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DEFINED BENEFIT IS REDEFINED

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CHARLOTTE, N.C. -- Can a new type of defined benefit pension plan that allows employees to direct the investment of their funds assure adequate retirement income while cutting corporate pension costs?

That is the question benefit experts are asking in the wake of a cash balance pension plan introduced by NationsBank Corp. that offers employees investment options as well as the ability to transfer 401(k) account balances to the cash balance plan. The Charlotte, N.C.-based financial giant, which now operates under the name Bank of America following its merger with BankAmerica Corp., declined to discuss the innovative plan.

The NationsBank plan, like other corporate cash balance plans, has 401(k) plan-like features, including individual account statements and an easy-to-understand benefit formula in which company "contributions" or compensation credits are expressed as a percentage of compensation.

These contributions, which are based on an employee's age and service, currently range from 1% to 10% of compensation. For example, an employee whose age and years of service equal 48 would receive a compensation credit of 3%. If that employee earned $50,000 in 1998, the compensation credit would total $1,500 and his or her cash balance account would be credited with that amount.

But NationsBank's plan differs markedly from traditional cash balance plans.

Traditional cash balance programs automatically credit employees' account balances with a pre-set interest formula, such as the one-year Treasury bill rate plus 1 or 2 percentage points.

NationsBank's plan instead permits employees to direct company contributions among 11 different investment options, including fixed income and various equity funds. Employees' account balances are credited with the actual returns of the funds they select.

In addition, employees had a one-time opportunity -- available through June 28 -- to transfer to the cash balance plan their pretax contributions previously made to the 401(k) plan and to direct those 401(k) monies among the 11 investment options. NationsBank's 401(k) plan is still in existence.

When an employee leaves the company, he or she can take the credited amount in the cash balance account as a lump sum or as an annuity. Employees are guaranteed their annual pay credits, the funds they transferred from their 401(k) plan, pension benefits accrued under a previous defined benefit plan and the gains earned by the funds in which they invested company contributions.

As a result, even if the investment funds that an employee selects have negative investment returns, the value of the employee's account balance will not be reduced.

"To protect your cash balance plan benefit (retirement income) against investment loss, NationsBank will guarantee your opening account balance (including money you transfer from the 401(k) plan) and future compensation credits -- regardless of the performance of your investment elections," NationsBank told employees.

In fact, the cash balance accounts are only on paper. There is only one cash balance plan and no actual individual employee accounts. As a defined benefit plan, NationsBank can invest cash balance plan assets as it and its professional investment advisers decide, rather than funneling them to the investment options the employees have elected. It isn't known how closely NationsBank is directing its pension plan investments to match employees' selections.

Benefit experts note that employers adopting this approach can cut costs. For example, assume most employees select "conservative" investment options earning an average annual rate of return of 5%. If, for example, the employer chooses investments that produce returns averaging 12%, the employer can reduce its future pension costs. On the other hand, if employees choose investments that in the aggregate outperform corporate pension plan investments, companies may have to contribute more than they expected into the plans.

A company adopting this approach "thinks it will be able to outperform the investment choices (made by employees), which effectively reduces the corporate contribution to the plan," said Bob Howley, senior actuarial manager with Buck Consultants Inc. in New York.

A Towers Perrin memo describes this "arbitrage" feature this way: "Because most employees invest more conservatively than a pension plan, the employer would have the opportunity to capture the 'excess' investment return. The intended result? More investment return for the pension plan and less cost -- all without reducing benefits."

Towers Perrin is one of many consultants used by NationsBank. However, the lead consultant for the new participant-directed cash balance plan was Price WaterhouseCoopers. The benefit consulting and accounting firm declined to discuss the NationsBank plan.

NationsBank itself has told employees that the new plan -- with the 401(k) transfer feature -- could save money for the company. In a benefit brochure, NationsBank told employees: "The assets of the cash balance plan are held in a trust account that NationsBank invests. Proceeds from the investment of the trust account are used to grant investment credits to associate accounts based on their individual investment elections. Excess proceeds decrease plan expenses, saving money for the company."

Benefit experts cite several positive features of participant-directed cash balance plans such as NationsBank's. For example, by giving employees the opportunity to select investment options, the arrangement has -- from an employee perspective -- the complete look of a defined contribution plan, notes Eric Lofgren, a consultant with Watson Wyatt Worldwide in New York.

"This is what cash balance plan sponsors would have liked to have done from day one," Mr. Lofgren added.

Others note that NationsBank employees could reap investment returns on compensation credits far greater than what they could obtain under the interest rate credits provided in traditional cash balance plans.

"This enables employees to get returns comparable to that of a 401(k) plan," Mr. Howley said.

Others, though, question whether companies want to introduce an element of risk in both their defined benefit and defined contribution plans.

"Long term, will there be adequate retirement benefits for employees? Is allocating investment risk to employees something that is beneficial?" asks Dave Cantor, a consultant with William M. Mercer Inc. in Charlotte.

For example, employees who direct pay credits in investment funds that do poorly and have negative investment returns would receive only accumulated pay credits, which might not generate a sufficient retirement benefit, some say.

At the same time, employees who direct the compensation credits into conservative investment options also might not receive as high a benefit compared to traditional cash balance plans, consultants say.

That is because NationsBank's compensation credit schedule is on the low side, especially for younger, shorter-service employees, compared to traditional cash balance plans, say consultants who have examined the schedule.

If those employees invest conservatively, they might not receive as great a benefit as they could in a traditional cash balance plan that had a more generous compensation credit schedule.

In a sense, some risk is transferred to employees, consultants say. If they stick to conservative investments, their benefits could be smaller than a traditional cash balance plan. If they choose to invest compensation credits more aggressively, they could receive much higher benefits than they would in a traditional plan, or -- depending on the performance of the investment options they choose -- they might get only the compensation credits.

"My concern is with benefit adequacy. This creates much uncertainty with regard to ultimate benefit levels," Mr. Cantor said.

The same "arbitrage" feature in the participant direction of compensation credits also is inherent in the 401(k) transfer feature of NationsBank's plan.

This allows the company to actually earn the spread between what the cash balance trust fund is earning and the returns on investment options selected by employees, Mercer's Mr. Cantor said.

In addition, employer investment of these funds through one pension plan is much more efficient than employee investment through individual 401(k) accounts, some say.

"Moving 10,000 people with 10,000 accounts to one plan is more efficient" because of lower transaction costs, said James Klein, a partner with Deloitte & Touche in New York.

On the other hand, employers could expose themselves to new financial risk. Take the case of an employee nearing retirement with a hefty 401(k) account balance. Because the company guarantees the amount it contributed, employees nearing retirement might be inclined to select investment options with the riskiest, though potentially the greatest, return.

"Because of the guarantee, you can bet the farm. You can go for a home run without a downside," Mr. Howley said.

If the value of those investments went down sharply, the employer would still have to make up the difference. "There could be a substantial short-term risk to the company," he said.