated. Our baseline parameters are a life expectancy of 15 years, a discount rate of 4 percent, a retirement age of 65, a benefit factor of 1.5 percent, and salary growth of 4 percent annually. While it would be useful to have plan specific data on each of these parameters, we were unable to obtain this information. After calculating gross potential cost saving, we next examine whether variation in gross potential cost savings is associated with the probability that the firm freezes its plans. In particular, we run probit regressions to estimate parameters in the equation, (8) where PotentialSaving is from equation (6) as described above. Finally, we examine whether short run cost savings were in fact achieved by considering sponsor level changes in DB accruals versus sponsor level changes in contributions to DC plans. Planlevel DB accruals should decline to zero, and sponsor level accruals should decline dramatically as well, given that the frozen plan represents 70% of sponsor DB participants on average. If workers are compensated for freezes with increased contributions to new or existing DC plans, however, this cost savings will be offset. We also examine suggestive evidence about long run cost savings through changes in recognized liabilities. 15
16 5. Empirical Results 5.1. Comparison of Freeze and Control Plans and Their Sponsors Table 2 presents plan level information on freezes and controls before and after the freeze. Panel A presents the averages for all 76 freezes with data available before and after the freeze, and all 99 control firms for which data is available before and after the freeze. Panel B presents the averages only for the 58 freezes for which both freeze data and matched control data were obtainable before and after the freeze. The results in the two panels of Table 2 are qualitatively very similar. There are somewhat more active and total participants in control plans than freeze plans before the freeze (2,088 versus 3,520 at the mean). While total participants is an element of the propensity score match, the limitation of the possible choices of control plans to plans with sponsors in the same narrowly defined industry leads to an imperfect match on number of participants. Nevertheless the differences are statistically insignificant. Looking at the effect of the freeze, the number of active participants declines by around 25% at the mean and 35% at the median, with little or no change shown in the control plans. We note here that the difference in differences are statistically significant. Average pension liabilities before the freeze are quite close for freeze and control firms, amounting to $175 million and $169 million respectively. Liabilities increase for control firms from $169 million to $204 million at the mean, while for freeze firms the increase is much smaller: from $175 million to $187 million. The plan service cost drops to essentially zero for the freeze plans, but not for the control firms. Again, the difference in differences are statistically significant. It is interesting to note that 17% of freeze firms and 29% of control firms are unionized. Freeze firms also have a smaller ratio of active to total participants, 49% compared to 57% at the control firms. They have worse funding ratios than control firms ( 12% of liabilities compared to 7% of liabilities). The decision to freeze will most likely depend on the sponsor characteristics as well. In Table 3 we examine the financial position of the firms that have taken the decision to freeze one DB plan, 16
17 relative to control firms, both before and after the freeze. Most firms offer different pension plans to different groups of employees, based on their employment contract (salaried or hourly workers), unionizations status or location. The typical firm sponsors three DB plans. About 85% percent of them have frozen the only plan sponsored by the firm. Table 3 shows that the sponsors of the frozen plans have higher leverage ratios, are less profitable, and consequently have lower interest coverage ratios during the years leading to the freeze. However, none of these differences in the sponsor characteristics before the freeze are statistically significant. We do see statistically significant changes in the difference in difference of debt to cash flow ratios and market to book ratios before versus after the freeze. These effects are linked to the lower expected profitability ratios in the future (possibly higher expenses). We note that the book leverage declines more than market leverage. Our measure for book leverage is adjusted for the occurrence of the additional minimum liability, which is reported as part of comprehensive income portion of the book equity. The freeze of the plan potentially removed the status of severely underfunded plan for some of these frozen plans. Removing the additional minimum liability improves the value of the reported book equity. 