Cash balance conversions.

Assessing the accounting and business implications.

Wishing to attract younger talent and control costs, companies have been redesigning their defined benefit pension plans. An estimated 16% of Fortune 100 companies have switched to a so-called cash balance formula. Some of the new cash balance plans allow employees to take lump-sum distributions. This appeals to the typical member of today's younger and increasingly mobile workforce, who may not stay with a company long enough to enjoy the full benefits of a traditional pension plan.

Congressional concerns about cash balance conversions focus on whether companies are adequately disclosing to participants the resulting changes in benefits and whether cash balance formulas discriminate against older employees. This has led the IRS to mandate that all determinations and examinations of cash balance conversions be forwarded to the IRS National Office for review. In informal discussions, the IRS has indicated it might withhold approval of all pending conversions to give the agency time to formulate a policy on qualification issues. In addition, the Equal Employment Opportunity Commission is considering whether conversions violate the Age Discrimination in Employment Act.

Many companies have made the transition to a cash balance plan (for details on how some of them went about it, see "Staying Off the Cover of Time" on page 31). A company considering whether a cash balance conversion is in its best interest should understand

* How cash balance pension

plans differ from both traditional defined benefit and defined contribution plans.

* How a participant's opening account balance and subsequent benefits are determined.

* What the accounting and disclosure implications are of a conversion.

* How converting to a cash balance formula affects the company's projected benefits obligation, annual pension cost and funding requirements.

* What business and employee-relations issues lead employers to switch to cash balance plans.

NAME THAT PENSION

The addition of cash balance plans essentially has added a third option for companies to choose from in providing benefits to their employees.

Defined benefit plan. Under a defined benefit plan, a company promises to pay an employee a specified retirement benefit. The benefit is the amount the employee is deemed to have earned during his or her employment. Employer contributions usually are placed in a trust and invested; benefits are paid from the trust's accumulated assets. The employer's annual contribution is actuarially determined based on employees' ages and salary histories, mortality rates, the performance of the trust's investments and ERISA contribution requirements.

The employer bears the financial risk if the investment return on plan assets falls short of expected performance or if trust assets are not adequate to meet the promised benefits. Traditional defined benefit plans are "backloaded"--benefits generally relate to time in service and salary levels immediately before retirement. Thus, a significant portion of an employee's pension benefits accrues in the last 5 to 10 years of employment.

Defined contribution plan.

Under a defined contribution plan, employees are not guaranteed a specific benefit. Instead, an individual account is maintained for each participant. A participant's account balance is based on

* Amounts contributed by the employer and/or employee.

* Investment experience on these amounts.

* Forfeitures allocated to the accounts. When a fully vested participant retires or withdraws from the plan, the amount allocated to his or her account represents the accumulated benefits the company must pay to the participant or use to purchase a retirement annuity. Benefits are not guaranteed and the participant bears all investment risks. The benefits a participant receives generally are not determined until he or she withdraws from the plan or retires.

Cash balance plan. In the mid-1980s, the IRS approved the underlying structure of cash balance plans, and some companies began converting defined benefit plans to cash balance formulas. A cash balance plan is a defined benefit plan because the employer bears the investment risks and rewards and the mortality risk if the employee elects to receive benefits in the form of an annuity and lives beyond his or her normal life expectancy.

Unlike a traditional defined benefit pension plan, a cash balance plan establishes allocations to an individual account (the cash balance) for each participant. Benefits under cash balance plans often are paid as a lump sum rather than as a life annuity. If a vested participant switches careers or retires, he or she usually can roll over the lump-sum payment (based on the cash balance) into a self-directed IRA or another qualified plan, where it will continue to grow tax deferred. In contrast, most traditional defined benefit plans freeze a departing employee's benefits at a monthly level until the employee reaches retirement age, which means the employee does not have a lump-sum benefit to reinvest.

Because a cash balance plan provides a defined benefit, it is accounted for as a defined benefit plan under three FASB pronouncements--Statement no. 87, Employers' Accounting for Pensions; Statement no. 88, Employers' Accounting for Settlements and Curtailments of Defined Benefit Pension Plans and for Termination Benefits; and Statement no. 132, Employers' Disclosures about Pensions and Other Postretirement Benefits.

