Coca-Cola is the latest big US company to convert its final salary pension plan to cash balance, thereby becoming part of a trend highlighted in a recent survey of the Fortune 100 companies by professional services firm Towers Watson. Of these companies, the number replacing their traditional defined benefit (DB) plans with account-based retirement plans for new employees continues to increase.
Account-based plans include defined contribution (DC) plans, such as 401(k), and hybrid pension plans, typically cash balance, where the participant has an account that is topped up each year with a pay credit - such as 5% of compensation from the employer - and an interest credit - a fixed or variable rate that is linked to an index such as the one-year Treasury bond rate. The final benefits depend on the individual account balance; the employer is responsible for the plan’s investments, which are similar to those of traditional DB plans, heavy in equities and bearing its risks and rewards.
According to Towers Watson, 58 companies in the Fortune 100 offer a DC plan to new employees, compared with 10 companies in 1985, while 17 companies continue to offer a traditional DB plan, a decline from 20 at the end of last year, and 89 in 1985. Moreover, 25 of the 42 companies with DB plans offer hybrids, such as cash balance plans, which are interesting employers due to two key new circumstances.
“First, the recent crisis is having an impact on DC plans, where members are exposed to market risks,” explains Alan Glickstein, a senior retirement consultant with Towers Watson. “Employees are not as good as professionals in devising investment strategies and now they are having trouble with capital losses. This can influence the design of future DC pension plans. Second, hybrid pension plans will become more popular if the uncertainty about their rules is clarified, as we expect by the end of this year”.
The first hybrid plan was created in 1985; their numbers grew rapidly to 23 by 1998, reaching 34 by 2002-04; thereafter, their numbers declined, and since 2005 have stabilised at 25. “The problem is that 25 years after the first hybrid plan materialised there are no rules to describe clearly what these funds are and how they should work,” says Glickstein. “The reason why their number started declining in the mid 2000s is that a number of lawsuits were filed against their sponsors. Many companies didn’t feel at ease shifting to the new formula.”
In 2006, the new Pension Protection Act clarified the legality of the transformation of DB funds into cash balance plans, but established that the interest credited on individual accounts may not be higher that the market rate, which has not yet been defined. “We know that if the interest is simply equal to long-term government bond yields that’s OK,” continues Glickstein. “But many companies use a combination of fixed rates, for example 5 or 6%, together with Treasury bond yield, and the total can be higher than T-bond rates. We hope that new rules will soon bring clarity to this issue.”
According to Glickstein, cash balance plans may appeal to employers more than DC plans, which have efficiency problems: their participants usually do not diversify enough and achieve worse results than DB. “Pension benefits of the same size end up costing less in a DB hybrid plan than in a DC plan,” says Glickstein.
“It’s true that companies managing hybrid plans that are invested in equities can incur losses in the short term, but they may prefer to deal with financial risks instead of having management issues because their employees cannot retire due to 401(k) losses.
Besides, employees are happier with cash balance plans because they understand better how their accounts grow compared to traditional DB plans, where the formula to calculate final benefits can be obscure. Young workers especially like the portability of balance plan benefits.”
Towers Watson does not think that traditional DB plans will totally disappear. “Traditional DB plans will be kept by very large companies in industries where jobs are stable, careers develop long term, and unions are influential; they may even enjoy a comeback because of demographic changes,” says Glickstein.
“Older high-tech companies which used to pay their employees primarily in shares, may now think of changing their compensation systems, including that of retirements benefits.”