5.2 Age Service Patterns and Gross Potential Cost Savings In this section, we examine age service patterns for freeze versus control observations, and we compare our estimates of gross potential cost savings across the two groups. Panel A of Table 4 shows the service distribution of employees in plans that become frozen in a given year and the service distribution of employees in the control plans. Plans that undergo a freeze have 1.7 percentage points fewer employees with less than one year of service (statistically significant at 90%), and 5.4 percentage points fewer employees with 1 4 years of service (statistically significant at 95%). Freeze firms have 2.3 percentage points more employees with 5 9 years service, although this difference is not statistically significant; they also have 2.1 percentage points more employees with years service (statistically significant at 95%). 17
18 Figure 1 shows these service patterns in graphical form. The density of service for freeze firms lies below that of the freeze firms for the first two categories (<1 year and 1 4 years), and then lies at or above for the rest of the distribution. Firms that freeze pension plans have longer tenured workforces than comparable firms that do not freeze. Panel B of Table 4 shows the age distribution of employees in plans that become frozen in a given year and the age distribution of employees in the control plans. Plans that undergo a freeze have 1.0 percentage points fewer employees under 25 (statistically significant at 90%), 1.7 percentage points fewer workers in the age bracket (statistically significant at 95%), and 1.7 percentage points fewer workers in the year age bracket (statistically significant at 95%). Conversely, freeze firms have 1.5 percentage points more workers in the age bracket (significant at 90%), 2.2 percentage points more workers in the age bracket (significant at 99%), and 1.5 percentage points more workers in the age bracket (significant at 99%). Figure 2 shows these age patterns in graphical form. The density of age for freeze firms lies above that of the freeze firms for the categories up to around age 49 and then lies below for the rest of the distribution. Freeze firms clearly have a lower share of younger workers and a greater share of older workers than control firms. Figure 3 shows the joint age service density for freeze firms. Figure 4 shows the joint age service density for control firms. Figure 5 shows the surface that is the difference between the two. Both freezes and controls have more younger and shorter tenured workers than they do older and longertenured workers. However, the density difference in Figure 5 clearly shows that freeze firms have a larger share of older and longer tenured workers than control firms. Next, we estimate gross potential cost savings for freeze and control firms as explained in section 4 above. Our hand collected data requires a salary imputation when the compensation table is either not reported or particular age service group salary data is missing. For confidentiality purposes, the compensation is not reported if the number of participants in a certain age service group is below 18
19 20. 7 We estimate the missing compensation cells for freezes and control separately as their age servicesalary characteristics might be inherently different. Our baseline salary imputation regression has log salary as the dependent variable, and age and service as independent variables. To incorporate nonlinearities in compensation we include square terms of these variables. To integrate other plan level idiosyncrasies we include plan level fixed effect components to our regression. Plans with similar ageservice distributions might have, for example, a completely different starting point for the salary base depending on the human capital intensity in the industry. If a plan reports only participant level data, the fixed effects component is replaced by the average fixed effect of all plans in the regression. The first row of Table 5 shows our baseline calibration: a life expectancy of 15 years, a discount rate of 4 percent, a retirement age of 65, a benefit factor of 1.5 percent, and salary growth of 4 percent annually. Under this calibration, freeze firms accrue 14.2% of total salary annually due to newly promised DB benefits, while control firms accrue only 13%. The difference of 1.16% is statistically significant at the 99% level. The rest of Table 5 shows the sensitivity of these measures to changes in the nominal salary growth assumption (Panel A), the discount rate (Panel B), and the benefit factor (Panel C). Both the level of the gross potential cost savings and the freeze control difference are increasing in salary growth, decreasing in the discount rate, and increasing in the benefit factor. Within reasonable alternative parameterizations of the calibration, this effect varies from approximately 1 percentage point to approximately 2 percentage points. 