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Cash Balance Plans: Danger or Opportunity? (1999)

Last year, workers at Central and Southwest, a Dallas utility, got a rude surprise. Without explaining or even admitting what it was doing, the employer had drastically cut the pension benefits the workers had expected to support them in old age. The company was switching to a new, hybrid form of defined-benefit (DB) plan called a cash balance (CB) plan. As The Wall Street Journal and other papers eventually reported, older employees saw their expected pensions shrink by as much as 50 percent.

Cash balance plans have shaken up the world of defined-benefit plans like nothing else in years. As increasing numbers of employers switch their DB plans to a CB basis, workers are finding their pensions transformed in ways that are hard to understand — that is, except in one respect: They almost always get smaller.

While CB plans have apparently not yet appeared among public employers, the fact that they are increasing among private employers provides fair warning that they will appear soon. There are reports that some jurisdictions have already entered into discussions about them.

What is a cash balance plan? For all the confusion, the answer is fairly simple: It’s a defined-benefit plan that is structured to look to participants like a defined-contribution plan. Under a cash balance plan, the company sets up “accounts” for participants. The company contributes to these accounts at a set rate — typically 5 percent of an employee’s wages — and credits them with a certain return each year. These are not real accounts: The company still pools all employees’ contributions and bears all the investment risk. The accounts are just ways of tracking the size of the benefit the employee has accrued.

With traditional defined-benefit plans, pensions usually are based on tenure and final pay; the size of the benefit increases slowly at first and very rapidly in an employee’s last few years of service. With a cash balance plan, the size of the benefit increases steadily over the course of an employee’s tenure. This means workers who stay with one company through much or all of their careers usually will do better with a traditional defined-benefit plan, while those who change jobs more frequently may do better with a cash balance plan.

In theory, CB plans can be good or bad — or often, good for some workers and bad for others. But in practice, adoption of CB plans almost always has been bad news for workers. Conversion from a traditional DB plan to a CB plan can leave workers worse off in two ways:

  • The first has to do with the benefits workers already have accrued. By law, these belong to the worker and cannot be rescinded. But since the cash balance “account” is just an internal accounting device, the company has a great deal of flexibility in setting its level. It need not be the same as the worker’s legally accrued benefit. If a worker’s opening account is less than the benefit already accrued, as it often is, the worker’s benefit will not increase until his or her cash balance account catches up with what he or she already has earned under the old system. In some cases, this process may take years.
  • The second way cash balance plans can leave workers worse off is through their effect on the benefits workers have not yet earned. Workers have no legal claim to these benefits, but they may still have given up wage increases or made other sacrifices in the expectation of getting them in the future. For a worker nearing the end of his or her career, the difference between benefits expected under a traditional plan and benefits received after conversion to a cash balance plan can be enormous.

Positive Potential

While there are good reasons to be wary of cash balance plans, they don’t have to be a bad deal for workers.

Establishing new cash balance plans is not very problematic since workers won’t lose accrued or anticipated benefits. Conversions from existing plans, while trickier, still can be structured to protect workers, especially older workers who might otherwise see their pensions evaporate. The most important thing is that workers’ representatives have a seat at the table when the plan is being developed.

“At AT&T, the conversion to cash balance was negotiated over three full rounds of bargaining, starting in 1992,” says Morty Bahr, president of the Communications Workers. But as both company and union became more familiar with the mechanics of cash balance plans, the negotiators found ways to protect older workers while preserving the new plan’s flexibility and advantages for younger workers. The final plan involved larger opening balances, 7 percent “interest” on account balances — an unusually high figure — and a guarantee that workers with long tenure would not lose out. Those with 15 or more years of service at the time of the transition are given the choice, at retirement, of the old plan or the new one, and can choose whichever offers a better benefit.

Over 300 medium and large private companies, including 22 of the Fortune 100, have converted from defined benefit to cash balance plans. Many CB plan critics are suspicious that companies are making this switch because it saves them money by reducing benefits in a way that most employees cannot detect. Lawyers representing workers have discovered that consultants marketing CB plans to employers have often used the ability to hide reductions in benefits as a selling point. Because of the difficulty in comparing the benefits provided under DB and CB plans, workers generally cannot figure out whether a conversion will help or hurt, without the assistance of actuaries. In situations where employees have access to such expertise, they have begun to realize that their final retirement benefit will often be considerably lower under the new plan.

That’s what happened with employees of IBM, which announced a conversion earlier this year. When first announced, the CB plan allowed employees with less than 5 years until retirement to stay under the defined benefit plan. While that provision protected those close to retirement, it did nothing to protect other workers with many years of service that were not within 5 years of retirement age. When employees began getting their personal profiles from IBM on the new plan, many realized that their benefit would be reduced substantially. The employees reached out to the Internal Revenue Service (IRS), the Equal Employment Opportunity Commission (EEOC) and Congress. IBM subsequently allowed employees with at least 10 years of service who have reached age 40 to choose between the existing DB plan and the new CB plan. Even so, hundreds of IBM employees under age 40 and/or with more than 10 years until retirement age, have registered complaints about the new plan.

The cash balance issue is attracting the attention of Congress and federal regulators. Following are some examples of what is happening:

  • up until now, the IRS has approved the adoption of CB plans. Following the IBM debacle, IRS regional offices were directed to stop approving DB/CB conversions and to instead consult with the national IRS office, until further notice. In the meantime, the IRS will review three issues: rates of accrual, the protection of benefits already accrued, and whether CB plans illegally reduce benefit accruals because of age;
  • the EEOC is undertaking an age discrimination investigation of CB plans;
  • disclosure during CB conversions was addressed during a recent Senate Finance Committee hearing;
  • in testimony prepared for the Senate hearing, the American Association of Retired Persons (AARP) requested an investigation into whether CB plans violate anti-discrimination laws; and
  • several bills are pending in Congress to regulate the plans.

For more information on cash balance plans, contact the Department of Research and Collective Bargaining Services at (202) 429-1215 or e-mail research@afscme.org.

Note: Major portions of this article were taken from the Spring 1999 issue of “Working Capital.”

Key Questions to Ask About a Cash Balance Plan

Converting an existing defined benefit plan to a cash balance plan can be a complex and confusing process. Some management consultants even offer this as an advantage of the plans. In the hands of unscrupulous management, they can be a way to cut pensions without beneficiaries realizing what is going on. Even with the best intentions, the complexities of the conversion process may inadvertently threaten some workers' retirements.

On the other hand, a well-constructed cash balance plan can have advantages for workers and management alike. The service of actuaries and other professionals is essential to evaluate any plan, but here is a quick guide for trustees and others contemplating cash balance plans who wonder what questions they should be asking.

  • How will the opening balance be calculated? The key issue here is interest rate assumptions — the higher the assumed interest rate, the lower the present value of a worker's accrued benefit.
  • How will contributions to accounts be calculated? One of the goals of cash balance plans is to flatten out pension contributions, so workers accrue benefits steadily over their careers instead of disproportionately in their last few years. But flatter does not have to mean perfectly flat: Many well-designed cash balance plans adjust contributions on age and tenure.
  • What protections are there for older workers? Those about to enter their final years of employment, when pensions increase fastest under traditional defined benefit plans, have the most to lose from cash balance conversion.
  • Do workers' representatives have a role in shaping the plan? In the end, this is the key question. There is no reason management and workers cannot both benefit from the adoption of a cash balance plan, but if workers have no voice in the process, it is more likely they will lose.

 

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