DETERMINING THE OPENING BALANCE

To convert a traditional defined benefit plan to a cash balance formula, the employer establishes an opening account balance for each plan participant by calculating the lumpsum present value of each participant's accrued annuity benefit under the traditional defined benefit formula. Employers have discretion, however, in determining key assumptions used in calculating the opening balance. For example, retirement age and mortality assumptions affect the length of time that benefits may be paid, and the interest rate assumption determines the rate the company uses to discount future benefits to a lump-sum present value. Thus, in some cases, accrued benefits under the cash balance formula may be lower than those under a traditional defined benefit plan.

Additional benefits do not accrue to a participant until the benefits payable under the cash balance plan equal the amount accrued under the traditional defined benefit plan at the transition date. Accordingly, a participant may have to work several years before he or she earns pension benefits beyond those already accrued at the time the company converts. If the participant does not retire or leave the company, the length of time it takes for the lower value cash balance formula to catch up to the benefits accrued under the traditional plan is the time the participant is not earning new benefits. This period is commonly referred to as the "wear-away" period.

For example, at the time a company converts to a cash balance formula on 1/1/X1, employee X's accrued benefit is $100,000. Because employee X's benefit under the cash balance formula is only $90,000, she will not accrue any new benefits until 1/1/X4, a three-year wear-away period. This is the time it will take employee X to earn $10,000 of benefits. In essence, she will earn no additional benefits during this period compared with what she had earned under the old plan.

Under existing ERISA rules, when a participant retires or terminates employment, any benefits paid under a lump-sum option must be the greater of the current value of an employee's cash balance plan account or the benefits accrued under the traditional defined benefit plan. If a participant leaves after a cash balance conversion, and the accrued benefits under the cash balance plan are less than the benefits under the traditional plan, the participant is entitled to receive the larger, preconversion amount.

OPENING ACCOUNT BALANCE INCREASES

After the cash balance plan's opening account balance is determined, the participant's account accumulates annual pay credits based on a percentage of annual compensation. The pay credits may be level for all age groups or may be graduated--lower for younger age groups and higher for older age groups. In addition, the plan credits the participant's account with interest annually. Each year, the participant earns that year's pay credits and interest on accumulated pay credits and on prior interest credits. Although the examples below use a fixed annual interest credit, most cash balance plans use a variable rate, linking it to an index such as one-year Treasury bills.

Example. Mary has a salary of $25,000, a hypothetical opening account balance of $3,000 at the beginning of year one, an annual pay credit of 5% of salary and an annual interest credit of 6%. To determine the opening account balance in year two, Mary's $3,000 opening account balance in year one is "credited" with a pay credit equal to 5% of salary, or $1,250 ($25,000 x 5%), and an interest credit of 6% ($3,000 x 6% = $180). The result is a second-year opening account balance of $4,430 ($3,000 + $1,250 + $180 = $4,430). Subsequent credits are determined in a similar manner.

Effect of converting to a cash balance formula. The two simplified examples in exhibit 1, page 26, illustrate the impact on participants of converting from a traditional defined benefit to a cash balance formula. One participant is 30 years old, with 5 years of service. The other is 60 years old, with 30 years of service. In the first example, benefits accrued under the cash balance formula exceed those that would have accrued under the traditional defined benefit formula. The second example illustrates the wear-away period during which no new benefits accrue under the cash balance formula.

Exhibit 1: Converting to a Cash Balance Plan The examples assume the following:

Defined benefit plan

* Traditional defined benefit pension plan benefits are based on a final 5-year average pay formula.

* Average annual salary increase: 4%.

Cash balance plan

* Date of conversion to cash balance formula: January 1, 1999.

* Cash balance plan benefits are based on interest credit of 6%, pay credit of 5% of salary and an average annual salary increase of 4%.

Amounts shown for both the traditional defined benefit plan and cash balance plan have been actuarially determined and amounts have been rounded for ease of presentation.

