Cash balance pension plans: will the public sector follow the private-sector stampede?

In recent years, cash balance pension plans have become increasingly popular among businesses and other organizations with traditional defined benefit pension plans. As of 1999, more than 300 organizations (including at least three public pension funds - the California State Teachers Retirement System, the Texas Municipal Retirement System, and the Washington State Teachers Retirement System) have placed more than $330 billion in assets into cash balance plans for all or many of their employees.

While public pension funds have not been particularly active in the recent surge in cash balance pension plan conversions, there are signs suggesting that some level of interest might be developing. An increasing number of public pension plans are beginning to examine the applicability of cash balance plans to their systems. Proponents of cash balance plans argue that these plans represent the best hope for reversing the continued shift from defined benefit pension plans to defined contribution plans, while also providing an incentive to attract younger skilled workers. However, critics are voicing strong concerns that the cash balance plan offers employers an avenue to actually cut retirement benefits for those workers nearing retirement. These criticisms have prompted several groups to petition the U.S. Congress to examine cash balance plans and consider possible regulations.

What is a Cash Balance Plan?

In formal terms, a cash balance pension plan is a hybrid plan that encompasses the characteristics of both defined benefit and defined contribution plans. A defined benefit plan offers a specified and guaranteed retirement benefit based upon a formula comprised of length of service and compensation level. The plan sponsor invests the accumulated funds within the plan and also bears the risks associated with those investments. In contrast, a defined contribution plan provides for the establishment of individual accounts for each employee. The plan sponsor regularly contributes a specified amount. Each individual employee is responsible for the investment of his or her account assets and the associated risks. In addition, each individual receives a retirement benefit based upon the investment performance associated with his or her account with no guaranteed retirement benefit level.

Under the law, a cash balance plan is considered a defined benefit plan. It offers employer funding options as well as a guaranteed retirement benefit with no investment risk to the individual employee. However, by design, cash balance plans resemble defined contribution plans insofar as they establish individual accounts and provide regular account statements. These statements provide employees with a snapshot of their accumulated retirement assets at a given point in time. They also contain features that are inherent in defined benefit plans, chiefly the fact that the plan sponsor, not the individual, contributes to the fund and assumes all the investment responsibility and risk.

What is the Attraction of Converting?

Many of the corporations and organizations that have already made the switch to these plans have done so because the benefit calculations are easier. Cash balance plan accounts are technically a recordkeeping feature only. The plans are funded on an actuarial basis, in the same manner as defined benefit plans. The amounts reflected in the account statements of cash balance plans are based upon actuarial assumptions. The actual sums might be greater or less than what is reflected in the account statement.

Each individual participant's account balance grows through the earning of annual credits that are, in most cases, based upon a flat percentage of pay with an optional integration of Social Security benefits. For example, under AT&T's newly created cash balance plan, benefits are based upon a percentage of salary, ranging from 3 percent for participants under the age of 30, to 10 percent for participants 55 years and up. In addition, participants usually earn some level of interest, at a rate that is set by the sponsor or one that mirrors either the Consumer Price Index or U.S. Treasury bills. Compared to traditional defined benefit plans, which employed complex formulas, cash balance plans offer a much easier administration process.

The Texas Municipal Retirement System (TMRS) is an excellent example of a cash balance system currently in operation in the public sector. TMRS operates a $7.2 billion fund for more than 700 municipalities in the state of Texas. In operation since 1948, the TMRS system is believed to be the oldest cash balance plan in existence.

Under the TMRS system, each individual municipality determines its own payroll contribution rate and matching contribution ratio. Each participant receives an annual statement detailing individual account balances along with a projection of benefits at various points of retirement. The TMRS system establishes actual individual accounts and credits interest payments into these accounts. The interest payments result from the system's philosophy of providing a guaranteed level of return. One hundred percent of the system's funds are invested in fixed assets.

TMRS' vested plan participants who terminate their employment prior to retirement age can elect a portable lump-sum distribution. Otherwise, they can elect to leave their accumulated account balance in the system where it will continue to be credited with the regular interest payments.

As a tool to attract younger skilled workers who are more likely to switch jobs several times during their careers, supporters of cash balance plans point to their accessibility. Cash balance plans offer a portable benefit that can be received in lump-sum form. However, for companies and organizations that experience high rates of turnover, cash balance plans may prove to be an expensive option with large numbers of employees cashing out lump sum payments. In this instance, an organization may decide to continue offering a traditional defined benefit arrangement where the retirement assets remain with the employer until an individual reaches retirement age.

A Concerned Response is Raised

The trend of converting traditional defined benefit pension plans into cash balance plans has engendered significant attention in recent months. Critics of cash balance plans contend that such a conversion will tend to reduce the retirement benefit of senior and mid-career employees when compared to the benefits that were accrued under the previous defined benefit plan. To mitigate this inequity towards older employees, a plan sponsor can institute a provision in the cash balance plan that would ease the transition for workers with high seniority. For example, an employer could elect to compute the present value of the employee's accrued pension benefit under the old plan (utilizing standard interest rate and mortality rate assumptions). This amount then becomes the opening credit to the individual's account under the cash balance plan.