5.3 Determinants of Plan Freezes Table 6 presents the results of the probit estimation of parameters in equation 8. The parameter of interest is θ, the effect of gross potential cost savings as a percent of salary on the probability that a 7 For our sample of frozen plans, 112 plans report the age service distribution of participants and 42 plans report the compensation matrices in the year preceding the freeze. For about half of the total participants there is an associated salary in the corresponding age service cell. For the sample of control plans, 113 plans report the ageservice distribution of participants and 63 plans report the compensation matrices in the year preceding the freeze. For about 80% of the total participants there is an associated salary in the corresponding age service cell. 19
20 firm freezes its plan. The control variables in the regression are an indicator for whether the plan is unionized, the plan funding ratio, the sponsor funding ratio, the ratio of active participants to total participants, and the size of the pension plan as measured by log assets. The top panel of the table shows coefficients with p values in parentheses, the middle panel shows marginal effects, and the bottom panel shows summary statistics. As shown by the marginal effects, the main finding is that for each additional percentage point of gross potential cost saving as a fraction of salary, a firm is percentage points more likely to freeze its plans. This coefficient is closer to 3.5 and statistically significant at the 1% level when including controls for whether the firm is unionized and one of the funding ratio variables. With all of the controls together, including the plan ratio of active participants, the coefficient is closer to 2.5 and is significant at the 5% level. Given that freeze firms have 1 2 percentage point higher levels of θ than control firms, this regression therefore explains anywhere from 2.5 percentage points to 7 percentage points of the difference in freeze likelihood. 8 The ratio of active participants itself has a statistically strong determinant of the freeze probability. For each percentage point increase in the ratio of active participants, a firm is 0.34 percentage points less likely to freeze its plans. A one standard deviation change in the active ratio is 23 percentage points, so that a one standard deviation increase in the active participant ratio reduces the probability of freezing by 8 percentage points. One potential explanation for this is that there may be large fixed costs associated with the administration of the plan. The smaller the fraction of active participants the more costly must be carrying it forward. The sponsor funding ratio also affects freeze probabilities in a statistically significant way. A 20 percentage point higher funding ratio (about one standard deviation) reduces the freeze probability by 8 percentage points (= 0.2 * 0.393). Unionization also has a statistically strong effect on freeze 8 While the effect of a one standard deviation change in θ on the freeze probability appears to be small (0.34 percentage points), θ is an estimated variable and therefore its standard deviation is expected to be small. 20
21 probabilities. Changing the status of the plan from non unionized to unionized decreases the probability of a freeze by 39 percentage points. 6. Effects of Freezes on Costs Finally, we quantify the potential cost savings associated with the freezing of DB plans in the absence of any wage offsets. We measure the long term savings by the change in the projected benefit obligation (PBO), which reflects the present value of pension liabilities based on expected future salary increases of current plan participants. The calculation of the PBO naturally relies on the age and the years of service of all employees with the company. Following the hard freeze of their pension plan, the sponsor experiences an immediate decrease of the DB pension liability down to the accumulated benefit obligation (ABO). The change in the pension liability is therefore a reflection of the present value of forgone (or saved) contributions. We measure short term savings by comparing the change in service cost (the annual pension cost accrual due to an additional year of service) with the increase in the firm contribution to the DC plans. In Table 7 we show the changes in these variables, PRE and POST the decision to freeze for both our sample of freezes and their controls. The analysis here is restricted to the 87 events for which we have data for both the freeze and its control in the period preceding and following the freeze. Panel A of Table 7 presents the absolute level of these variables, while Panel B normalizes them by the lagged value of corporate assets. Finally, the last column shows the difference in difference of these variables for freezes and their control. We find that, on average, long term savings as measured by the change in PBO are substantial, amounting to $272 million or 3.3% of assets in the freeze year. The service cost (or the flow component of PBO) decreases for freeze sponsors relative to their controls by about 13 million or 0.17% of assets. Service cost will generally not fall to zero because firms often sponsor several plans. In contrast, contributions to DC plans increase significantly during the sample period, for both freeze plans and their controls. Freeze plan sponsors contribute on average $28 million (or 0.3% of assets) to DC plan in the 21
