Looking to lower costs and reduce future funding obligations, many U.S. companies are taking a hard look at the retirement plans they offer to their employees. The harshest scrutiny is being focused on defined-benefit pension plans, which usually reward employees for years of service with a guaranteed monthly retirement benefit. Many employers are deciding that their traditional pension plans are simply too expensive to maintain, and the result is that they are freezing these plans. (To find out more about these plans, see The Demise Of The Defined-Benefit Plan.)
For employees - particularly those close to retirement - who spent a number of years with the same employer, a frozen pension plan deal a severe blow to their post-work plans. The guaranteed income they had been anticipating upon reaching retirement age could be reduced significantly as a result of a pension freeze, which may force them to rely on the uncertainties of a 401(k) or some other type of defined-contribution plan.
What is a frozen pension plan?
A frozen pension plan is one that has been amended to discontinue benefit accruals under the plan, although the assets remain in the plan. Certain administrative requirements must continue for a frozen plan, including ensuring that the plan satisfies minimum funding standards.
Generally, there are two types of frozen pension plans, a hard freeze and a soft freeze.
A "soft freeze" is when benefit accruals that are determined based on years of service are discontinued. This means that years of service after the effective date of the freeze are not factored into determining an employee's benefits under the plan. However, benefits continue to accrue based on increases in covered participants' compensation. An alternative version of the soft freeze is to freeze out a certain class of employees or new participants.
Under a "hard freeze", employees will receive the benefits already accrued, but no new benefits are accrued after the date the plan is frozen. Thus, if a worker has spent 20 years with a company and plans to stay for an additional five years until retirement, no pension benefits are accrued during those last five years. Further, no new participants are allowed to participate in the plan.
Most companies that freeze pension plans either introduce a 401(k) plan or other defined contribution plan, or enhance an existing plan.
Freeze Vs. Termination
A pension freeze is different from a pension termination. In a termination, a company must pay out all benefits as soon as administratively feasible, usually no longer than one year after the termination date. Distributions can be made as a lump sum, if permitted under the plan, or by buying employees an annuity that pays benefits over time. Companies in bankruptcy may transfer their pension liabilities to the Pension Benefit Guaranty Corporation (PBGC), a federal government agency that insures pension plans. (For more on the PBGC, see The Pension Benefit Guaranty Corporation Rescues Plans and Lump Sum Versus Regular Pension Payments.)
Pension Protection Act of 2006
The Pension Protection Act, as its name implies, was meant to help ensure the financial viability of pension plans following high-profile plan terminations at several airline, steel and other companies. A few of the PPA's provisions, however, resulted in many businesses either shying away from adopting new defined-benefit plans, or terminating/freezing those that were being maintained.
Signed by President Bush in August 2006, the PPA runs more than 900 pages and includes a number of provisions related to retirement plans. These include provisions that allow companies to enroll employees automatically in 401(k) plans, provide investment advice to employees and establish default investment elections. These are viewed as some of the positive provisions.
The negative provisions include those that seem to encourage companies to consider freezing or terminating their pension plans. PPA sets much stricter standards for ensuring companies set aside enough capital to fully fund their pension obligations. In particular, PPA gives most pension plans seven years - beginning in 2008 - to make sure their plans are 100% funded. For employers that fail to meet this funding obligation, a 10% excise tax may be levied on the company if the deficiency is not corrected in time. For many companies, this will mean they must accelerate their contributions. While these employers are permitted to deduct the cost of making these additional contributions, the end result will likely have a negative impact on the company's bottom line.
What a Frozen Pension Plan Means for Employees
Under most defined-benefit plans, an employee's retirement benefits accumulate the most during the last few years before retirement. This means that a pension freeze for employees in their 50s and likely approaching their highest earning years can be a significant blow to the plans they had for retirement.
Pension plan formulas typically take into account the number of years an employee has been with a company and the average salary over the course (or over the final few years) of the employee's employment with the company. A pension freeze reduces the number of years used in the calculation, reducing the monthly amount the employee receives from the plan during retirement. (To find out how to save more for retirement, see Retirement Saving Tips For 45- To 54-Year-Olds, 55- To 64-Year-Olds and 65-Year-Olds And Over.)
Consider this example: Company ABC's defined-benefit plan pays an annual benefit at retirement age that equals 1% of final salary multiplied by years of service (final salary x 0.01 x years of service).
Assume a worker, now 55-years-old, currently earns $50,000 a year and has been with the company for 20 years. Assuming a 3% annual increases and 10 years until retirement, that worker could anticipate an annual retirement benefit of $20,159. That would be based on a final salary of $67,196 ($67,196 x .01 x 30 years).
If that worker's pension plan is frozen when he is 55, his future benefit will be reduced by more than half to $10,000 ($50,000 x .01 x 20 years). The reduction occurs because the calculation incorporates fewer years of service and a lower salary figure.
Rescue Your Retirement: Five Steps to Take
Rarely is a pension freeze good news for employees. However, there are steps that can be taken to minimize the negative impact. The key is that employees must take a more active role in preparing and saving for retirement. The following are some steps that employees can take:
- Read Everything: To understand the impact of the freeze, employees must read the documents given to them when their employer announces its intentions to freeze the plan. Also, attend any information sessions held by the company. Not every frozen plan works the same way. It is critical to understand how yours will work and how you will be affected There may be provisions to ease the transition or enhanced 401(k) contributions to help make up for the lost benefits that were promised under the pension plan. You should also read the summary plan description in effect prior to the effective date of the freeze and the summary of material modification that you should receive after the freeze, to help you understand the changes.
- Run the Numbers: Using the formulas outlined in plan documents, calculate what you are likely to receive from a frozen pension. You may need to pull some of your old tax records to determine your income in prior years, but it will be worth the effort. Nothing gives you a clearer picture than putting numbers on paper and tabulating the results.
- Save More: Increase contributions to your 401(k), 403(b) plan or other defined-contribution plan. Contribute more to a Traditional or Roth IRA - if you do not already have one established, consider changing that as soon as possible. Regardless of the scenario, you will probably need to save more for retirement if your pension plan is frozen. Also, you want to be sure you're capturing the maximum matching contributions if your employer provides matching contributions under a 401(k), 403(b) or SIMPLE IRA. (For more information, see Making Salary Deferral Contributions - Part 1.)
- Consider Your Employment Options: Traditional pension plans give employees an incentive to stick with a single employer for many years. A frozen pension plan removes that incentive. Because benefits under defined-benefit plans usually accumulate most rapidly as one nears retirement, an employee who has been with a company for 25 years but leaves five years before retirement age, for example, will receive a monthly pension benefit that is considerably smaller than if he or she remained with the company. A frozen pension plan removes the incentive to stay with the employer. Of course, there are other factors to consider including salary, health insurance and other retirement benefits that are being offered to replace the pension plan.
- Seek Financial Advice: The shift from defined-benefit plans with guaranteed monthly income toward defined-contribution plans means employees are more responsible for the financial security of their retirement. Therefore, employees should consider seeking professional assistance with their finances. Even with the most generous employer contribution to a 401(k), poor investment decisions can ruin a retirement plan. Seeking professional assistance can help you to guarantee the financial security of your retirement.
Like it or not, the traditional pension plan is on its way out. In the years ahead, more employers will likely decide to freeze or terminate their pension plans as they face the strict funding requirements established under the PPA. The good news is that there are steps employees can take to ensure a financially secure retirement. Be sure to take those steps and seek the assistance of a competent financial planer.