Judging from predictions 10 years ago, defined- benefit plans should no longer exist. After all, 401(k) plans cost so much less to sponsor and are more appealing to an increasingly youthful and mobile workforce. But a funny thing has happened to traditional defined- benefit plans. A growing number have morphed into a long-standing variation known as cash- balance plans.
Why haven't most large companies abandoned their defined-benefit plans yet? For one thing, federal pension law makes it difficult for companies to do so. Those that want to pull the plug on a traditional plan must effectively fund all accrued benefits at once. What's more, those with overfunded plans must pay a significant excise tax, as well as income tax, on the surplus. As a consequence, few healthy companies have ended their defined- benefit plans outright.
Instead, with the demographics of the workforce changing, and with a soaring stock market leading to an increasing number of overfunded traditional plans, more and more companies are converting them to the cash- balance kind. The idea isn't new: Bank of America is credited with doing the first conversion in 1985. But since then, some 15 percent or more of Fortune 500 companies have switched to cash balance. And today, another 30 percent to 40 percent are considering converting, according to Larry Sher, a principal at PricewaterhouseCoopers Kwasha HR Solutions, in Teaneck, New Jersey.
Cash-balance plans are a hybrid arrangement that combines certain features of traditional pension plans with those of 401(k) and other defined-contribution arrangements. As with other defined-benefit plans, most sponsors of cash-balance plans make all contributions for employees. Funding must meet the minimum requirements of the Employee Retirement Income Security Act (ERISA). And the benefits, which can be paid out as a lump sum or an annuity for life, are covered by federal insurance under certain circumstances.
But unlike a conventional defined benefit, a cash-balance benefit is typically earned more evenly over an entire career, rather than being based on years of service multiplied by the average salary in the final years. As with a 401(k) plan, an account is opened in an employee's name. Every month the company credits the account based on a percentage of the worker's pay, typically 4 to 6 percent. Interest accumulates according to a specified return, usually between 5 and 7 percent. Anything earned above that stays in the pension plan to reduce future company contributions. In return, the company shoulders the risk of any shortfall in the promised return. With the market producing gains well above promised returns, sponsors often needn't contribute a dime to meet minimum funding requirements, at least for a period of time.
No wonder converts, in addition to Bank of America, include such giants as Aetna, AT&T, BellSouth, CBS, Chase Manhattan Bank, Eastman Kodak, IBM, and SmithKline Beecham, as well as smaller companies, such as American President Lines Ltd., a maritime shipping company based in Oakland, California; Niagara Mohawk Power Corp., a New York State utility; and Southwestern Energy Co., of Fayetteville, Arkansas.
The plans offer more than just a guaranteed minimum return to employees. Unlike traditional defined-benefit plans, but like 401 (k) plans, cash-balance plans are portable. An employee departing for another company can often roll over into an IRA or a new plan the amount accrued in his or her previous employer's plan, which helps build a bigger retirement benefit. While employees who leave a company with a traditional defined-benefit plan may be able to take a lump-sum payment based on the benefit they had accrued to date, it's usually impossible to roll that over into another defined-benefit plan. And the benefit won't amount to much to begin with, because most of the benefits in such plans build up toward the end of a career.
But as more companies have converted to cash- balance plans, they've sparked a backlash from older employees, pension activists, and sympathetic politicians, with conversions by such companies as Niagara Mohawk spawning class-action lawsuits.
The basic complaint is that the companies are illegally squeezing pension benefits. Older workers, in particular, are allegedly short- changed by cash-balance plans, because they simply don't have the time to build up anything close to what they were due under the old arrangement. While consultants report that many employers design their conversions so that current workers within 5 or even 10 years of retirement are allowed to keep their old defined benefit, advocates for plan participants say such transition benefits for middle-aged, midcareer workers are often inadequate or nonexistent.
What's more, critics contend that some companies establish the opening balance in the new plans at a much lower value than the accrued benefit in the old defined-benefit plan, and that this is patently unfair. IBM's conversion has been subject to vociferous criticism by middle-aged, midlevel employees, with Internet sites devoted to the changeover receiving tens of thousands of hits.
One of IBM's most outspoken employees, David Lovelace, a senior project manager from San Diego, claims that the benefits of 140,000 IBM workers have been cut by as much as 40 percent. During a recent press conference, Janet Krueger, a 46-year-old application software consultant from Rochester, Minnesota, claimed that IBM set opening balances in the new plan that are so far below the accrued benefit in the old plan that "I would have to work 10 years extra before I'd earn an additional benefit." Added Krueger: "They're fixing it so we can't afford to retire."
