As defined contribution plans, especially 401(k)s, have exploded in popularity in the past 15 years in the US, traditional defined benefit pension plans have declined both relatively and absolutely by comparison. While the rush to terminate traditional pension plans has slowed from its peak in the 1980s (in large part as a result of draconian excise taxes on surplus assets rather than a change of heart by CFOs), the establishment of new defined benefit plans seems as rare as the birth of a giant panda!
The reasons for this state of affairs are many and varied, but clearly one of the most important is that most employees (other than those within sight of retirement) tend not to think very much about their pensions payable at age 65. In contrast, the arrival of the quarterly 401(k) statements generates a fair amount of excitement, attention, and, importantly to employers, appreciation in the air.
A cash balance plan addresses this perception gap by recasting how the pension is presented to employees. Instead of explaining how a complex formula results in a monthly annuity amount payable decades in the future, the benefit under a cash balance plan is simply explained as a single sum payable today. The following communication examples demonstrate this phenomenon.
q Traditional pension plan. “Your pension is calculated as a life annuity payable at age 65, determined using the following formula:
A. Your final average salary
B. 1% (.01)
C. Your years of credited service
D. Your final average salary in excess of social security covered
E. _ of 1% (.0075)
F. Your years of credited service
Your monthly pension payable at age 65 as a life annuity is the result of C and F above, divided by 12. If your benefit commences prior to age 65 or is payable in a form other than a life annuity it will be actuarially adjusted.”
q Cash balance pension plan “Each year you will receive an allocation of 4% of your pay to your cash balance account. Your account will be credited each year with interest equal to the rate currently being paid on 30-year US Treasury Bonds (currently 6%). When you leave XYZ Company, you may either take your cash balance account or convert it into an annuity (based on interest rates in effect when you leave).”
This simplicity of communication is reinforced, in many instances, by publishing the current value of an employee’s cash balance account on the individual’s 401(k) statement.
However, the US pension regulatory environment being what it is, cash balance plans are technically very complex, and, as a result of the emphasis on traditional plans in the rules, the application of various regulations is somewhat unclear. Furthermore, and as will be discussed below, the conversion of a traditional pension plan into a cash balance plan creates unique issues of compliance and equity.
The most prevalent type of pension design in the US is the final average pay formula (see graph above). In addition to the basic formula described, most US plans also provide for a “subsidised early retirement”. (The formula produces a benefit payable at age 65; the subsidy arises because the benefit payable at earlier ages is greater than the actuarial equivalent of the age 65 benefit.) The blue line in the figure shows the pattern of accrual under this type of plan.
As can be seen, under a traditional plan design, the value of the pension is not earned ratably over a career. Rather, early in an employee’s career, it remains very low, then dramatically jumps when rights to the subsidy mature (usually around age 55).
This seemingly arcane point accounts for another major plan design rationale for the popularity of cash balance designs. First, the traditional plan accrual pattern is not of much value in attracting young employees – an important point in the extremely tight US labour market. Secondly, as job tenure tends to be shorter, the traditional plan’s pattern of rewarding long careers is also of diminished value to many employees. A related issue is that, under the traditional plan, an employee who leaves before retirement is entitled to a non-indexed deferred annuity commencing at age 65. Obviously, the toll of inflation over time reduces both the perceived and the real value of the pension earned.
The red line on the figure illustrates the accrual pattern under the cash balance plan also referred to in the example above. It shows that a cash balance plan addresses the three issues discussed above. First, the cash balance plan provides higher values at younger ages. Second, the benefit increases ratably over a career and doesn’t jump upon attainment of eligibility for the early retirement subsidy. Finally, employees who leave before retirement generally can take their cash balance with them. When the cash balance sum is rolled over into an Individual Retirement Account (IRA), the accrued pension continues to grow in a current-tax-protected environment by virtue of re-investment of dividends and gains earned in the IRA.
These characteristics of cash balance plans make them an especially attractive option for employers who wish to attract a younger, more mobile workforce. On the other hand, a traditional design will generally yield a better pension for employees who settle in for a long career.
Another frequently cited attribute of cash balance plans is that they are less expensive than traditional pension plans. It is true that several companies have instituted cash balance plans as a way to substantially reduce prospective pension cost. They have used the radically different nature of the design to disguise the reduction in future pension accruals! It is not true that a cash balance plan is intrinsically less expensive than a traditional plan. In companies with high turnover, for example, the higher benefits given to young, short service employees who leave will substantially increase costs for the employer.
However, when compared to a pure defined contribution plan, a cash balance plan of similar design is usually less expensive over time. All US tax and funding rules treat the cash balance plan as a traditional defined benefit pension plan. Typically, a cash balance plan will credit a relatively modest rate of interest (eg, 6%). Since the pension fund generally earns considerably in excess of this rate (eg, 9%), the employer can use the excess fund earnings to reduce the required contribution. For example, a 5% cash balance plan may only require a 4% funding contribution, whereas a 5% defined contribution plan will require a 5% cash contribution. More significantly, an existing defined benefit plan with “excess” assets can provide that no cash contributions be required for the cash balance plan. (Some plan sponsors have replaced cash contributions to a defined contribution plan with a comparable cash balance plan funded out of accumulated pension assets.)
Finally, a cash balance plan is treated as a traditional plan for US financial disclosure (FAS 87) purposes.
Cash balance plans are the subject of much controversy in the US today. While there are valid concerns about the designs adopted by some employers, the real controversy concerns the impact on certain classes of employees when a traditional plan is converted into a cash balance plan. As was shown earlier, a cash balance plan tends to provide better benefits to younger, shorter service employees. If an employer chooses to retain the traditional plan for older, longer service employees, while funding a cash balance plan for younger, shorter service employees, the overall cost to the employer for both cash balance plus traditional plans necessarily will be greater. Since very few employers are willing to accept a real increase in expense when adopting a cash balance plan, the actual increase in costs associated with a more attractive benefit for younger, shorter service employees will be offset by a concommitant decrease in costs associated with a less attractive benefit for older, longer service employees.
While employees close to retirement may be grandfathered in the prior design, a large portion of the population (say between ages 40 and 50) typically is not. As, under US law, employees aged 40 and over are protected against age discrimination, the impact of a conversion has given rise to claims of age discrimination. In addition, unions in the US have responded to the cash balance conversion issue as an attempt by employers to reduce pensions. The IBM cash balance conversion resulted in an explosion of press coverage of these issues. As an aside, IBM eventually liberalised its grandfather criteria partially in response to a concerted web-based protest movement, illustrating the power of the internet in uniting employees over pension issues.
These complaints have generated several new plan design approaches (for example, employee choice of pension plan type), various legislative initiatives in the US Congress, and increased regulatory scrutiny from the Labor and Treasury departments. As a result, it is virtually certain that employers’ flexibility in converting an existing plan into a cash balance will be somewhat more constrained in the near future.
Cash balance plans have become a widespread design in the US. While there certainly will be statutory and regulatory changes impacting their design, they have a place in the US pension system, and are the best choice for many.
Richard Koski is a principal and benefit consultant with Buck Consultants in Secaucus