Example 1. Effect of conversion to a cash balance formula on participant A, age 30, vested in the plan with five years of service and earning $25,000 in the year of conversion. Assume a 4% discount rate is used to determine the hypothetical opening account balance:

Participant A
Age at hire                          25
Age at 1/1/99                        30
Salary in 1998                  $25,000
Service at 1/1/99               5 years
5-year average pay at 1/1/99    $23,000
                                           1/1/99   1/1/00   1/1/01

Traditional defined benefit plan
Annual accrued benefit payable at age 65   $1,200   $1,400   $1,700

Cash balance formula
Annual accrued benefit payable at age 65   $1,200   $1,600   $2,200

                                            1/1/02   1/1/03

Traditional defined benefit plan
Annual accrued benefit payable at age 65    $2,100   $2,400

Cash balance formula
Annual accrued benefit payable at age 65    $2,700   $3,200

By using a 4% discount rate to determine the hypothetical opening account balance, benefits accrued under the cash balance formula exceed benefits that would have accrued under the traditional defined benefit plan formula. In fact, if the employee leaves the company in year two, he or she would receive a windfall benefit because the annuity value under the cash balance formula ($1,600) exceeds the value of the annuity the employee would have earned under the traditional defined benefit plan ($1,400). Because the participant immediately accrues additional benefits under the cash balance formula, there is no wear-away of benefits in this example.

Example 2. Effect of conversion to a cash balance formula on participant B, who is age 60 and earning $50,000 in the year of conversion. Assume that a 6% interest rate is used to determine the opening account balance:

Participant B

Age at hire                          30
Age at 1/1/99                        60
Salary in 1998                  $50,000
Service at 1/1/99              30 years
5-year average pay at 1/1/99    $46,000
                                            1/1/99    1/1/00

Traditional defined benefit plan
Annual accrued benefit payable at age 65    $11,600    $12,500

Cash balance formula
Annual accrued benefit payable at age 65     $9,000     $9,400

                                             1/1/01     1/1/02

Traditional defined benefit plan
Annual accrued benefit payable at age 65    $13,500    $14,600

Cash balance formula
Annual accrued benefit payable at age 65     $9,700    $10,100

                                              1/1/03

Traditional defined benefit plan
Annual accrued benefit payable at age 65     $15,700

Cash balance formula
Annual accrued benefit payable at age 65     $10,400

By using a 6% discount rate to determine the opening account balance, no new pension benefits accrue during the five years of service subsequent to the conversion. It should be noted that much of the negative publicity surrounding cash balance formulas is focused on "older" employees who typically lose future benefits upon conversion, as demonstrated in this example. However, some employers "grandfather" older employees under the old plan or provide transition credits upon converting to a cash balance formula to prevent this reduction in the accrual of future benefits.

ACCOUNTING AND DISCLOSURE IMPLICATIONS

A company's conversion from a traditional defined benefit pension plan to a plan that uses a cash balance formula to determine future benefits generally constitutes a negative plan amendment, the beneficial effects of which the company would recognize prospectively on its financial statements as a reduction in prior service cost. For such a conversion, a company must amend the existing plan to provide for the new benefits structure. The plan's actuary uses the information in the amendment to calculate the benefits obligation under the amended plan. Because plans subject to ERISA must be in writing, any amendment also must be in writing and approved by the authorized parties. Amendments usually are approved by the board of directors, by a pension committee of the board or by management. The accounting implications of converting a traditional defined benefit pension plan to a cash balance plan are consistent with other types of plan amendments under Statement no. 87.

Statement no. 87 requirements. ERISA regulations do not permit an employer to reduce a participant's accrued benefits--the benefits accrued to date based on the participant's salary and service. However, because a plan's projected benefits obligation may exceed the amount of accrued benefits, plan amendments that reduce a projected benefits obligation to the benefits already earned are possible. Such negative plan amendments generally reduce an employer's annual pension cost and projected benefits obligation.

A company first must use a reduction in the projected benefits obligation to reduce the balance of any existing unrecognized prior service cost. It must amortize the excess (negative prior service cost), if any, on the same basis as the cost of benefits increases--based on the remaining service period of employees expected to receive benefits as determined at that time. If no excess exists--because the unrecognized prior service cost from past positive amendments is large enough to absorb the negative amendment--the company continues to amortize the unrecognized positive balance remaining after the reduction over the period (or periods, for multiple past amendments) it initially determined at the time of the positive amendment.