The Moynihan Bill
Jana Weatherbee, director of workforce communications at IBM, counters that the company still offers generous benefits, with total annual costs of $3.5 billion. And Weatherbee defends the conversion as a necessary move to help the company compete against computer companies that offer no defined-benefit plan but do offer more- generous 401(k) benefits and stock options to a broad range of workers. While the conversion saves the company about $200 million a year, Weatherbee says the savings will be used to offer higher salaries and more stock options.
Nevertheless, the Senate Finance Committee held widely publicized hearings on the issue last June. After these, Sen. Daniel Patrick Moynihan (DN.Y.) and Rep. Jerry Weller (RIll.) introduced a bill to require employers with 1,000 or more workers to provide individual statements to all plan participants if a plan amendment significantly reduces the benefits of a single employee. The bill has since died, but observers say there's a good chance that Congress will soon enact disclosure requirements of some kind. A proposal by the Clinton Administration would require companies to disclose what effect a smaller opening balance would have on benefits in a cash- balance plan over time. And supporters hope disclosure requirements will pressure employers into providing better transition benefits.
Under Moynihan's bill, the statements would have had to disclose the present value of the old and new benefit, as well as projections comparing the values of the two plans in 3, 5, and 10 years, and at normal retirement age. Companies that failed to provide accurate calculations in a timely manner would have had their conversion from a defined-benefit plan nullified, and would have lost the deductions they'd taken for their old plan.
"It is time to let the sun shine on pension- plan conversions," Senator Moynihan asserted during the hearings.
But lobbyists for employers blasted the Moynihan proposal as a Draconian overreaction to isolated problems. "I think the effect and the apparent intent of Senator Moynihan's bill is simply to prevent employers from converting to cash-balance plans," Mark Ugoretz, president of The ERISA Industry Committee, testified.
Some benefits consultants even suggest the bill would have imposed such a heavy regulatory burden that employers might have found it less costly simply to eliminate their defined-benefit plans.
"The micromanagement and overregulatory approach of the Moynihan bill would hasten the already steep decline in defined-benefit plans," contends Scott Macey, senior counsel at ASA, a Somerset, New Jersey, benefits consulting firm.
Whatever happens in Congress, observers predict that the public spotlight on cash- balance conversions will lead to closer regulatory scrutiny. The Internal Revenue Service, for example, is under pressure to suspend qualification of new conversions. That suggests that companies that use cash-balance conversions simply to slash pension costs to the bone had better hope their efforts don't backfire.
Those that want to clear potential regulatory hurdles would do well to follow Eastman Kodak's example, though it means forgoing much of the potential savings.
Sher contends that employers should also help employees understand that they could face bleaker benefits prospects without conversions. "We would see a lot more terminations of defined-benefit plans without the cash-balance plans," he says. "Some would go immediately to termination, while others might wait for awhile to use up their surplus assets," he says.
As Sher points out, that would leave employees increasingly dependent on their own contributions to 401(k) plans and investment expertise at a time when the returns in the stock market sound increasingly like a siren song.
----------------------------------------------- --------------------------------- Cost Isn't Everything
Contrary to much-publicized protests, most conversions of traditional defined-benefit plans to cash-balance plans have not cut employees' benefits, according to a survey of 100 conversions by consulting firm Towers Perrin.
The survey found that a majority of the companies provided transition benefits for employees who would otherwise have found their benefits cut by the switch. About a third of the companies grandfathered employees for life under the prior formula. Others made up the difference by offering additional credits or subsidies to an employee's opening account balance, guaranteeing a minimum benefit based on the prior formula, or adding value through 401(k) or other benefit plans.
The findings suggest that most conversions aren't driven by potential cost savings. In fact, the survey respondents most frequently cited the following reasons for switching a traditional pension plan to a cash-balance plan:
- To offer a benefit whose value is better understood by employees. Many employees do not value traditional retirement benefits, even though they are costly to the company.
- To support recruitment of employees with the most valuable skills. Cash-balance plans can support recruiting efforts among workforce segments in high demand and expected to be more mobile.
- To support performance-based culture. Cash- balance plans place more importance on performance and less on tenure than traditional plans.