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When Pensions Freeze

IBM is the latest in a list of companies (also including Verizon and Sears) that are freezing their pension plans.

Eliminating defined benefits can help boost a company's bottom line, but what does it mean for employees? Personal finance adviser Ray Martin visits The Saturday Early Show to explain.

Workers who move into a 401(k) plan will still receive a pension when they retire, but only the benefits they accrued up to the date of the pension freeze. Since the most significant accruals of pension benefits typically occur when workers hit their late 40s and 50s after a long tenure at a company, a freeze can mean a significant reduction in expected retirement income for someone at the peak of their career.

The bottom line is that workers in pension plans that are frozen or terminated will need to boost their savings now to make up for any shortfall in expected pension income.

In a "hard freeze" like those at IBM and Verizon, all participants stop earning benefits. The assets remain in the pension and will be paid out when the workers retire or leave the company, but the workers' benefits don't grow with additional years on the job. It's as if the affected employees had changed jobs and stopped building a pension at their former employer. So far, relatively few large companies have done this, including Circuit City Stores Inc., Sears and hospital-products firm Hospira Inc.

More common are "partial freezes," such as closing the pension to new workers, which is something Motorola Inc., Lockheed Martin Corp. and Aon Corp. have done, or to workers under a certain age, as NCR Corp. has done.

Companies often freeze their pensions in stages. Sears froze its pension as of Jan. 1. But in 2004, before its merger with Kmart Corp., Sears stopped offering pensions to new workers and cut off existing employees below age 40 from building benefits.

Why are companies freezing pensions? Companies say they're trying to become more competitive and adapt to changing times. Some, including technology firms like Hewlett-Packard Co. and IBM, say they must compete with younger companies that never made pension promises, or foreign companies where the government provides significant retirement benefits.

Workers in many industries are concerned that their employers will put the brakes on their pensions. Here are some groups that are most at risk:

  • People in companies with a large percentage of older, longtime employees.
  • Managers and other employees not covered by a collective-bargaining agreement.
  • Employees whose companies have already cut some retiree benefits in the past. These firms are most likely to do so again.

    This is an opportune time for companies to freeze pensions, for a variety of reasons. For one thing, people aren't surprised: Financial crises at steelmakers and airlines, several of which have actually abandoned their pensions, mean people are used to hearing about a "pension crisis." Also, as more companies in a certain industry end pension benefits, rivals can argue more persuasively that they need to stay competitive.

    Who gets hurt the most? Workers who have been at the company many years (especially in their 40s and 50s) could end up with much less money than expected. Traditional pension benefits build up fastest in an employee's final years at a company. That's because benefits are typically calculated by multiplying years of service by the average salary in the final years, when pay usually is highest. As much as half of a person's pension is earned in the last five years on the job. Even with bigger 401(k) contributions, these workers may never catch up.

    Here's a chart showing the extra savings you need, based on your age.

    Additional Savings6%10%3%16%19%
    *Source: Employee Benefits Research Institute

    Retirees aren't affected by freezes. Younger workers and those who switch jobs frequently also will be less affected.

    Something is better than nothing, but employees whose companies switch to a 401(k), even one with benefits that are more generous, could well prove worse off than with a pension. Investing their savings themselves means that just a few years of bad returns could leave them with no time to recover and a poorer retirement.

    What's more, there's nothing to stop employers from cutting the 401(k) contribution in the future.

    So how is freezing different from terminating a pension plan? When employers terminate a pension, they must pay out all of the benefits immediately, either in lump sums or by buying each worker an annuity.

    With rare exceptions, only companies operating under bankruptcy protection can dump unfunded liabilities on to the Pension Benefit Guaranty Corp. (PBGC), the government-run insurer that guarantees private-sector pensions.

    For all of the media attention about companies terminating under-funded pensions, it isn't common. Fewer than 2 percent of the plans that were terminated from 1986 to 2004 lacked enough money to pay every employee's pension, according to the PBGC.

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