Previous unrecognized prior service cost may consist of several layers, each with a different remaining amortization period. Statement no. 87 does not specify which layer a company should reduce first (or write off, in the case of a curtailment). Using a specific identification technique would seem preferable but generally is not practical. Accordingly, FASB rules permit an employer to use any rational method (for example, Lifo, Fifo or a pro rata method) if it is applied systematically.

Measurement date. A measurement date is the date a company measures plan assets (such as stocks and bonds) using fair value techniques and measures pension obligations (benefits earned) using actuarial valuation method,;. Statement no. 87 generally requires those measurements to be current with the date of the company's financial statements. Because actuarial calculations are complex, a company may make such measurements several months before yearend as long as that date is used consistently. A material plan amendment such as a conversion to a cash balance formula generally requires remeasurement to update actuarial assumptions used in calculating the net periodic pension cost. In addition, the converting company uses updated assumptions to reflect changes in market interest rates and assumptions about employee turnover and salary and benefit increases.

Curtailment events. Statement no. 88 defines a curtailment as "an event that significantly reduces the expected years of future service of present employees or eliminates for a significant number of employees the accrual of defined benefits for some or all of their future services." A cash balance plan conversion could result in a curtailment if a lengthy wear-away period affects a significant number of employees.

Funding requirements. A company undertaking a cash balance conversion may find its funding requirements are lower because of a reduction in its overall pension liability. The employer often gains additional savings from interest arbitrage--crediting participant accounts using an interest rate lower than the rate the plan actually earns on its investments.

Disclosures. A company sponsoring a cash balance plan makes necessary disclosure in the notes to the financial statements in accordance with Statement no. 132. An actuary quantifies the financial effects of converting to a cash balance plan, including any transition benefits or changes in eligibility requirements adopted to protect older participants, according to Statement no. 87. The company generally discloses the financial effects in the pension footnote as a single line item in the reconciliation of the beginning and ending balances of the pension benefits obligation. If the amendment has a material effect on the financial statements, the company discloses the nature of the amendment and its effects on the projected benefits obligation and pension cost in the notes to the financial statements.

Exhibit 2, page 28, illustrates some results of converting from a traditional defined benefit plan to a cash balance plan, effective January 1, 1999.

Exhibit 2: Balance Sheet Impact of Cash Balance Conversion

The Widget Co. had a noncontributory defined benefit pension plan that covered most of its employees in the United States. Effective January 1, 1999, the company converted the plan to a noncontributory cash balance plan for all active employees. Participants were credited with an initial account balance equal to the present value of their accrued benefits under the plan in effect on December 31, 1998. Participants received pay credits equal to 5% of annual compensation and their accounts were credited with annual interest based on 30-year Treasury bond rates equal to 6% in 1999. As a result of the conversion, the company experienced a reduction of approximately $1.8 million in pension expense and a reduction in its benefits obligation of $8.6 million.

The table below illustrates the changes in the benefits obligation, funded status of the plan and pension costs as a result of the conversion from the traditional to a cash balance formula. (Amounts at December 31, 1999, under the traditional defined benefit plan formula are shaded gray and included for illustrative purposes only. Such amounts would not be presented in the disclosures required under FASB Statement no. 132.)

                                              Traditional
                                                 12/31/99
Change in benefits obligation
  Balance--beginning of the year              $21,589,000
    Service cost                                2,666,000
    Interest cost                               1,826,000
    (Gain) loss                                    39,000

    Plan amendments                                     0
  Balance--end of the year                    $26,120,000

Change in fair value of plan assets
    Balance--beginning of the year            $18,554,000
    Actual return on plan assets                4,046,000
    Balance--end of the year                  $22,600,000
Funded status:                                $ 5,131,000
    Unrecognized transition obligation        $ 1,062,000
    Unrecognized prior service cost                     0
    Unrecognized net (gain)/loss                3,183,000
(Accrued)/prepaid pension cost                $   725,000

Components of net periodic pension cost
  Service cost                                $ 2,666,000
  Interest cost                                 1,826,000
Expected return on plan assets                 (1,881,000
  Amortization
    a. Transition obligation/(asset)              354,000
    b. Prior service cost                               0
    c. Unrecognized (gain)/loss                    35,000
  Net periodic pension cost                    $3,000,000

