Pension design can boost cash flow: defined benefit plans, far from being dead weight on the balance sheet, can be engineered to be tools for reducing cash needs and attracting employees. (Benefits).

Let's face it: Many financial executive think of defined benefit (DB) pension plans as a financial dead weight shackled to the corporate balance sheet with little redeeming value in terms of attracting and retaining younger workers. Further, with plan assets declining recently, pension plans are often considered a cash drain on a corporation.

Ironically, today as never before, DB plans can be harnessed in imaginative ways to yield valuable cash management solutions for plan sponsors, while serving as an alluring employee benefit that appeals to prospective recruits and newly hired employees.

While having an over-funded DB plan gives the greatest flexibility during a corporate cash crunch, even under-funded plans can be put to use without jeopardizing employee retirement income security or federal regulatory compliance. For example, creative plan designs may allow employers to manage cash flow by:

* Boosting the equivalent of a 401(k) employer match without creating additional cash contributions when least affordable

* Financing severance benefits

* Mitigating adverse impact when employee compensation increases need to be reduced or eliminated, or pay cuts implemented

Consider the case of Avnet Inc., a Fortune 200 wholesaler of electronic components, computer products and embedded systems. As with most distributors, employee compensation-related expense (current and deferred, as well as benefits) represent a very large cost for Avnet. A cyclical business slowdown was putting a squeeze on cash, yet the Phoenix-based company did not want to pursue belt-tightening moves that would limit its ability to attract and retain employees or respond rapidly to customer needs.

Looking for Savings

Avnet sponsors both a traditional 401(k) plan and a cash balance DB plan. Unfortunately, the very modest employer match in the 40 1(k) program wasn't viewed as a meaningful support to Avnet's recruitment and retention efforts. However, Avnet's low-margin business sector and the current phase of the economic cycle limited the company's ability to provide a more robust employer match. The solution: a creative modification to Avnet's well-funded DB plan that, in effect, creates an even better benefit for younger workers without triggering any short-term increase in Avnet's annual funding obligation.

Specifically, the employer match on 401(k) deferrals was suspended, and the DB plan was amended to provide for a minimum annual crediting to employees' cash balance plan "accounts" equal to 3 percent of their compensation. Annual earnings on those "accounts" are pegged at 7 percent.

That 3 percent minimum crediting rate was based on the goal of making the Avnet retirement package (consisting of the cash balance DB plan and the 401(k) plan) at least as attractive as the typical 401(k) plan providing a 50 percent match on up to 6 percent of compensation. In addition, Avnet introduced a true performance-based match in the 401(k) plan to share future, better times with employees.

Indeed, unlike the voluntary 401(k) plan that benefits only employees who elect to participate, Avnet's cash balance DB plan automatically covers all workers. Hence, the upgrade to the DB plan benefited all employees; a 401(k) upgrade would not have done so.

Yet Avnet's goal was not to increase benefit costs at counter-cyclical times, nor to introduce a program that required additional cash, but rather to keep costs level and, more importantly, to conserve cash and make full use of accumulated pension assets. Under the new cash balance pension formula, younger employees and new hires could, if they left Avnet after a relatively short tenure, wind up with a better retirement benefit than they would have under the old formula. But, the new formula would leave longer-term employees in at least the same position they would have been in under the old formula -- and potentially better, if Avnet's financial performance met the goals required for the new performance-based 401(k) match.

Attracting and retaining workers in the 21-40 age bracket was an important strategic goal for Avnet. Under the revised benefit formula, a new hire earning $50,000 who gets annual raises averaging 3 percent would wind up with about $5,000 in his or her cash balance account after three years of service -- at least double that under the old formula for a younger new hire. While the prospect of a $5,000 accumulation after three years might not excite a middle-aged prospective employee, it is likely to be meaningful to a 20-something.

From a cash flow perspective, because Avnet's DB plan was over-funded, the company won't see any impact of the change in the benefit formula for several years after making the change. Further, the performance-based match requires cash only when, by definition, Avnet has cash to put into the program. Of course, the fact that the pension plan was used to reduce a cash burden does not mitigate the impact on the company's profit and loss statement (P&L). Indeed, the P&L impact of the changes discussed in this article (for example, using the pension assets to finance a "match" in a cash balance account) is the same as if the plan had not been used as the source for the financing.

