Human Capital & Careers

Pension Act Tilts to Cash-Balance Plans

But employers still might want to shun old-style defined-benefit plans for the comfort of a 401(k).
David KatzAugust 23, 2006

By boosting the volatility of the cash demands that traditional defined-benefit plans place on employers, the new pension reform law makes cash-balance plans all the more alluring, retirement plan experts say.

Indeed, some foresee a sizable up-tick in the number of conversions from old-style pension plans to cash-balance programs. A major reason is that the Pension Protection Act of 2006 reins in employers’ ability to “smooth,” or average over time, the interest rates used to gauge the assets and liabilities of traditional pensions. Before President Bush signed the act into law on August 17, plan sponsors could smooth the interest rates they used for assets and liabilities over five years and four years, respectively. The act changes smoothing to a two-year time period for both.

That change puts DB plan sponsors much more at the mercy of real-world interest-rate fluctuations, producing greater volatility on corporate financial statements. Under the tightened smoothing strictures, employers are “going to contribute a whole lot more to the plan” over shorter periods, said Jan Jacobson, director of retirement policy for the American Benefits Council, an employer advocacy group.

Not so for cash-balance pensions, which are also known as “hybrid” plans because they’re DB plans that look like defined-contribution plans such as 401(k)s. Unlike traditional plan sponsors, employers who supply cash-balance plans don’t have to worry about estimating their future outlays on the basis of fluctuating, market-driven interest rates.

Instead, cash-balance sponsors provide each worker with a hypothetical “account” into which the employer allots two kinds of credits: a “pay credit” (a percentage of current salary) and “an interest credit” (a percentage of the previous year’s pension balance). Those credits are calculated to provide a defined benefit at the end of each employee’s career.

Thus, “while with a hybrid plan [employers] know what their obligations are, with a traditional plan it’s difficult to do forward planning,” observes Jacobson. The increased volatility will make it even more difficult.

Still, many defined-benefit plan sponsors worried about volatility might still be wary of moving to cash-balance plans if the act hadn’t made them so appealing. After all, hybrid plans had been in hibernation since 2003, when a federal judge ruled in Cooper v. IBM that the company showed a bias against older workers by converting from a DB plan to a cash-balance plan.

But barely ten days before the new law was enacted, an appeals court overruled the previous decision. “An employer is free to move from one legal plan to another legal plan, provided that it does not diminish vested interests,” the appeals court judge for the Seventh Circuit ruled. Experts feel that the decision sets a precedent in favor of existing cash-balance plan conversions that may hold sway in other circuits.

Soon after, the pension act erased all doubts about future conversions by making the design of cash-balance plans legal. Now, employers mulling a conversion know that “it’s not something they’re going to get penalized for after the fact,” says Jonathan Waite, chief actuary for SEI, an outsourcer of asset-management services.

But the act also provides at least one positive inducement to employers to fund cash-balance plans: it increases the tax-deductible limit on funding for plan liabilities—supplying “wiggle room on the upside,” as Jacobson puts it.

That provision has caught the eye of Mark White, the CFO of SAP America, a subsidiary of SAP AG, the software giant. White thinks that SAP America, which last year was able to make a tax-deductible contribution of $36 million to its cash-balance plan, might be able to sock away more than $50 million more as result of the act. While the plan is already fully funded, SAP would over-fund it up to the tax-deductible limit to save for rainy days in the software business.

Despite providing such enticements for the sponsors of traditional DB plans and existing cash-balance plans, the new act seems to provide little reason for employers to form new hybrid plans. More likely, it might stem employer flight from pensions to 401(k)s. “It gives [ plan sponsors] the opportunity to change the shape of their plan but still stay in the pension world,” says Waite.

Why would some employers want to stay in the fold rather than switch to the much less onerous—and cheaper—defined-contribution arena? An employer with a relatively young group of workers might be interested, the actuary points out, since a cash-balance plan doesn’t reward seniority as much as a traditional DB plan might. Some companies may want to differentiate themselves in the labor market by providing richer benefits.

Nevertheless, there are considerable barriers standing in the way of a wave of conversions to cash-balance plans. The act, by tightening funding rules, could push financially shaky employers to dump responsibility for their DB plans on to the Pension Benefit Guaranty Corporation, the nation’s pension insurer. In turn, the PBGC could hike the premiums it charges the sponsors of healthy plans—and drive them out of the pension system entirely.

Even though he’s relatively satisfied with SAP America’s cash-balance plan, for example, White says that the company would switch to a DC plan if PBGC premiums get high enough. High enough, he suggests, is when providing a generous 401(k) match is a more sensible use of funds than bailing out imprudent plan sponsors.

While he hopes the act will push such employers to live up to their obligations, “I don’t see it,” the finance chief says. “It’s too easy for top executives to get bonuses by slashing pensions.”

Another barrier to conversions from DB plans to cash balance plans is the toll they can take on certain employees. “If defined-benefit plans are volatile and you want to move that volatility, those risks don’t go away,” says Joel Rich, a senior vice president with The Segal company, a benefits consulting firm. “They’re just going to be shouldered by the employees.”