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Cash balance plans may see resurgence among employers

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Cash balance pension plans, once a star player in the defined benefit plan arena, may be poised for a comeback, albeit a modest one.

The plans blazed a new trail in design when they were developed just over two decades ago. Their development by benefit consultants was a response to employer demand to make pension benefits more understandable and thus more appreciated by employees.

Cash balance plans, which imitate 401(k) plans, accomplish that in two key ways. First, the benefit formula is a model of simplicity, with employees earning pay-related credits, such as 5% or 6% of pay, each year. Added to the credits is interest, with the amount tied, for example, to the yield on the 30-year Treasury bond.

Like 401(k) plans, the benefits employees earn in cash balance plans are available immediately and as a cash lump sum after an employee terminates employment.

And, as career average pay plans, employees who leave after a few years earn much richer benefits compared to traditional plans, an appealing design for more mobile workers.

The advantages of cash balance plans soon became apparent to employers by the hundreds, with such household names as AT&T Corp., Hewlett-Packard Co. and IBM Corp., adopting the design in the late 1980s and throughout the '90s.

But not everyone was so enamored. Plaintiffs' attorneys targeted the design. They sued numerous employers, charging that the plans discriminated against older employees. The bias occurred, the suits claimed, because the same benefit earned by an older employee would buy a much smaller retirement annuity than the same benefit earned by a younger employee.

That theory was accepted by one federal judge in 2003 in a class-action suit filed against IBM, which adopted a cash balance plan in 1999. A federal appeals court reversed the lower court ruling this year.

Meanwhile, the Treasury Department, acting after the House of Representatives approved a bill barring the agency from doing anything that would undermine the federal court ruling in the IBM case, withdrew proposed regulations that would have made clear that cash balance plans did not violate age discrimination law.

Amid a torrent of litigation and a reluctance by federal regulators to provide guidance, cash balance plan formation over the last few years just about came to a halt.

But now the wheels have turned and benefit experts expect cash balance plan formation to begin anew, though at a much slower pace compared to the 1980s and 1990s.

The principal reason for the new optimism is action Congress took this summer. As part of a comprehensive pension funding reform measure approved in August, legislators included a provision that protects new cash balance plans from age discrimination suits.

With the age discrimination issue resolved, "cash balance plans are back and I believe we will see a number of plan sponsors rediscovering the value of these plans," said Kevin Wagner, a consultant in the Southfield, Mich., office of Watson Wyatt Worldwide (see related story).

"Those who have traditional plans will again explore cash balance plans as a viable plan design," added Tonya Manning, chief actuary with Aon Consulting's U.S. retirement practice in Winston-Salem, N.C.

Modest growth

With Congress clearing the way for employers to convert—without fear of being hit with an age bias suit—traditional pensions to cash balance plans, the number of employers that do so, at least for a while, is likely to be modest, experts say.

One reason is many employers have only started to analyze whether a plan conversion makes sense.

"A lot are in the analysis stage and want to act very carefully," said Larry Sher, a principal and director of retirement policy at Buck Consultants L.L.C. in New York.

Even with Congress resolving the age bias issue, plenty of employers remain unlikely to take the cash balance plan route. That is because a growing number no longer want the exposure to volatility that is inherent with defined benefit plans, including cash balance plans. In defined benefit plans, interest rate swings and investment results on plan assets can cause significant year-to-year fluctuations in required plan contributions, making it difficult to forecast with precision how much they will have to contribute to their plans.

"Companies have looked at volatility and have said defined benefit plans are not for them," said Alan Glickstein, a senior Watson Wyatt consultant in Dallas.

That contribution uncertainty, in fact, has been a principal driver over the last few years in the flight of defined benefit plan sponsors, including those with cash balance plans, to enhanced 401(k) and other defined contribution plans.

"Some companies just want the certainty of putting 5% of pay each year" into a defined contribution plan and "never have to think about it (volatility) again," said Sheldon Gamzon, a principal with PricewaterhouseCoopers L.L.P.'s Human Resources Services unit in New York.

But others may conclude they can manage contribution volatility—such as investing more assets in bonds and less in equities—and decide that adopting a cash balance plan will, in the end, make more sense than an all defined contribution plan approach, said Ethan Kra, chief actuary with Mercer Human Resource Consulting in New York.

"There will be greater realization that defined contribution plans are not all that they are cracked up to be," Mr. Kra said.

Mr. Glickstein notes that while defined contribution plans may eliminate contribution volatility, they can lead to workforce volatility. Because investment risk in such plans shifts to employees, that can result in employees not accumulating enough to retire at a typical age.

"It is a hidden risk and cost. Employees may feel they have to stick around even though they have reached the end of their productive years," Mr. Glickstein said.

At the same time, if employees rack up spectacular returns, such as during the booming equities markets in the late '90s, they may retire sooner than expected, depriving companies of experienced workers.

By contrast, in defined benefit plans, such as cash balance plans, where employees receive what they earned—as a lump sum or a monthly annuity—retirement is likely to be more orderly, Mr. Glickstein said.

Companies that switch to cash balance are likely to find the move appreciated, some say. In the past, the plans "were generally well received by participants. Employees understood that the benefit is secure, that the company is funding it and that they don't have to manage the money," said Mike Pollack, a principal in the Stamford, Conn., office of Towers Perrin.