How IBM reopened its DB plan to replace 401(k) contributions
- Starting in 2024, IBM will replace its 401(k) plan matching contributions with a new benefit earned within its overfunded DB plan, which has been frozen since 2008. This move essentially un-freezes the tech giant's DB plan.
- Until now, pension surplus has not typically been utilized by plan sponsors to fund new benefits. Doing so completely changes the return needs and risk considerations for a fully funded plan. It also impacts the design of any glide path in place.
- It's unclear whether IBM's decision could mark the start of a small trend away from 401(k) plans and back to DB plans among U.S. corporations. However, we believe IBM's decision will likely cause sponsors of fully funded plans to reconsider their strategy.
IBM, one of the largest defined benefit (DB) plan sponsors in the U.S. and fifth-largest in our ongoing $20 billion club research, recently made a landmark change to its employee retirement benefits. In 2024, they plan to replace their 401(k) plan matching contribution with a new benefit (ostensibly of similar value) kept within their legacy (and overfunded) defined benefit (DB) plan. This change is noteworthy since it bucks a trend from the last 40 years of transitioning from DB to 401(k). With this change, for once, 401(k) takes a back seat to DB. Moreover, this DB plan has been closed to new participants since 2005, and benefits have been frozen since 2008. This move essentially re-opens (i.e., un-freezes) their DB plan, albeit with a different benefit than the legacy participants once received.
Most frozen, overfunded DB plans consider their timelines finite, possibly with a hibernation strategy in place or viewing a plan termination as inevitable, with limited potential use of pension surplus. IBM openly challenged this notion by directly utilizing its pension surplus to reduce ongoing costs.
According to their 2022 annual report, IBM held about $3.5 billion in pension surplus for its US DB plan and paid about $550 million to its 401(k) plan. DB plan funding requirements depend directly on the funded status of the plan, whereas 401(k) contributions are paid annually on a pay-as-you-go basis. With no funding requirement in sight for its DB plan (due to its stellar funded position), IBM could potentially eliminate the need to pay out any significant amount in cash to its 401(k) plan for years to come, instead allowing the DB plan to absorb that cost and many of its associated expenses.
What risks does IBM face?
IBM's U.S. pension plan will now likely introduce tens of thousands of new participants, with the associated costs of actuarial valuations, PBGC premiums, and annual notices that come with every qualified DB plan. PBGC premium costs, in particular, are worth noting since the flat rate will be $101 per participant in 2024, adding millions of dollars in new administrative costs.
While the account balance set up for these participants is just notional (until paid at termination or retirement), IBM will need to pay the promised "interest credits," which for a few years will be 6% and thereafter the 10-year Treasury yield. These do not necessarily tie directly to how the assets perform, and therefore, IBM will carry this asset/liability mismatch. The extent of this mismatch will depend on how IBM chooses to invest, but typically, cash balance liabilities are more challenging to hedge than traditional annuity DB benefits.
Big picture, the new benefits will represent a relatively small portion of the $21.5 billion in U.S. DB liabilities, at least to start. But in contrast to the legacy benefits earned decades ago, this portion of the plan is growing with new participants and benefit accruals; while the rest of the plan matures, benefits are paid out, and retirees pass away.
While IBM may be able to take a contribution holiday for the first few years, at some point, they will likely need to fund the plan for these new benefits, but those contributions could be reduced from what they would otherwise be if investment returns in the DB plan can help offset them. At the very least, the funding of DB plans is much more flexible than that of 401(k) plans, with any unfunded amount being paid for over the course of 15 years (after normal cost is paid) rather than being an essentially fixed, annual cash expense of a 401(k) plan each year.
What should plan participants consider?
By removing the matching 401(k) contribution, the plan participant does lose some of the incentive to contribute directly. While they don't lose their ability to contribute, many employees are motivated, knowing the employer will match their contribution.
This could impact the employee's ability to retire in the long term if they contribute less.
Participants will also not have any control over how the assets are invested for the employer portion. Their account balance "return" (i.e., "interest credit" in DB parlance) will be defined by the plan or the yield on the 10-year Treasury. This could be beneficial in some instances—for example, if interest rates remain relatively high at 4%-5% guaranteed (since this will help to improve the account balance steadily). However, if rates fall back to 2%-3%, the return on the notional account balance may only barely keep up with inflation. However, in either case, participants are unable to seek higher returns in equity, as is typically encouraged for participants pre-retirement. This could be concerning for plan participants and impact their ability to be financially ready to retire.
Another consideration is portability, or the ability to move account balances around if they change employers. With 401(k) plans, rollovers to other plans or IRAs are commonplace and routine. With DB plans, to have the same portability, the employer must allow a lump sum and the ability to take the benefit at termination (both likely in this case). If these two provisions are allowed, the DB benefit is just as portable as a 401(k) benefit and can be rolled over to other tax-qualified accounts and invested however they prefer.
What might this mean for current de-risking trends?
Most frozen DB plans are on a glide path that systematically reduces return-seeking assets as funded status improves. In place for the last 15 years or so, these de-risking strategies assume that the return needs to decline as the funded status improves. They also point toward an asymmetric risk profile for fully funded plans, prioritizing the need to stay fully funded over the potential to further improve pension surplus.
Pension surplus, while it does have benefits, has not typically been utilized by plan sponsors to fund new benefits. Doing this completely changes the return needs and risk considerations once fully funded. Under this framework, sponsors could reasonably "re-risk" by increasing their allocation to return-seeking assets to help reduce future contribution burdens. This also impacts the design of any glidepath in place.
What could this mean for the DB industry?
Will this plan change be a topic du jour that is quickly forgotten, or will it start a trend for fully funded DB plans to employ their pension surplus in a useful way? The tangible reduction in cash expenses could be enough to motivate sponsors to adopt this type of strategy if they can acknowledge and accept the potential downsides. If this does start a trend, it is good news for a DB industry that has for many years been trending toward plan freezes and, more recently, toward risk transfer transactions that reduce the DB assets and liabilities. If nothing else, IBM should have all sponsors of fully funded DB plans reconsidering their strategy.