Millions of Retired Americas Rely on Private Pensions and Employer-Sponsored Retirement

Employee Pension Plan Conversions

May 12, 2004

This case was written by an MBA student. The name has been removed to protect the author.

Employer sponsored benefit programs are a recent phenomenon. Earlier agricultural driven economies and shorter life expectancies did not encourage the creation of employee benefit programs. As the U.S. economy shifted to a more industrial focus and competition for good employees intensified, businesses began to see the value in employee benefits. Pension plans were the first employee benefit to become popular.

Modern companies offer many benefits to employees without the legal requirement to do so. Today, the U.S. Bureau of Labor Statistics reports that total benefits represent 39% of wages and salaries and only one third of that amount is expense from legally required benefits (Steidler). Corporate pension plans are one benefit provided voluntarily by employers. The U.S. Chamber of Commerce reports that millions of retired Americas rely on private pensions and employer-sponsored retirement savings as their most important source of income after Social Security (US Chamber of Commerce). In fact, “…company sponsored retirement plans alone hold more than $3.5 trillion, which is in sharp contrast to the cumulative $5.4 trillion federal debt and the expected bankruptcy of the Social Security System by 2030” (Steidler).

Employer sponsored pension plans fall in two main categories: defined contribution plans and defined benefit plans. Defined contribution plans specify the amount of contributions to be made by the employer towards an employee’s retirement account. The amount of the retirement benefit depends on the amount of contributions to the account by both the employee and employer. Defined contribution benefits are also impacted by the over-all investment gains or losses in the account and the risk associated with these gains or losses are the responsibility of the employee. In contrast, defined benefit plans provide a specific benefit at retirement. This defined benefit is guaranteed and there is no investment risk borne by the employee.

There is a third group of plans referred to as “hybrids”. Hybrid plans are a melding of the two previously defined pension constructs. Cash balance plans, along with pension equity plans and contributory plans, fit in this hybrid category. Cash balance plans are defined benefit plans that have some attributes of a defined contribution plan but the security of a traditional pension plan. The U.S. Chamber of Commerce reports that there are currently 1,200 hybrid pension plans covering over 7 million workers (US Chamber of Commerce).

The U.S. Department of Labor reports that in a basic cash balance formula participants benefits are stated as an account balance. The employer credits a “hypothetical” employee account on yearly basis with a compensation or pay credit (such as 5% of compensation) and an interest credit (fixed rate or variable rate linked to an index). Compensation credits end after a participant terminates employment but interest credits continue until a participant withdraws his or her benefit. In contrast to a defined contribution plan the increases or decreases in the value of the plan investment do not directly affect the promised benefit amounts. Many cash balance plans allow participants to receive benefits as a lump sum at retirement or receive their accrued benefits in a lump sum prior to retirement if employment with the plan sponsor is terminated.

The number of hybrid plans has increased over the past decade due to employers choosing to undergo pension plan conversions from traditional defined benefit plans to cash balance plans. Twenty years ago, Bank of America was the first major US employer to undergo a conversion from a traditional defined benefit plan to a cash balance plan. Since then hundreds of other companies have done the same, including companies like IBM, Bell Atlantic/Verizon, AT&T, SBC, Boeing, Monsanto, RJ Reynolds, and Citibank. To-date conversions to cash balance plans have involved over $335 billion in pension assets (Strope).

Companies cite the primary reason driving plan conversions is the changing workforce. Because modern employees are no longer working for one company their entire career, firms are searching for pension designs that would be popular with younger and shorter-term workers while maintaining the advantages provided by defined benefit plans. Younger employees prefer defined contribution plans to traditional defined-benefit plans because of the perception they can earn more money in defined-contribution plans and they like to have visibility to the investment activity within their account. Defined-contribution plans are also more portable for employees who wish to terminate employment with the plan sponsor. Cash balance plans meets the objectives of both the employer and the modern employee and are cheaper for firm’s to administer than traditional defined benefit plans. An employer who does not accommodate the preferences of younger workers may find itself at a competitive disadvantage in the labor market.

The Cash Balance Practitioners Group, a group advocating workable rules for cash balance plans, says a major part of the reason companies convert a defined benefit plan to a cash balance plan instead of moving to a defined contribution plan is financial (Stein). A company who terminates an over-funded pension plan and establishes a new defined-contribution plan is subject to income and excise taxes. In addition, conversion critics believe that employers switch to cash balance plans in an attempt to implement benefit reductions without employee awareness, “…when an employer terminates a defined-benefit plan, employees understand what is happening. The employer's motive and the effects of the termination are transparent. Employees compare their benefits of the new plan with those of the old plan. When hurt, they can complain. Angry employees erode morale and damage a firm's reputation. With conversions, however, employees often do not understand what is happening. They do not understand what it is they are losing and what it is they are gaining…” (Stein).

