BY MARK D. MEYER, J.D., F.S.A., AND JAMES A. VAN IWAARDEN, F.S.A.
This article appeared in the Second Quarter 1999 issue of Employee Benefits Planner.
A series beginning last December in the Wall Street Journal on companies switching to cash-balance retirement plans has created a stir. In one article about Fridley-based Onan Corporation, the newspaper stated that the issue is whether cash balance plans “discriminate against older workers, even though they appear to pay older workers the same benefit — and, in some cases, a bigger benefit — than younger workers receive”. So are these hybrid retirement plans friends of employees because they provide all workers the same benefits? Or are they a fraud because they only “appear” to do so?
Cash Balance plans are defined benefit plans that look like defined contribution plans. As with a 401(k) plan, the emphasis is on an account balance. In fact, much of the controversy about the plans relates to their behaving exactly like a defined-contribution plan. There is no promise of a lifetime income, but there is an account balance that grows with interest credits and pay-related credits, like a 401(k) plan. Workers can choose to receive their benefits in monthly payments or in one lump sum equal to — or sometimes larger than — the account balance.
The clear trend in America today is to involve employees in investing and planning for retirement. Nevertheless, surveys show that employees have unrealistic expectations of investment returns and have done little to plan a budget for retirement. So perhaps 401(k) plans, with their attractive account balances and investment options, aren’t the answer to all retirement needs.
Most larger companies have already recognized that. Only 10 percent of the Fortune 100 offer defined-contribution plans and nothing else. About 68 percent have both a traditional annuity-based pension plan and a 401(k) plan. But here is the new trend: According to a recent survey by the national benefits consulting firm, Watson Wyatt, 22 percent of the Fortune 100 have converted their traditional plan to a hybrid plan, either a Cash Balance plan or its sibling, a pension-equity plan. That 22 percent is astonishing when one considers that the plans barely existed 10 years ago.
Companies are converting to account-based plans because of the success of 401(k) plans. Employees love to see that balance grow. And in our experience, most workers under age 50 have little understanding or concern about a plan that guarantees a lifetime income at age 65, as most traditional plans do.
If the new plans are so good, why did Onan get sued? According to the Wall Street Journal, Onan adopted a cash balance plan in 1989 that provides all workers with annual credits of about 3.5 percent of their pay. The credits are accumulated into hypothetical individual accounts that then earn a guaranteed rate of interest. But a class-action lawsuit argues that the equal credit is, in effect, unequal. Equal annual credits or contributions yield an unequal amount of annuity income at age 65 because of the power of compound interest. At 6 percent interest, a $2,000 credit for two employees, one age 30 and one age 60, will project to a monthly income at age 65 that is six times larger for the 30-year-old than for the 60-year-old.
BIAS AGAINST WHOM?
But one reason companies are moving to cash-balance is to address the age bias inherent in the traditional defined-benefit plan. Its bias is in the opposite direction. The present value of a $100 monthly benefit for the 60-year-old is six times larger (about $9,000) than the value of the same benefit (about $1,500) for the 30-year-old.
The Onan lawsuit focused on a type of employee rare today — that is, one who has worked a full career for one employer. According to a study by the Employee Benefit Research Institute, fewer than 15 percent of employees will work 30 or more years for one employer. That means over 85% will not, so the traditional defined benefit plan delivers an inadequate benefit for most employees. It depends on the individual plan, but most workers who change jobs even once get higher benefits from the cash-balance plan.
Another reason employers are shifting to account-based plans is to address the issue of increasing employee mobility. Account-based plans deliver more benefits in the early years of a worker’s career than traditional plans. When the younger workers change jobs, they take more retirement benefits with them.
ONE TOUGH ISSUE
Any conversion from a traditional pension plan to an account-based plan must address one very tough issue. How do you handle the transition from one plan that provides very little in the way of benefits in the early years of a career (and a very steep ramp-up in benefits in the last few years) to one that provides relatively level benefits throughout an entire career? A simple conversion delivers the worst of both worlds to older long-service employees — not much in the early years and not much more later.
Most companies carefully consider that issue and make sure that-long service employees don’t get the rug pulled out from under them. But the issue is even more complicated. Account-based plans provide for markedly higher benefits early in an employee’s career. Because most employees change jobs frequently, that means short-service employees will take more out than in the past. If the company wants to keep the cost of the conversion neutral, then long-service employees must take out less. Is that fair?
Most employees will think it’s fair when the change is explained. Simply put, employees will have better benefits under the new plan until age 60 and worse benefits after age 60. For employees under age 50, receiving more benefits before age 60 more than offsets the potential loss of benefits after age 60. In planning a conversion, employers should be aware that most of the lawsuits are coming from those over age 50 and should plan ways to limit legal exposure.
There are those who just miss the transition eligibility and who are relatively close to retirement, as in the Onan situation. In order to make the new plan affordable, a line must be drawn somewhere. Another alternative is to have special additional credits under the new cash-balance plan that are higher for older workers. That makes the new plan more complex but avoids the “all or nothing” situation that may make a lawsuit likely.
One unfortunate implication of the Wall Street Journal series on cash balance plans is that they are designed only to save money for the employer. Although an employer may wish to reduce its cost, most of the companies have other objectives; most end up spending the the same or slightly more on retirement benefits. It’s a tough balancing act between human resource objectives and financial constraints.
Common objectives are to show employees appreciation, to give them access to the benefits (rather than pay them a little at a time from age 65 on), to attract employees by showing them faster benefit accruals that will pay out more to those who do not work a full career, and to level out the accrual of benefits so the retirement plan provides no artificial incentive to stay or to leave at a particular age.
Employers often reduce the benefits and the costs related to the defined-benefit portion of the retirement program so that they can afford to increase the defined-contribution portion. Often a higher match on the 401(k) or a higher target payout on the profit sharing plan will accompany the change to a cash-balance plan. Employers emphasize total retirement income and total compensation.
There is an ironic challenge in communicating with employees about the transition — namely, the employees least interested in their retirement benefit are the most likely to receive higher benefits. The employees most interested (the 12 percent who have worked a full career) are most likely to lose. Companies often provide those employees with “grandfathering” protection so they don’t lose anything. But the company must then communicate and administer both the old and the new plans.
So do cash-balance plans represent a fraud or a friend to employees? It depends. Many employees love the understandability and portability of an account-based plan that provides more benefits sooner, even if it means fewer benefits later, but companies should be careful to avoid lawsuits by considering the needs of those who lose out.