Traditional pension plans are not back. But news from IBM might make you think so.
Last month, IBM banned a defined benefit pension plan that had been frozen more than 15 years ago. The company has also stopped making contributions to employee 401(k) accounts.
These moves are surprising because, on the surface at least, IBM appears to be reversing a decades-long trend of companies moving away from traditional pension plans. Under the old plans, companies promised to pay workers a retirement income that rewarded them for many years of service. But these plans were expensive, and IBM and hundreds of other companies began emphasizing the 401(k) that shifted the primary responsibility for saving and investing to employees.
IBM’s new approach is significant because the company is a leader in employee benefits policy. What he is doing now is not a simple return to the classic cradle-to-grave benefits system. In fact, IBM’s new pension plan is not as generous for long-term employees compared to its predecessor.
The move has real advantages for some people who work at IBM, particularly those who put little or no money into 401(k)s and stay with the company for a relatively short time.
Most importantly, IBM’s maneuver is likely to be great for its shareholders. The company saves hundreds of millions of dollars a year by stopping contributions to employee 401(k) accounts. And he doesn’t need to put money into the retirement plan this year—and, possibly, for years to come—because he already has plenty of money. From a purely financial perspective, IBM is improving cash flow and results.
For a small but important subset of companies — those with fully funded, closed or frozen pension plans — IBM’s move could be a harbinger of things to come, pension advisers say. IBM is using a surplus in its pension fund to simultaneously change its employee benefits package and help the company’s finances.
“You’re going to see more of this,” said Matt Maloney, senior partner at Aon. “But I don’t think it’s really a momentum event, because not that many companies are able to do what IBM is doing.”
Retirement Basics
IBM calls its new retirement plan a “retirement benefit account.” It is nested, legally and bureaucratically, within the old version. Because it is part of the defined benefit pension plan, the new plan is backed by the state Pension Benefit Guaranty Corporation, which will pay benefits, up to certain limits, if the plan runs out of money or the employer goes out of business.
Unlike 401(k)s, in pension plans the employer “makes the contribution, owns the assets, chooses the investments and bears the investment risk,” said Alicia Munnell, director of the Center for Retirement Research at Boston College.
Employees are immediately covered by IBM’s new plan and can take their money with them when they leave, IBM says. So far so good.
But for many workers, change comes at a cost.
IBM will no longer make contributions to employee 401(k) plans. So far, he has made 5 percent matching contributions and 1 percent automatic contributions, according to publicly released internal documents authenticated by IBM spokeswoman Jessica Chen. This money and these accounts belong to employees. It took a year to get workers on those accounts.
The new retirement benefit accounts are part of a so-called cash balance plan, a retirement plan in which the employer controls how the money is invested.
In IBM’s new accounts, employees receive credits equal to 5 percent of their salary — 1 percentage point less than the company’s maximum 401(k) contribution previously. For the first year only, employees receive a 1 percent salary increase to cover the difference in contributions between the old 401(k) and the new retirement accounts.
Risk and Return
IBM documents show that on the new accounts, employees are guaranteed a 6 percent interest rate return for the first three years — an excellent rate under current market conditions.
From 2027 to 2033, the return is likely to decrease. Workers will receive the 10-year bond yield, with a floor of 3 percent. From 2034 onwards, there is no floor. So if bond yields fall below 3 percent — as they did most of the time from late 2008 to early 2022 — a paltry return is all workers will get.
Remember, in a 401(k), employees are free to invest as they wish. People with a long investment horizon may favor the stock market, which tends to produce higher returns than government bonds over long periods.
Although IBM employees can keep their 401(k)s and continue to add money to them, they won’t have the incentive of a company. How many will continue to contribute remains to be seen. In the new accounts, employees receive only fixed income investments.
This may be good for people in retirement, but it is questionable for those with years to come in the workforce. Employees may need to increase equity allocations in their 401(k) or other accounts.
Background
At the height of defined benefit plans in the 1970s, as many as 62 percent of private sector workers were covered exclusively by these pension plans, according to the Employee Benefit Research Institute, an independent organization that researches retirement issues.
By 2022, the institute found, only 1 percent of private sector salaried and salaried workers had just a defined benefit plan, while 41 percent participated in only a defined contribution plan — or 401(k) — and 8 percent participated in both.
The underfunding of corporate pension plans has led to a large shift away from defined benefit plans. Originally, 401(k)s were supplemental savings vehicles for employees. Now, along with Social Security, 401(k)s have become staples of retirement.
By closing old defined benefit plans to new hires and freezing benefits for people already enrolled in them, companies have reduced their potential pension liabilities. They poured money into old pension plans to comply with government rules, which were relaxed to give relief to companies.
But smart management and cooperative financial markets also helped increase plan funding. Because pensions are a form of annuity, rising interest rates over the past two years have made it cheaper to fund existing pensions. Additionally, strong stock returns over the past decade have boosted mutual fund assets.
These factors have led to a radical change in the funding of legacy corporate pension plans. (Public pension plans, on the other hand, face an estimated $1.45 trillion funding gap, according to the Pew Charitable Trusts.) For large companies, the average private defined benefit plan now has more than enough money to pay out his pension obligations. For defined benefit pension plans at S&P 500 companies, Aon says, funding levels rose to 102.7 percent as of Feb. 6 from 78.4 percent in 2011.
The bottom line
IBM’s defined benefit pension plan is now extremely well funded. Its annual report shows it had a $3.5 billion surplus in the plan last year while paying $550 million a year in 401(k) contributions. He doesn’t need to put any new money into the retirement plan, and now, with the switch to the new retirement benefit accounts, he doesn’t even make 401(k) contributions.
Professor Munnell estimated that IBM would be able to credit workers with benefits in the new accounts for at least the next six or seven years. Several pension advisers said that if market conditions were favorable and IBM invested the $3.5 billion surplus at a higher rate of return than the fixed-income rates it offered employees, it could avoid putting cash into those benefits for many years. years.
The company said the retirement innovation is improving its finances. In an earnings call on Jan. 24, James J. Kavanaugh, IBM’s chief financial officer, said the company’s cash flow was better this year, in part because of “lower cash needs due to changes in our pension plans.” This could be true for years to come.
Other companies with fully funded frozen plans could follow IBM’s lead.
This is not a return to the richer benefits for long-term workers provided by traditional defined benefit plans.
But perhaps cash balance plans combined with a 401(k) are the best that most major companies are likely to offer. If so, Zorast Wadia, principal and consulting actuary at Milliman, the pension consultant, suggested that there are several ways to design retirement packages that make use of pension plan surpluses. Unlike IBM, for example, some companies could continue their 401(k) contributions while starting cash balance plans.
Finding ways to use well-funded pension plans generously but responsibly is a challenge for large companies. IBM moved cautiously. But it’s in nobody’s interest for companies to make pension promises they can’t keep.