It is primarily older workers who are negatively impacted by the plan conversions. When a plan is converted older workers get only what they have earned, not future benefits promised under the old traditional plans. In a defined-benefit plan, the present value of promised future retirement income is directly related to the length of time until that benefit will be redeemed (the discount period). Therefore, there is larger value for a dollar’s worth of future benefit as an employee ages. Under a defined-benefit plan the majority of an employee's benefits are accumulated in the final years of service because the plan is based on years of service and final salary. An employee who spends most of his or her career with one firm will typically earn more than half of his or her defined benefit during the final ten years of service (Stein).

Employees can lose a large portion, for some up to 50% (Nader), of their expected retirement benefits when their traditional defined-benefit plan is converted and employees complain that in conversions older workers aren’t given enough time to build new savings for retirement. University of Alabama School of Law professor Norman P. Stein believes that “...pretty strong argument can be made that an employer who does this breaches an implicit bargain with such an employee--that long service will be rewarded in the last years of employment through large defined benefit accruals, the pot of gold at rainbow's end and retirement's beginning.” (Stein)

A study by the Labor Departments cites that workers are losing almost $200 million a year in conversions to cash balance plans (Strope), a factor helping make cash balance conversions a controversial topic for employers, employees, and Capitol Hill. International Business Machines (IBM) converted its traditional defined benefit pension plan to a cash balance plan in mid-1999 and has been at the forefront of the recent controversy. IBM is currently involved in a class action lawsuit, Cooper v. IBM, which is a testing ground for all cash-balance pension formulas. A U.S. District court judge recently ruled that IBM’s current pension formula violates age discrimination law and IBM is responsible for back payments to workers. Despite this, IBM continues to believe its pension plan is legally sound and intends to appeal the ruling. “We continue to disagree with the Court’s ruling on liability…IBM, like hundreds of other companies, reasonably assumed” that its pension plan was legal, according to IBM spokeswomen Kendra Collins (Dale).

Employers are not required to establish pension plans for their employees because the private pension system is voluntary. Many companies don’t offer a pension plan; IBM does and could be penalized for wanting to change it. Randy MacDonald, Senior IBM Vice-President of Human Resources states the following, “…the technology industry is constantly evolving at a rapid pace. At IBM we have had to adjust our business strategy to these realities to ensure we are the leader and agenda-setter for our industry. IBM continues to invest significantly in benefits, offering retirement benefits that outpace what’s available at nearly every one of our major competitors”. MacDonald goes on to say that most of IBM’s major competitors don’t offer pension plans at all (IBM). Companies like Dell, Microsoft, and Cisco offer only 401(k) plans. In contrast, IBM offers a pension plan in addition to an employee savings plan (form of defined contribution plan) and an employee discount stock purchase plan.

Interpreting the courts ruling in the Cooper v IBM case employment attorney Mark Hansen states that “…under the Equal Retirement Income Security Act (ERISA) a defined benefit plan "must provide for a definitely determinable, non-forfeitable, accrued benefit.'" A pension plan violates ERISA if "an employee's benefit accrual is ceased, or the rate of an employee's benefit accrual is reduced, because of the attainment of any age…the Court ruled that any accrued benefit "must be expressed in the form of an annual benefit commencing at normal retirement age," and that the interest credits earned under the plan "are a part of the accrued benefit," and must therefore comply with the benefit accrual requirements of ERISA.”

Mark continues that “...under this reasoning, the Court stated that as the "interest credits must be valued as an age 65 annuity," and as the interest credits would always be more valuable for a younger employee than an older employee," the "result is inevitable." Therefore, the Court concluded that the plan violated the literal terms of ERISA, because an employee's benefit accrual from interest credits was reduced for each year of the employee's age. This ruling is premised upon the unremarkable fact that money invested for a longer period earns more interest. That is, when valuing the interest credits as an age 65 annuity, the interest credit earned in the previous year will always be more valuable than the interest credit earned a year later, simply because the interest credit earned in the following year will have one less year to accrue value before the age 65 cutoff date. Indeed, the Court recognized this point, but determined that as a defined benefit plan such a method of benefit accrual violated ERISA” (Hansen)

IBM employees have differing opinions about the conversion and the subsequent court ruling. Many younger workers hadn’t paid close attention to the details of IBM’s traditional defined benefit plans prior to this controversy and are happy with the portability offered by the new plan. Older IBM employees are unhappy with the change and many believe that IBM has turned its back on older employees. “For career employees like me, the cash balance plan is a ridiculous substitute for any of the previous defined benefit plans”, says David Finley, an IBM senior engineer.

