Pension Conversion, Termination, and Wealth Transfers

• Published date: 01 March 2014
• Date: 01 March 2014
• DOI: http://doi.org/10.1111/j.1539-6975.2012.01497.x

© The Journal of Risk and Insurance, 2014, Vol. 81, No. 1, 177–198

DOI: 10.1111/j.1539-6975.2012.01497.x

177

PENSION CONVERSION,TERMINATION,AND

WEALTH TRANSFERS

Joel T. Harper

Stephen D. Treanor

ABSTRACT

This article explores the motivation to change their defined benefit pension

plan by either terminating the plan and replacing it with a defined contribu-

tion 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 at-

tract 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 require-

ments. 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 ben-

efit plan has increased 7.43 percent annually between 1981 and 1996, but increased

Joel T. Harper is an Associate Professor of Finance and Williams Companies Professor of Busi-

ness, Oklahoma State University. Stephen D. Treanor is an Assistant Professor of Finance,

California State University.Joel T. Harper can be contacted via e-mail: joel.harper@okstate.edu.

The authors would like to thank Frank de Jong and participants at the 2007 Southern Finance

Association meeting, NetSPAR symposium, Universityof Arkansas, and Oklahoma State Uni-

versity for valuable comments.

178 THE JOURNAL OF RISK AND INSURANCE

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. The advantage to using

plan-level data is twofold. First, firms may sponsor many DB plans, but choose to

terminate or convert only one or two, so using firm-level data does not precisely

measure the impact for these types of changes for firms with multiple DB plans if

not all plans are changed. Second, these data, and not financial accounting data, are

used to determine regulatory funding levels, as well as any pension funds reverting

to the firm upon termination, which is essential in measuring tax implications as well

as wealth transfer. We find taxes are an important motivation in both the decision

to change the defined benefit plans as well as the decision between cash balance

and defined contribution. Increase in a firm’s tax burden increases the probability

a firm chooses a cash balance conversion over a defined contribution plan. Further-

more, firms with large plans and potential wealth transfers are also more likely to

choose a cash balance conversion. The results are broadly consistent with previous

studies.

The rest of the article is as follows. The next section of the article reviews the relevant

literature on plan terminations and cash balance conversions of defined benefit plans.

Motivations for pension plan changes are given special attention. The “Hypothesis

and Sample Selection” section discusses hypotheses related to ending a defined bene-

fit plan and sample selection. Empirical methods and data requirements are discussed

in the “Empirical Methods and Data” section. Empirical results and discussion are