22 year before the freeze and $55 million (or 0.5% of assets) after the freeze. The difference in difference is significant both in absolute and in relative terms. Nevertheless, total pension cost does not appear to significantly change in short run. Our results suggest therefore that if cost savings are generated through the pension plan freeze, they must be generated in the long run. The extent to which they will materialize depends on the long term path of the DB service cost relative to DC contributions. If DC contributions will be relatively stable but the service cost would have grown at a rapid rate, then long run cost savings would be achieved. 7. Conclusion This paper addresses three main aspects of the causes and consequences of the freezing of defined benefit (DB) plans. First, how large are potential short term cost savings from freezing DB plans? Second, to what extent are these short term cost savings offset by raising contributions to 401(k) plans? Third, to what extent does potential cost savings impact the decision to freeze or not? Sponsors of defined benefit (DB) pension plans are subject to mandatory disclosure of the ageservice compensation matrices. The data allows us to quantify the accrual loss for the firm s workers as a whole and for workers who have worked at the firm for different lengths of time. They also allow a measurement of the changes in wage and salary compensation for the firm as a whole and for workers with different tenures at the firm, relative to workers at similar firms that did not freeze their pension plans. The results suggest that gross potential cost savings are an important determinant of the firm s decision to freeze pension plans. However, in the initial years following the freeze, contributions to DC plans increase on an order of magnitude that is comparable to the initial accrual decline. Combining these results suggests that firms expect larger cost savings in the long run than in the short run. Further research on the future experience of these firms is required to test whether those larger cost savings are in fact realized in the long run. 22
23 References Ballester, M. D. Fried, And J. Livnat, 2002, Pension Plan Contributions And Financial Slack, Working Paper, New York University. Beaudoin, C. A., Chandar, N. and E.W. Werner, 2010, Are Potential Effects Of SFAS 158 Associated With Firms' Decisions To Freeze Their Defined Benefit Pension Plans?, Review Of Accounting And Finance, forthcoming. Belt, B., 2005, Testimony before the Committee on education and the workforce, United States House Of Representatives. Bergstresser, D., M. A. Desai, And J. Rauh, 2005, Earnings Manipulation, Pension Assumptions And Managerial Investment Decisions, Quarterly Journal Of Economics. Black, F., 1980, The Tax Consequences Of Long Run Pension Policy, Financial Analyst Journal, 36 (4), Buessing, Marric And Mauricio Soto, 2006, The State Of Private Pensions: Current 5500 Data, Center For Retirement Research Issue In Brief 42. Clark, Robert And Ann Mcdermed, 1990, The Choice Of Pension Plans In A Changing Environment. Washington: American Enterprise Institute. Cocco, J. And Volpin, 2007, The Corporate Governance Of Defined Benefit Pension Plans: Evidence From The United Kingdom, Financial Analysts Journal, January/February 2007, Vol. 63, Friedberg, L. and M. Owyang, 2004, Explaining The Evolution Of Pension Structure And Job Tenure, NBER Working Paper # Friedberg, L., M. Owyang, and T.Sinclair, 2006, Searching For Better Prospects: Endogenizing Falling Job Tenure And Private Pension Coverage, Topics In Economic Analysis And Policy 6(1). Gustman, Alan, And Thomas Steinmeier, 1992, The Stampede Towards Defined Contribution Plans, Industrial Relations 31, Heckman, J. et E. Vytlacil al., 2002, Econometric Evaluation Of Social Programs, Part I : Causal Models, Structural Models And Econometric Policy Evaluation, Handbook Of Econometrics, Volume 6b, Edited By J. Heckman And E. Leamer. Amsterdam: Elsevier, Pp Ippolito, R. A., 1985, The Economic Function Of Underfunded Pension Plans, Journal Of Law And Economics 28, Ippolito, Richard A., And John W. Thompson, The Survival Rate Of Defined Benefit Plans, , Industrial Relations 39,
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