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Benefits and Pensions MonitorDoes It Pay To Switch From DB Plans? By: Jim Helik When a firm announces that it is freezing its Defined Benefit pension plan and switching to Defined Contribution pension plan or a hybrid plan, mention is often made of accommodating the needs of a more mobile workforce and providing flexibility to plan members. Yet money, and the related issue of the many risks that come with funding a DB plan, is really a central point to all of this. DB plans are assumed to cost more and have additional financial risks for the employer as well. So if DB plans are more costly, the switch should positively impact the bottom line of the plan sponsor. For a publicly traded company, we should then ask the question “does the stock market recognize this and reward those companies that switch out of DB plans?” The related broader question is how markets, in general, value company pensions. The evidence so far has been mixed. Some studies have found that the stock market has not always accounted for the pension plan’s funding status. This inefficiency has been greatest at times when market valuations have been excessive, as in the technology bubble of the last decade. Yet others have shown that the market does discount firm value when management makes highly unrealistic pension assumptions. Stephen Brown, of Emory University, in a paper titled The Impact of Pension Assumptions on Firm Value, concludes that market analysts are able to “see through” any overly optimistic pension assumptions, and appropriately discount them in valuations of the firm. Valuation Issues Wading into this argument is a new paper by Jordan Rubin, of the Pension Research Council, Wharton School at the University of Pennsylvania titled The Impact of Pension Freezes on Firm Value. Rather than looking at complex pension valuation issues, he examines firms that have announced that their DB plan has been frozen. He notes that such pension freezes can be grouped into three main categories:
If the switch from DB to DC improves the cost structure of a firm, it is reasonable to assume that a freeze will create value for a firm. If an efficient market exists, prices should fully reflect all publicly-available information. In this case, investors would be expected to immediately incorporate the effect of a DB plan freeze into the market value of the firm. If this is true, then any unexplained market value change on the date that the freeze is announced can be assumed to be created as a result of the DB plan freeze. However, pension matters are complex, so it is also reasonable to assume that investors might not immediately accurately account for their impact on firm value. In this case, there may be a market inefficiency as it may take some time until an announced freeze ‘creates value,’ so it may be necessary to track a longer period of time after the freeze announcement to note any value creation.
In the examination of 20 plan freezes in the 2003-2006 period, Rubin found that the immediate impact of a DB freeze is negligible. However, the longer-term movement of the company’s stock is positive and prolonged. These results are consistent across the various companies that were examined. In many ways, this time lag should not be surprising. Given annual (not quarterly) disclosure of detailed pension data in the financial statement notes, as well as what other observers have noted is a more gradual impact of valuation changes on market prices, we can only conclude that both investors and analysts wait many months until there are impacts on quarterly earnings to modify their financial expectations. To add to this delay, almost all of the firms examined were in the midst of much broader restructurings, with the pension freeze just one component of a larger firm overhaul. As Rubin notes, “The fact that the impact (between plan freezes and an increasing stock price) takes a long time to be seen may disappoint executives hoping a DB freeze will result in a clear and immediate boost in market value.” But, it seems that investors, eventually, do cast their vote on this issue, which can only hasten current trends against retaining DB plans. ■
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Jim Helik is co-author of ‘Strategic Wealth Conversion,’ a textbook published by the Canadian Securities Institute. He also teaches at the School of Business, Ryerson University in Toronto.