Will 2005 be the end of the road for cash balance plans? Everybody in the US pension fund industry is asking this question, after IBM’s decision last December to end such benefit for new employees after 1 January. “Companies are looking to see what their competitors are doing,” says Lynn Dudley, vice president and senior counsel with the American Benefits Council.
IBM’s decision follows many years of controversy about cash balance plans, which are defined benefit (DB) plans with a defined contribution (DC) ‘twist’. They create a hypothetical account for each employee las in DC schemes. Yet the plan remains a DB scheme, because the assets are pooled and invested at the discretion of the employer. The individual accounts are merely bookkeeping entries. The employer contributes annually to each ‘account’ with an amount equal often to 3-5% of pay, and each account earns an interest rate specified by the employer, often near the long-term treasury bond rate.
Bank of America became the first large US employer to convert from its traditional final pay DB plan to an individual notional account cash balance plan 20 years ago. Since then hundreds of employers have followed sut. According to the Pension Benefit Guaranty Corporation (PBGC) some 25% of active participants in DB pension plans now belong to such ‘individual account’ schemes, offered by more than 1,200 companies.
The switch to cash balance plans came to a halt at the end of the 1990s when older employees started to dispute its fairness and claim that with the new formula they would lose 20 -50% or more compared with what they might have earned under their traditional pension plan. A DB plan guarantees retirement benefits based on the last years of service. These are usually the highest paid and therefore it rewards long-term loyalty.
Younger employees prefer the cash balance formula because it enables them to start accruing pension benefits earlier. Cash balance plans are also easier to roll over into new account s when employees change jobs.
In 1999, some 130,000 current and former employees filed a lawsuit against IBM, accusing them of age discrimination for replacing its traditional pension plan in 1995 with a new cash balance scheme. In August 2003 Judge Patrick Murphy of the Federal District Court in Southern Illinois ruled in favour of the employees, stating that the pension conversion was age discriminatory. Last September, IBM reached a settlement with lawyers for current and former workers that would limit its liability to about $1.7bn (€1.3bn). At the same time it announced that it planned to appeal against the ruling. It seems likely that the case will eventually go before the Supreme Court and that a final decision could take many years.
In the meantime the uncertainty about the legal status of cash balance plans has become so great that IBM decided to stop offering such plans to new employees. Not only is the court rule pending, but also the Internal Revenue Service stopped issuing approvals for new cash balance plans in 1999 while it studied the issue. Congress is unwilling to take a position. The first Bush administration had proposed regulations that would have deemed cash balance plans not to be age-discriminatory, but critics on Capitol Hill blocked these rules. The issue could perhaps become part of the more general pension reform proposed by the second Bush administration.
More than half of employers are thinking of making some type of change to their cash balance or pension equity plans in 2005 if regulatory questions about the programs are still unresolved, according to a survey by Hewitt Associates.
“Employers are fed up. They’re beginning to react by closing the plans,” says Ari Jacobs, a benefit consultant with Hewitt Associates.
Studies by Mercer Human Resource Consulting and AON confirm that many employers have been freezing their current defined benefit plans since 1999, some are planning to do so, and others are considering closing their plans and sponsoring only a DC plan.
The new Financial Accounting Standards Board rules for pension funds, which are expected to take effect in 2005 have added a new urgency to the issue. The new rules will require many companies to calculate the pension benefits their workers have earned in a new way, increasing the reported value of the benefits by as much as a third and threatening to disrupt some companies’ balance sheets.
It may be better to offer a more generous DC plan like a 401(k), but avoid the risks of investing pension assets into the stock market and of dealing with complicate accounting rules: that’s why IBM is offering its new employees “one of the richest defined contribution matches available in our industry” says Kendra Collins, an IBM spokeswoman.
IBM’s new 401(k) plan allows participants to set aside 6% of their pay each year in individual retirement account. IBM will match these contributions dollar for dollar. This is double the rate at which it currentlycontributes under its existing 401(k) plan, which is offered as a supplement to the cash-balance plan.