                                             Cash Balance
                                                 12/31/99
Change in benefits obligation
  Balance--beginning of the year              $21,589,000
    Service cost                                1,829,000
    Interest cost                               1,194,000
    (Gain) loss                                 2,034,000
    Plan amendments                            (9,177,000)
  Balance--end of the year                    $17,469,000

Change in fair value of plan assets
    Balance--beginning of the year            $18,554,000
    Actual return on plan assets                4,046,000
    Balance--end of the year                  $22,600,000
Funded status:                                $ 5,131,000
    Unrecognized transition obligation        $ 1,062,000
    Unrecognized prior service cost            (8,651,000)
    Unrecognized net (gain)/loss                3,183,000
(Accrued)/prepaid pension cost                $   725,000

Components of net periodic pension cost
  Service cost                                $ 1,829,000
  Interest cost                                 1,194,000
Expected return on plan assets                 (1,735,000)
  Amortization
    a. Transition obligation/(asset)              354,000
    b. Prior service cost                        (526,000)
    c. Unrecognized (gain)/loss                    59,000
  Net periodic pension cost                   $ 1,175,000

BUSINESS AND EMPLOYEE ISSUES

Some companies switch to cash balance plans in response to concerns other than cost considerations. Pension costs do not always decrease after a cash balance plan conversion. When costs do decline, some employers shift some or all the savings to other compensation programs. In today's competitive marketplace, companies may need to attract a younger workforce in order to grow. The model of the long-service employee retiring at or near age 65 is no longer considered the norm for U.S. companies. Today, many employees want to earn benefits earlier in their careers so they can take the benefits with them if they switch jobs or retire early.

Subsidized early retirement benefits employers offer in traditional defined benefit plans have been counterproductive for some companies, resulting in an early loss of the company's intellectual capital. Many companies now prefer to use the early retirement option as a special downsizing tool rather than as a standard benefit. Cash balance plans appeal to younger workers because they resemble 401 (k) plans. Employees see the value in cash balances and are apt to appreciate them more than they do the way their employers determine benefits under traditional defined benefit pension plans.

Companies continually try to achieve a balance between controlling costs and delivering value to employees. The design features of cash balance plans can reduce costs in several ways:

Because most traditional defined benefit plans are back-loaded, an employer's pension costs generally increase as its workforce ages and more employees approach retirement.

* Most traditional defined benefit pension plans include early retirement provisions. Early retirement subsidies can account for as much as half of current funding requirements. Most cash balance formulas do not include early retirement subsidies in their standard designs.

* Most cash balance plans use a variable interest rate for the interest credit on a participant's account, generally tied to an index such as one-year Treasury bills. By crediting interest at a rate lower than the rate the plan earns on its investments, the employer can reduce costs as a result of interest arbitrage.

Employers that have not switched to cash balance plans often reduce pension and other benefits costs in other ways. Because the U.S. pension system is private and voluntary--except for protecting benefits already accrued--an employer can reduce or eliminate future pension accruals to adjust to changing business requirements. Some employers with traditional defined benefit plans have made changes that reduce future pension accruals, such as modifying the formula used to calculate benefits from a final-pay to a career-average formula, reducing the rate of future accruals, eliminating early retirement subsidies and, in some extreme cases, terminating the plan.

CAUTION ADVISED

Despite recent negative publicity, companies continue to incorporate cash balance formulas into existing defined benefit pension plans. Cash balance conversions have captured the attention of the public, Congress and various government bodies (the IRS and the Department of Labor among them). The attention is unlikely to fade unless various policy issues are resolved. Until that time, companies thinking about converting to a cash balance formula might want to consider delaying such a conversion until these difficult regulatory issues are settled.

Making the Transition

When a company converts its pension plan to a cash balance formula, older workers may incur a reduction in benefits. To make the conversion easier on employees, some companies provide transition benefits, such as continuing the old benefit formula for some employees, providing additional cash balance credits or determining a participant's opening balance under a different formula. Even companies that offer no transition benefits may compensate employees outside the pension plan with stock options or increased employer matching contributions in company-sponsored 401(k) plans.

