An examination of changes in pension plans when tax laws restrict firms' financing decisions

The impact of tax law changes on firms' pension plan choices was examined using the regulation and the financial flexibility hypotheses. Prior to tax law changes, firms that sponsored defined benefit plans had wide latitude in funding plans and reverting excess assets from over funded plans. The cost of the financial risk of employees' retirement benefits offset the benefit of financial flexibility. Tax law changes during the years 1986 through 1990 increased the cost of sponsoring defined benefit plans and curtailed financial flexibility. As a consequence, changes in firm behavior were expected: firms would either terminate or replace their defined benefit plans with a less risky plan for the firm, the defined contribution plan. Form 5500 data from the Department of Labor were used to form groups and trace plan activity.; The regulation hypothesis tested for a difference between the proportion of changed defined benefit plans and changed defined contribution plans. Defined benefit plans engaged in significantly more terminations and plan replacements than defined contribution plans. Although the difference was significant, a monumental movement from defined benefit plans to defined contribution plans did not occur.; The financial flexibility hypothesis was partially supported. The proportion of plan changes was significantly greater for over funded defined benefit plans than for defined contribution plans. Increased costs and loss of financial flexibility led firms to change pension strategies. Changes made by firms sponsoring over funded plans fluctuated among years, peaking prior to the imposition of excise taxes. A tax policy concern is that some firms, while able to meet employee retirement benefits, chose to terminate or replace those plans.; Firms sponsoring under funded plans did not behave as expected. Under funded plans participated in significantly fewer terminations and plan mergers than any other group of plans. A shorter examination period did not alter the results. The average funding ratio of continuing (unchanged) under funded plans increased, which was one legislative objective. A comparison of plans that were under funded and subject to the penalty tax revealed that the penalty tax exists in form, but not in substance.