Variations on a Theme

The same principle used in the Avnet case can be applied in other situations. For example, a decade ago IBM Corp. tapped its over-funded DB plan to increase pension benefits to offset relatively modest merit salary increases. An employee who would normally have received, say, a 3 percent merit raise might have instead been given 2 percent, but also have credited to a pension cash balance account a sum worth more than 1 percent of salary.

A more aggressive application of that approach would involve freezing salaries -- or possibly even lowering them. For example, if cash flow needs are forcing an employer to contemplate cutting salaries or wages, the company should consider this same concept of mitigating potential employee pain by establishing an offsetting cash balance feature in a DB plan. Rather than risk angering employees by cutting wages by 5 percent, employees could receive a onetime credit to a cash balance account equal to 5 percent of pay to offset this cut in actual compensation. In the case of an over-funded pension plan. this will afford significant breathing room until the time when these new accounts affect pension funding requirements.

But, what if the employer's pension plan is under-funded? The cash management strategy can still work by effectively using the lag between the time a change is made to a DB plan formula and the regulatory deadline for funding adjustments.

Suppose, for example, you have a calendar year DB plan and cut wages by 5 percent on April 1, 2002 and immediately amended the pension plan to give all employees a 5 percent credit in a new cash balance account. Under ERISA rules, your actuary may not need to assess the impact of the formula change until January 2003, and the funding payment for 2003 wouldn't be due until September 2004, 29 months after the change was made.

In a similar cash management strategy using a DB program, another large firm with more than 5,000 employees used its plan to provide a more generous severance benefit than would otherwise have been possible. Specifically, the Fortune 1000 industrial company increased "contribution credits" to DB participants' pension cash balance accounts in lieu of equivalent direct cash payments to departing workers. Former employees had the choice of allowing those sums to remain and grow within their pension plan, roll them into an IRA or take the money as taxable cash.

The common denominator in all of the above is the fact that pension benefits are increased in lieu of some other Form of compensation that would have required an immediate cash outlay. Keep in mind that pension funds can be used only to finance pension benefits or cover pension administrative costs, even if the increase is tied to a broader strategy.

Also remember that there is no "free lunch": the fundamental effect of these tactics is to postpone -- not eliminate -- a corporate cash cost. Also, in nearly all of these situations, the impact on corporate P&L is not postponed.

From the employee perspective, having extra dollars credited to a pension account instead of receiving an equivalent direct cash payment might be something of a letdown. Yet, if you communicate, with sensitivity, that the alternative is a reduction with no offsetting pension increase, the news may be easier to digest.

What's more, you may have the flexibility to increase the pension benefit by a greater-than-equivalent basis in nominal dollar terms so that employees perceive (accurately) that they're coming out ahead.

In Avnet's case, employees who didn't even participate in the 401(k) or take full advantage of it wound up in a much better position after the cash balance DB plan was changed, since the elimination of the employer match didn't affect them in the first place. While Avnet has no immediate plans to restore its 401(k) match or revert to its original DB design, that option is always open. IBM, after using its DB plan a decade ago to offset below-market salary increases, later returned to its original policy on raises and no longer uses its pension pool as an alternative funding source.

In all these examples, the bottom line is flexibility. If you've got it, you should feel free to explore how it can help you meet your organization's evolving needs.

RELATED ARTICLE: Avent's Modified Pension Approach

* Suspended modest employer match on employee 401(k) deferrals.

* DB plan amended to provide for a minimum annual crediting to employees' cash balance plan "accounts" equal to 3% of compensation (annual earnings on those "accounts" pegged at 7%).

* True performance-based match added to 401(k) plan to share better times with employees.

Stewart Lawrence, FSA, senior vice president and national director for The Segal Co.'s Corporate Market, has more than 20 years experience as a consulting actuary designing retirement plans for major organizations. He is a member of FE's Editorial Board and can be reached at 212.251.5315 or [e-mail].