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September 01, 2007 at 04:00 AM
Most professionals in the financial services industry are now aware of the continuing decline of traditional private-sector defined benefit (DB) pensions. Each new company press release, government study or scholarly report continues to document that DB plans are being frozen, replaced and converted into defined contribution (DC) plans such as 401(k), 403(b) and other hybrid structures.
There are many ways to quantify this trend; one is the recently released survey by EBRI in which two-thirds of pension plan sponsors are thinking about freezing their DB plan. Likewise, the following statistic should provide a perspective for the younger crowd looking for their first job. According to Watson Wyatt, in the year 1985 a total of 89 out of the largest 100 companies in the U.S. offered a traditional DB pension to their newly hired employees. By the year 2002 this number dropped to 50 out of 100 companies, and in the year 2005 it was down to 37 out of 100. No matter how you look at it, one would be foolish to assume this trend of reduced DB coverage in the private sector will halt or be reversed anytime soon. The only question is the magnitude and speed.
And, while there continues to be an intense public debate on which particular type of pension arrangement is better for the company’s employees — DB or DC — there has been very little if any debate around what is better for the company’s shareholders. Stop and think about this from the perspective of a business owner. If you were starting a large company from scratch today, would you set up a traditional DB plan or would you opt for a 401(k) plan for the employees?
You think you might know the answer to this question, but is there any way to test or quantify this? In an ideal world — or an economic laboratory environment — we would compare the market valuation of two identical companies with the same number of employees and in the same industry but with different pension arrangements. If the DB or DC plan were truly better for the shareholders this would be reflected in a market premium (or lack thereof) for one of the two companies. In practice of course, much to the chagrin of the experimental economists, it is impossible to locate identical corporate twins with different color pensions.
There is however an indirect way to answer this question and that is by examining the market’s reaction to changes in pension policy, or more specifically the announcement effect when companies shut down or freeze their DB plan. Bear with me here for a moment since the results have some interesting implications for your clients — even if they are not large business owners themselves.
Over the last few years, one of our Ph.D. candidates, Keke Song here at York University in Toronto, has spent quite some time in the local library archives digging up details on pension freezes and specifically the behavior of stock prices around these announcement dates. We are in the process of completing a detailed research study entitled “Do Markets Like Frozen DBs?” and I’ll share some of the preliminary results with you.
Since December of 2001 we located an average of one publicly traded company per month that announced intentions to freeze or shut down its DB plan and replace it with — or enhance — its DC plan. This one per month average is an underestimate of the magnitude of actual freezes, since there were many more companies also making this announcement about whom we were unable to get sufficiently accurate dates to be able to conduct the analysis.
Here is the bottom line from all of this number hunting. Over a window of 10 trading days before and after the announcement, the average increase in stock price for DB freezes was approximately 3.96 percent. These are pure returns. When you take into account the risk-adjusted out-performance of these stocks relative to the S&P 500 index, the announcement effect was approximately 4.2 percent. (Remember, if a stock price goes up 5 percent on a given date, but the market itself goes down 2 percent, the true value added relative to the market is 7 percent.)
As you can see from the chart below, if we expand the event window to 20 business days before and 20 business days after, the above-mentioned impact increases to almost 7.3 percent in risk-adjusted returns. Remember that these numbers occur over a mere few weeks. Annualize them to get a sense of the overall magnitude of this effect. In aggregate, these DB closures added at least $832 million in market value on the announcement date alone.