[GRAPH OMITTED]

Glossary of Cash Balance Terms

Accrued benefits. The benefits a plan participant has already accrued, based on his or her salary and service to date.

Cash balance plan. A type of defined benefit pension plan that uses a formula that is different from a traditional plan to determine benefits. The plan is considered a defined benefit plan because the employer bears the investment risks and rewards and the mortality risk if the employee elects to receive benefits in the form of an annuity.

Defined benefit pension plan. A plan that specifies the pension benefit the employee will receive, usually as a function of one or more factors such as age, years of service or compensation. The employer's annual contribution is determined on an actuarial basis, taking into consideration the employee's age and salary history, the performance of the fund's investments and ERISA requirements.

Defined contribution plan. A plan that maintains an individual account for each participant and specifies how contributions to the account are determined instead of specifying the amount of benefits the individual will receive. Individual account balances are based on employer and employee contributions, investment experience and allocated forfeitures.

Interest credits. In addition to annual pay credits (see below), a participant's account under a cash balance formula is credited annually with interest. The interest rate the plan uses may be fixed or variable, although many cash balance plans use a variable rate for interest credits, linking the rate to an index such as one-year Treasury bills.

Measurement date. The date plan assets (stocks and bonds) and plan obligations (pension liabilities) are determined based on actuarial assumptions.

Negative plan amendment. Plan amendments that reduce a company's projected benefits obligation to the benefits the participant has already earned. Such amendments generally reduce an employer's annual pension cost. ERISA regulations do not permit a company to reduce a participant's already accrued benefits.

Pay credits. After a company determines a participant's opening account balance under a cash balance formula, the account is credited annually with an amount based on a percentage of the participant's annual compensation. These pay credits may be level for all age groups or graduated-lower for younger age groups and higher for older age groups.

Transition benefits. Additional benefits the plan sponsor provides to certain employees when the plan is amended or upon other circumstances, such as the sale of part of a business, to ensure that the new benefits the plan provides are somewhat equivalent to those a participant would have earned under the prior plan.

Wear-away period. After a cash balance plan conversion, additional benefits do not accrue to a participant until the accrued benefits payable under the cash balance formula equal the benefits accrued under the traditional defined benefit plan. A participant may have to work several years before he or she earns pension benefits above the benefits accrued at the time of the cash balance conversion. The wear-away period is the amount of time it takes for benefits to catch up, when the participant is not earning new benefits.

EXECUTIVE SUMMARY

* IN AN EFFORT TO CONTROL COSTS AND MEET the needs of a changing workforce, some companies have converted their defined benefit pension plans to a cash balance formula. This has raised concern in Congress, the IRS and other government agencies that the conversions might discriminate against older workers, who might lose benefits as a result of the conversion.

* A CASH BALANCE PLAN ESTABLISHES ALLOCATIONS to individual participant accounts. If a vested participant switches jobs or retires, a lump-sum payment based on the account balance usually can be rolled over into an IRA or another qualified plan.

* AFTER A CASH BALANCE CONVERSION, A PARTICIPANT might have to work several years before he or she earns pension benefits above those accrued at the time of the conversion. This so-called wear-away period is the time it takes the cash balance benefits to catch up to the benefits accrued under the traditional pension plan.

* A COMPANY'S CONVERSION TO A CASH BALANCE PLAN generally constitutes a negative plan amendment that a company recognizes prospectively in its financial statements as a reduction in prior service cost. The accounting implications of the conversion are consistent with other types of plan amendments under FASB Statement no. 87.

* THE DESIGN FEATURES OF CASH BALANCE PLANS can reduce costs. Despite this, the increased public attention focused on conversions means they are not right for every company. Companies should keep abreast of cash balance plan issues and proceed with caution until certain regulatory issues are resolved.

ALEX T. ARCADE, CPA, is a partner in the national professional practice group of Ernst & Young LPL in New York City and a former fellow at FASB. His e-mail address is [e-mail]. FRANCINE MELLORS, CPA, is a senior manager in the national professional practice group of Ernst & Young in New York City. Her e-mail address is [e-mail].