Modified cash balance
B y mid-March 2003 a huge battle can burst out in the American workplace, involving up to 42m employees, who are still enrolled in traditional defined benefit (DB) pension plans. At stake is the conversion of these plans into the so-called ‘cash balance’ retirement schemes, which was halted in September 1999 by the Internal Revenue Service (IRS), following heavy criticism from workers at companies such as IBM.
What is more interesting, from a global point of view, is that according to some experts a cash-balance plan may be seen as a model for a new hybrid scheme with features from both DB and defined contribution plans (DC). In the words of the Office for Public Affairs of the US Treasury Department, it “combines the benefit formula of a DC plan with the investment security of a DB plan”. But critics say that it is just a way for companies to save millions of dollars, at the expense of older employees.
The mid-March deadline is 90 days after last December the US Treasury Department proposed new rules that would end a three-year moratorium on conversions. The new rules address the problem whether a conversion is discriminatory against older workers or not. All interested parties can submit comments to the proposals in the 90-day period, after which the rules can become effective.
About one-third of the US largest public companies have already cash balance plans or their equivalent. “A cash balance plan,” explains the US Treasury, “establishes a ‘hypothetical account’ for each employee and credits the account with hypothetical ‘pay credits’ and ‘interest credits’”. As in a 401(k) plan, each employee has an individual account that is portable; and the final benefits depend on the rate of return and on the number of years of contributions. It is the company that fixes the rate of return (it is usually indexed to the US bond market benchmarks) and it also guarantees this.
Cash balance plans can be appealing to younger workers, who are likely to change jobs several times in their careers and then prefer a portable account. But older workers would like to stick to traditional DB plans, because their benefits are not only based on the age of participants and years of services, but they are also calculated as a percentage of final salaries.
The problem arises when a tradition DB plan is converted into a cash balance plan while older participants are relying on benefits calculated according the ‘old’ system. The new system’s benefits are likely to be inferior for older workers who may not have enough time to save additional money for their retirement: that is why in the past few years hundreds of them have sued their companies, claiming that conversions violated federal prohibitions on age discrimination.
The Bush administration proposal defines what is not discriminatory. First of all, the ‘pay credit’ – the percentage of employee paychecks contributed by the employer – must be equal for younger and older workers. Second, the value of already earned benefits must not be reduced at the time of conversion: they have to be calculated as the ‘actual’ value of the lump sum necessary to pay the promised monthly annuity at age 65. But the new Treasury rules do not say which is the ‘discount’ rate to be applied to calculate the sum: they only require that the employer uses a ‘reasonable’ interest rate assumption.
Critics point out that this can lead to heavy abuses. Infact, the higher the assumed rate of the money’s growth, the smaller the current value of the benefits. Some would have preferred a clearer guidance, for example that it is ‘reasonable’ to use the 30-year Treasury bond yield, which is suggested as a safe assumption by current pension laws. Treasury officials reply that if a company uses a substantially different rate, IRS could deny permission to convert the old DB plan into the new cash balance scheme.
Finally, the new rules allows for a ‘wear-away’ period, during which cash balance benefits catch up with benefits under the traditional plan: so older employees can stay several years without earning additional pension benefits. This may happen because when a cash-balance plan is created, each participant would have two separate accounts: one would equal the current value of the vested pension benefits in the old plan; the other would be their opening balance in the new plan. If an employee quits, their should be entitled to whichever account has the higher balance. But if an employee stays with the company and the current value of their vested pension is higher, the latter would stay constant while the cash balance account would continue to accumulate company contributions.
William Sweetnam, benefits tax counsel at the Treasury Department, says the proposed guidelines would give employers flexibility without hurting workers. Employers groups also claim the new rules will benefit workers because they encourage many companies to offer pension plans otherwise non-existent.