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To freeze or not to freeze? That is the question -- and for many employers that have a cash balance pension plan or that are considering a conversion, it's apparently one of the hardest to answer.
Craig Schneider, CFO.com | US
November 19, 2003
Cash balance plans, a hybrid of traditional defined benefit pension plans and defined contribution 401(k) plans, lately seem to offer more risks than benefits — among them, increased funding obligations, a damaging court ruling on age discrimination, and pending Congressional action to curb conversions from traditional pension plans.
Last week, lawmakers in the House and Senate decided to bar the Bush administration from finalizing its proposed pension rules on cash balance plans — through the Department of the Treasury — in hopes of limiting the number of conversions to the hybrid plans, which many consider detrimental to older worker's retirement savings. The reconciliation was part of the annual spending bill that funds the Treasury Department.
According to Reuters, legislators also required that the Treasury offer legislation within 180 days on how best to convert traditional pension plans to cash balance plans. The compromise bill is expected to be voted on early next week.
Still, plan sponsors continue to fret over a ruling earlier this year by a federal judge, who found that IBM's cash balance and pension equity formulas discriminated against older workers, in violation of the Employee Retirement and Income Securities Act. If the decision is upheld next year on appeal, many experts believe it would render all cash balance plans illegal.
Chuck Longiotti, retirement practice leader at Mercer Consulting, says a resolution of the age discrimination issue can't come too soon. "The longer that we don't have clarification," says Longiotti, "the more employers are going to stop taking the risk" — that is, the more likely they'll be to freeze their cash balance plans.
Hundreds of major companies have been drawn to these hybrid plans as an effective recruitment and retention tool. Cash balance plans account for 25 percent of all participants in defined benefit plans and 40 percent of all assets invested in defined benefit plans, according to Federal Reserve Board data, cited by IBM in a recent press release. Last year benefits consultancy Watson Wyatt Worldwide found that 33 of the largest 100 corporations have instituted such plans.
In a cash balance plan, retirees have the security of a guaranteed monthly pension, a more easily understood individual "account balance," and the portability of a 401(k). And since the plan sponsor makes contributions that are evenly spread out over an employee's time with the company, employers often enjoy greater cash flow predictability, funding options, and in some cases, cost savings.
The Little Difference That Makes All the Difference
However, that distinction from a traditional defined benefit plan, in which employees receive a greater credit to their "account" in their final years of service, is at the heart of the IBM debate. When a company converts to a cash balance plan, younger workers have more years to accrue interest on those contributions than older workers do — thus raising the issue of age discrimination.
Lynn Dudley, vice president and general counsel at the American Benefits Council, a Washington, D.C., lobbying group, says companies are increasingly likely to freeze their plans and convert to a 401(k) amid the legal uncertainty. "I would never recommend to a client to adopt a cash balance plan before that [age discrimination] issue works its way through the judicial system," she says. "You expose yourself to a lot of litigation."
Perhaps more disconcerting among CFO circles are the hefty cash contributions that companies must make to fund the deficits in their traditional defined benefit plans and cash balance plans. Even after recent upswings in the markets, the Pension Benefit Guaranty Corporation estimates that three years of equity declines and low interest rates have left single-employer pension plans underfunded to the tune of more than $350 billion. A recent Towers Perrin survey of 300 Fortune 1000 companies found an average pension cost on the income statement of $23.8 million for 2002. Between 2001 and 2002, the average deferred pension cost for the surveyed companies nearly tripled, to almost $1.4 billion.
Help may be on the way. On October 29, a Senate committee approved a bill that would give $30.5 billion in relief from pension burdens. The measure replaces the outdated 30-year Treasury bond rate, used as a benchmark to determine pension funding, with a more lenient formula based on a blend of corporate bond rates for three years beginning in 2004. The House also recently approved a similar bill offering $25.5 billion in relief for two years.
While the language of the provisions was resolved at the Congressional committee level last week, some critics say it's not enough. Bill Gulliver, chief actuary at Towers Perrin, is still frustrated that Congress is considering only a temporary measure "because CFOs and businesses want to be able to plan their cash flow."