In the initial conversion only employees within 5 years of retirement eligibility were given a choice between the old plan and new plan. In protest, IBM employees held meetings, wrote letters to editors, and lobbied government representatives. Due to all the publicity IBM changed the conversion plan to allow all employees at least 40 years old and with at least 10 years of service the choice between the old and new plan. Neither ERISA nor the Internal Revenue Code (IRC) requires employers to give employee the choice of remaining on the old formula. The Cooper class action suit was brought against IBM despite the expanded plan choice provided to employees.

The law permits employers to terminate defined-benefit plans, regardless of the financial impact to senior employees. Advocates of conversions argue that conversions are better for employees than terminations, so if employers are permitted to terminate plans they should be able to convert them into cash-balance plans. For workers with low to moderate incomes with little to no extra money available to fund retirement savings traditional benefit plans are better than hybrid plans, but hybrid plans are better than defined contribution plans. Employees who don’t have extra funds can’t contribute to 401(k) plans and even among employees who do have extra income many don’t make material contributions towards retirement savings. Among workers with a 401(k) plan at work, one-quarter does not contribute (Salisbury).

Many modern workers just recently realized the benefits of an employee sponsored guaranteed pension. This recent realization could be attributed to an aging population rapidly approaching retirement age and the recent downturn in the stock market. As 401(k) account balances have declined, employees are looking to learn more about the other financial sources that will fund their retirement. Although employee education is increasing, only 6% of employees polled by the Employee Benefit Institute say traditional pensions are the most important benefit, compared to 23% who rank 401(k) plan that way (Weston). Pension attorney Dianne Bennett says she has a tough time convincing new employees of the value of traditional pension in her law firm, “…they’re far more interested, even now, in how the 401(k) works. Although the 401(k) most likely will be worth less in the long run…as an employer it’s hard to justify the cost of a benefit workers don’t appreciate” (Weston).

The latest court ruling on the IBM case is at odds with how other courts have ruled on similar issues and IBM isn’t alone in their claims that the pension formula in place at their firm (and in many other firms) is financially, legally, and ethically sound. The US Chamber of Commerce believes that “cash balance and other hybrid plans are not inherently discriminatory and fights to preserve this form of benefit for workers…we will continue to monitor and oppose efforts that would decrease the availability of hybrid retirement plans for workers” (US Chamber of Commerce).

If the ruling in the IBM case is applied broadly it has the potential of making all existing hybrid plans illegal under ERISA and the Code of Federal Regulations. Over 400 major companies have adopted cash balance plans (Hansen) and there could be substantial negative impacts for companies managing those plans. The ERISA Industry Committee, a lobbying group representing big employers, said the decision “may results in substantial litigation and liability for hundreds of companies that have transitioned from traditional DB plans to cash balance, pension equity, and other hybrid plans” (Dale).

Due to the controversy conversions have come to a standstill. Many employers are freezing current defined benefit plans or terminating defined benefit plans all together and moving towards sponsoring a defined contribution plan only. The complete elimination of defined benefit plans will impact the future of today’s worker, “the ultimate outcome, if action is not taken soon to preserve the defined benefit system, will be higher rates of elderly poverty, higher taxes, and ever greater reliance on Social Security and Medicare” (Salisbury).

Issues

1. Who is responsible for an employee’s financial security in retirement? Is it the employee, the employer, or the government?
2. Does IBM have a responsibility to provide its employee’s with “promised” future pension benefits?
3. Is it ethical for the desires of one group of employees to negatively influence the availability of cash balance plans for all workers?

References

Associated Press (2002). Americans Lack Retirement Funds. Retrieved May 4, 2004 from World Wide Web:

Cahill, Kevin and Soto, Mauricio (2003). How Do Cash Balance Plan Effect the Pension Landscape? Retrieved May 4, 2004 from World Wide Web:

Dale, Arden (2004). Judge Rules IBM Must Make Back Payments in Pension Case. Retrieved April 23, 2004 from World Wide Web:

Finlay, David. Once Upon a Pension. Retrieved May 4, 2004 from World Wide Web:

Hansen, Mark. Converting To A Cash Balance Plan Can Be Risky Business. Retrieved May 4, 2004 from World Wide Web: