In the Trenches: Saving money with a modified pension plan backfires on Acme

In this edition of "In the Trenches," Acme attempts to save money by modifying its pension plan. Remember, only the names are changed to protect the innocent.

Being an integral part of the macroeconomy, Acme wasn’t immune to the general deterioration of the market’s ability to keep every company afloat. The demand for Acme products had been plunging to levels the company last experienced during the early 1950s, when it was founded. Upper management knew that Acme was never going to qualify for a government bailout, subsidy or stimulus of any sort. Consequently, top management actually felt guilty about having to accept its traditional multimillion-dollar yearend bonus.

What seemed to be dragging down the Acme profitability picture were the obligations surrounding the looming payments soon to come due on the pension plan. Seeking to be viewed as a credible company, Acme established a defined-benefit pension plan soon after its earliest operations achieved profitability.

The benefits an employee would receive under this pension plan were a function of an employee’s total years of unbroken service and the final average salary during the last calendar quarter of work. This benefit was, in great measure, responsible for the long-term job loyalty exhibited by Acme employees.

Now, however, under financial pressure, Acme’s management decided that pension plans are passé and most impractical in this day and age. Like so many companies before them, Acme sought to move to a defined-contribution retirement plan. Acme’s plan provided a pension payment that was a function of the number of “credits” an employee garnered during many years of service. The credits were granted quarterly and were a function of a percentage of the employee’s current salary and the current yield on a U.S. Treasury Bond.

In deference to its long-term employees, Acme didn’t want to make this change suddenly and scare off the knowledgeable workers who were keeping things afloat. Instead, the company declared a five-year transition period. During this time window, employees accrued benefits under both approaches. Those who retired during the five-year window selected whichever plan was most beneficial to them once they left the company. Those who retired after the transition period could still select either plan, but the benefits accrued under the old plan were frozen when the window closed.

One would think that people whose jobs are somewhat insecure would be grateful to have a paycheck and be accepting of change — but not this time. The pension situation was the source of great and vocal dissatisfaction among Acme workers, most of whom had been with the company for many years. Penny Black, the very first Acme employee, was most outraged. She argued that Acme’s new pension plan discriminated against older employees by setting the employee’s initial account cash balances far below the equivalent value of any pension annuities that would result from the old plan. In her view, this was an age-discrimination issue. She convinced several 40-year-old current and former Acme employees who participated in the pension plan after the transition period expired to join her in a class-action suit alleging age discrimination on Acme’s part.

How could this situation have been avoided? Do defined-benefit pension plans have a future in this economy? What is the best way for an employer to get out from under heavy pension obligations? Are employees better off using their own privatelyfunded plans that are independent of the employer? Can employers make unilateral changes to an existing, long-standing pension plan? How can a company estimate the cost of a change in loss of employee goodwill and loyalty?

An attorney says:

Acme isn’t alone in moving from a defined benefit pension plan to a defined contribution plan. Many employers have made this change in recent years.

The best way to make such a change, to disadvantage as few employees as possible, is to review various scenarios and build the new plan so that it adversely affects as few long-term employees who are close to retirement as possible. Those who have been with the company for a few years might not remain, and younger employees have far more years to accumulate contributions under the new retirement plan. As a result, they would feel the effects much less.

Once the new plan has been properly developed, the key is good employee communications. Had Acme thoughtfully developed its defined contribution plan and explained to employees, especially older ones, such as Penny Black, that the change would minimally affect them, it would have had far fewer problems.

In a normal economy, the value of employee loyalty would be difficult to quantify. But in the current economic drought, for every employee who quits there are probably 10 unemployed workers standing in line to apply for the job. Rather than a loss of employee goodwill and loyalty, the cost of a law suit remains a heftier threat to an employer today, especially one that struggles to stay afloat in these perilous times.

As usual, Acme has acted too quickly and with not enough planning and foresight. Both the company and its workers likely will suffer the effects of a poorly planned change.

Julie Badel, partner
Epstein Becker & Green, P.C.
(312) 499-1418
jbadel@ebglaw.com

A maintenance planner says:

In my opinion, a class-action law suit based on age discrimination by Acme has no basis here. Acme offered two choices of retirement plans for the older employees during the five-year transition period, which seemed to be a generous offer on the part of the company. If anything, the younger employees should have an issue with not having a choice of plans when they reach retirement age. Defined-benefit pension plans can be a drain on a company’s balance sheet, and might not have a place in the economy of today.

Could this situation have been avoided? Yes. Treat each employee, regardless of years of service, on an equal basis. Acme could have set a definite date for the pension plan to be terminated, vested all employees, and then paid out the retirement funds they had accrued based on the calculation contained in the plan. These funds could then have been rolled into a 401(k), IRA or similar plan. It’s not an ideal situation for those close to retirement, but it would provide a substantial lump sum to the older employees to fund one of these retirement options. In addition, upper management should forego some, or all, of their year-end bonuses in an effort to shore up the shaky financial situation and to show the employees evidence of management’s commitment to them and to the company.

These changes definitely would have an effect on employees’ morale and their confidence in the company’s future. Acme’s management would need to be proactive and communicate to employees the status of the company. Employees want to know the reasons for the change to the retirement plan from the beginning, to show a commitment to keeping the company viable. In addition, the company might offer some incentives such as 401(k) matching funds and awards for years of service as a way to retain valuable employees. Ideally, the employees would step up and support these measures and the situation wouldn’t deteriorate into an “us-versus-them” situation, which could result from less-than-clear communication.

Acme’s biggest mistake in this situation was offering the five-year transition period, which allowed its obligations to multiply exponentially each year. Acme’s financial obligation to the pension plan would be better addressed early while the company had the means to fully fund the plan instead of waiting five years while hoping the company’s financial situation improves. Defined-benefit pension plans are much harder to keep funded, with even the largest organizations grappling for the means to fund their ever-growing responsibilities to the plans.

Bryan G. Trantham, maintenance planner
Evergreen Packaging-Waynesville Facility
(828)646-2140
tranthb@blueridgepaper.com

An academician says:

Employees usually like defined-benefit pension plans because of the fixed monthly payments for the rest of their lives, regardless of what the stock market does. If the market is going down, down and down, as it is now, and pension fund assets are going down with the market, it has no effect on the retired person with a fixed-benefit plan: The check will always be there. This gives retirees a great sense of security.

However, the defined-benefit plan isn’t such a great deal for the employer. These plans are the most costly to operate, and they’re administratively complex. Moreover, the company has an obligation to make a fixed monthly payment to its retirees, even under the current conditions in which sales and profits are declining rapidly, and the assets supporting the pension payments (usually stocks) have dramatically declined in value. This puts a severe strain on the company.

These concerns are why fixed-benefit plans are on the decline, and although I’m not an expert in this area, I don’t see much of a future for plans of this type. Although it sounded like a great idea for motivating and building loyalty among employees (however, I haven’t seen any data that support this assumption), it hasn’t been so good for the employer.

Obviously, Acme realized the problems with the fixed plans, and now is trying to reduce its pension commitments. Acme isn’t alone in this effort. For example, witness the restructuring plans of the American auto industry. Based on a 2006 study, it costs almost $2,400 more to manufacture an American-make of car than producing a comparable Toyota or Honda (manufactured in the United States). Probably close to half of this is in salary and benefit costs. It’s tough to compete when you start with a $2,400 disadvantage. So, the big pensions and lifetime health-care benefits probably will be one of the first costs to be trimmed dramatically in the auto industry restructuring.

How to change the pension plan without destroying employee morale and loyalty is the big question. Some “change experts” recommend one stroke of the sword and suffer about three months of anger, but after that, things gradually will get back to normal. Others (including me) recommend the Acme approach in which people are given options and a five-year transition period. Usually the young employees don’t care — their energy is directed toward paying the mortgage. It’s the older employees, like Penny, who are nearing retirement and who are the most interested and affected. And here, Acme is simply going to have to take its lumps, I’m afraid.

Professor Homer H. Johnson, Ph.D.
Loyola University Chicago
(312) 915-6682
hjohnso@luc.edu

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