In any event, for some companies the relief may arrive too late. Aon Consulting recently reviewed more than 1,000 private-sector defined benefit plans as part of an informal survey and found that since January 2001, 15 percent have taken action to freeze benefits, and an additional 6 percent are actively considering a freeze. Cash balance plan sponsors were among the respondents, but separate data was not available.
The most frequently cited reasons for freezing a plan were the amount of pension plan contributions (mentioned by 45 percent of respondents), the volatility of contributions (39 percent), the impact of pension plans on corporate expense (35 percent), and their impact on general business conditions (35 percent).
In addition, Mercer Consulting conducted an informal poll last month and learned that two clients, or 8 percent of the 25 respondents with cash balance plans, intended to freeze future benefits. And Avaya Inc., an S&P 500-listed company, announced last month that it would be freezing the accruals in its defined benefit pension plan and cash balance plan, and switching U.S. salaried employees to an enhanced 401(k) plan, on January 1.
One further impediment to cash balance conversions is the Internal Revenue Service moratorium on issuing favorable determination letters, which puts plans at greater risk because the tax structure is not assured.
Pressing Ahead Nonetheless
A few companies are converting to a cash balance plan nonetheless; they include Federal Express, Hartford Financial, Northrop Grumman, and The Tribune Co. "We're watching the court cases with interest, but we're going forward with our plan," Northrop Grumman spokesman Frank Moore recently told the The Daily Press in Hampton Roads, Virginia.
Eric Lofgren, global director of the benefits consulting group at Watson Wyatt, observes that the few companies which convert also take proper precautions. They may stipulate transitional grandfather provisions, he says, or they may find another way to give "extra credit to older employees to account for the difference." Another option, says Lofgren, is simply to "give the employees the choice of which plan they want."
Dudley agrees. "Most employers are generous in their transition," she says. "They are giving high opening account balances and generous grandfather clauses. And many employers are giving choice, not at retirement, but at the time of conversions."
Some academics, however, are not convinced that transitional provisions will keep companies altogether in the clear. Norman Stein, professor of law and a pension expert at the University of Alabama, says, "for the most part, the practices being trumpeted are ones that ease the pain but don't eliminate it."
Jim Verlautz, director of employee benefits for Deloitte and Touche, has other concerns. "What does a plan sponsor do with the interest accruals of frozen cash balance pension plans?" he wonders. "If you stop crediting interest, that doesn't seem fair for the participants, but if you continue, that appears to fly in the face of the IBM court decision" because interest accruals would still be greater for younger employees.
The Department of the Treasury has already proposed rules that would allow companies to convert to cash balance plans without fear of age-discrimination violations, but Congress is keeping the final regulation at bay. Specifically, through amendments to an appropriation bill, legislators would withhold money from any Treasury Department effort to support IBM's defense by joining in the appeal.
"I think there was a feeling [on Capitol Hill] that the regulations that the Treasury proposed didn't do much to limit the abuses of converting to cash balance plans," says Prof. Stein. "The very worst employers would have to do a little more," adds Stein, but he believes that employers that might otherwise have implemented greater reforms will instead "set the lowest common denominator."
The American Benefits Council's Dudley responds that Congress also needs to realize that benefits are voluntary; if legislation makes conversions too expensive or monitoring the plans too complex, companies may simply freeze their plans and offer only an enhanced 401(k).
Some plan sponsors that are considering freezing their pensions are considering replacing them with a profit sharing plan, says Mercer's Longiotti. But he notes that many cash balance plans have annuity benefits, as well as special transition benefits including grandfather provisions that protect older workers. "It's difficult to reproduce those types of features in profit-sharing plans," he says.
In the end, Mercer's Longiotti says cash balance plans will not be wiped out of existence. "The fact that these plans have existed for 20 years," he says, and that they make up nearly one-third of defined benefit plans, is "strong evidence that the business and legal community believe these plans have always been legal."