Pension Conversion, Termination, and Wealth Transfers

ABSTRACT This article explores the motivation to change their defined benefit pension plan by either terminating the plan and replacing it with a defined contribution plan or converting it to a cash balance plan. Using Form 5500 data as well as firm financial data, we find firms wishing to change their defined benefit plans are motivated by potential wealth transfer and tax implications. Firms terminating pension plans tend to have lower potential wealth transfers and lower taxes than firms converting to a cash balance plan, indicating a desire to modify the implicit contract instead of terminating the plan. INTRODUCTION Traditional defined benefit plans sponsored by an employer provided a means to attract and retain a skilled workforce, offer lifetime income security, and provide for an effective compensation package. However, many defined benefit plan sponsors have determined the cost and risk of offering defined benefit plans burden the sponsor's operations and profitability. Sponsors face uncertain costs resulting from funding an unknown and estimated liability based on future salaries, years of service, and the average life expectancy of the workforce. In addition, sponsors also bear investment risk of the plan assets, which can increase the volatility of annual funding requirements. Finally, changes in regulatory environment also increase the cost and risk to the plan sponsor. The Employee Retirement Income Security Act (ERISA) increased protections to beneficiaries' pensions, but also increased regulatory, maintenance, and reporting costs, including the costs associated with restrictions placed on the firm's ability to design an optimal plan benefiting both the firm and employees (Clark and McDermed, 1990). McGill et al. (2005) find the cost of administrating a defined benefit plan has increased 7.43 percent annually between 1981 and 1996, but increased only 4.42 percent for defined contribution plans. Furthermore, between 1977 and 1985, Clark and McDermed (1990) document a decline of over 10 percent in pension plan participants covered by a defined benefit plan, demonstrating ERISA marked the beginning of a steady decline in the number of participants covered by defined benefit plans. Although one motivation for ending a traditional defined benefit plan is the increased costs related to a defined benefit plan, reducing financial distress or responding to the needs of the contemporary mobile workforce (i.e., attract better qualified employees) are other factors in pension plan design and implementation. We model a firm's decision regarding each of its traditional defined benefit pension plans as a two-step process. First, a firm must decide whether to maintain the existing defined benefit plan or alternatively replace it with another plan. Second, if the firm decides to replace the plan, there are two common choices: (1) the firm may replace the plan with a defined contribution (DC) plan, or (2) the firm may convert to a cash-balance (or similar) plan. The purpose of this article is to determine the factors in this two-step decision leading to termination or to conversion. To do this we use a matched-firm cross-sectional analysis as well as firm- and plan-level data. Our research adds to the existing literature of plan terminations and the relatively new literature on hybrid pension plans. Niehaus and Yu (2005) employ financial statement data and a change in the tax regime to test a tax motivation for choosing between a cash balance conversion and a defined contribution plan. We extend the study of Niehaus and Yu (2005) by analyzing individual plan-level, as opposed to aggregate firm-level data, as well as implementing a cross-sectional methodology. This methodology tests the cross-sectional variation in tax-paying status and funding status to determine if tax avoidance is a motivation for the method of defined benefit plan change. In addition, the method also allows simultaneously tests of alternative hypotheses of wealth expropriation and financial distress. …