By law, workers cannot lose any retirement benefits that they have accrued prior to a conversion to a cash balance plan. However, the law does not stipulate that the opening account balance must equal the present accrued benefit under the old plan. This is where the controversy surrounding cash balance plans truly exists. Specifically, there is great concern over an opening account balance for an individual under a cash balance plan being less than the present value of the accrued benefit under the old defined benefit plan. In this instance, there would be no benefit accrual in the cash balance plan until such time as the pay and interest credits contributed by the employer equal the present value of their accrued benefits in the old plan. For workers in the later stages of their careers, it could take a significant period of time for the pay and interest credits to compound and accumulate a benefit equal to that which accrued under the old plan. For those who criticize this growing trend, their concern rests mainly on the proposition that cash balance plans are, at best, detrimental to older workers, and at worst, discriminatory against them. In fact, the Equal Employment Opportunity Commission is in the process of conducting an examination of cash balance plan conversions for possible violations of the Age Discrimination in Employment Act. In addition, several corporations already have been faced with lawsuits alleging age discrimination stemming from these plan conversions.

Congressional Interest

In response to these concerns, Congress has begun looking into the operations of cash balance plans to determine if remedies are needed to protect employees who might be negatively affected by such conversions. As a result of the work of a federal task force comprised of representatives of the Department of Labor, the Internal Revenue Service, Pension Benefit Guaranty Corporation, the Department of Treasury, and the Department of Commerce, the Clinton administration has developed a set of plan disclosure recommendations that will soon be introduced as legislation by Representative Robert Matsui (D-CA). This proposal would exempt employers with less than 100 employees. For all other employers, a disclosure notice must be provided to employees at least 45 days prior to the conversion taking effect. The notice must describe the terms of the conversion and provide specific examples that illustrate how the new plan will affect broad groups of workers (i.e., younger workers, mid-career employees, and long-serving employees). In addition, the proposal would require such notice to point out any particular class of workers who may see a temporary "freeze" on future benefit accruals. Participants also would have the right to receive a personal benefit statement detailing the impact of the plan conversion on their retirement benefits. This statement must be provided within a reasonable amount of time after the plan is changed.

Senator Patrick Moynihan (D-NY) and Representative Jerry Weller (R-IL) have introduced more stringent legislation. Their bill, the Pension Right to Know Act (S. 659 and H.R. 1176), would require greater disclosure of pension benefit reductions resulting from the conversion of traditional pension plans to cash balance plans. Specifically, the legislation would require employers with 1,000 or more employees to provide a "statement of benefit change" when retirement benefits are reduced as a result of the conversion. The statement would be required to include a comparison of employees' retirement benefits under the old plan versus the new plan at various points from the conversion date to retirement age. Employer groups have criticized the Moynihan-Weller legislation based upon the individualized retirement benefit calculation requirement, stating that it represents a time-consuming and costly review of employee salary histories.

H.R. 1102, the Comprehensive Retirement Security and Pension Reform Act of 1999 (introduced by Representatives Rob Portman (R-OH) and Ben Cardin (D-MD)) contains a provision giving plan participants the legal right to know when a change in a pension formula will result in a reduction in future benefits.

The Senate Finance Committee 'also has conducted a hearing on cash balance plan conversions and possible disclosure requirements, but there is no consensus yet on how far such disclosure should go, and in what particular form.

In a letter sent to the Senate Finance Committee, the American Academy of Actuaries outlined its concerns over the Moynihan/Weller legislation along with an alternative approach to the question of disclosure requirements. The Academy is concerned that the requirement that employers provide benefit calculation information may not necessarily provide meaningful information to employees. The Academy offered alternative disclosure principles that it has indicated would provide beneficial information to employees, without jeopardizing employer-sponsored defined benefit plans. Specifically, the Academy asked the Finance Committee to consider:

* providing employees access to clear and understandable information about their retirement benefits;

* providing employees timely information about changes to their retirement benefits;

* informing plan participants as to whether, and how, a change to their retirement plan will likely affect them; and

* providing participants the opportunity to request relevant information about their specific situations.

Finally, the Academy sought to remind Congress that the employer-sponsored retirement system is voluntary and already subject to expensive and complex requirements. Thus, they encouraged Congress to consider the added administrative feasibility and costs associated with any new regulations.

Absent any intervention from Congress, the administration, or the judicial system, it would appear that the trend toward converting traditional defined benefit plans into cash balance plans will continue, at least in the private sector. Some pension experts suggest that public pension funds are currently at a point where the private sector was a few years ago. These public funds are now beginning to explore the advantages and disadvantages of cash balance, or hybrid plans and are making determinations as to whether or not they fit with their plan philosophy and based on the demographics of their participants.

TOM OWENS is an Assistant Director in GFOA's Federal Liaison Center in Washington, D.C.