Statement of Norman P. Stein on Cash Balance Plans

ERISA Advisory Council Workgroup
July 14, 1999

I am Norman P. Stein, a professor at the University of Alabama School of Law, where I am privileged to hold the Douglas Arant Professorship of Law. I teach in the areas of Federal taxation, labor law and employee benefits. I have been asked by the workgroup to critique cash balance plans, or more accurately, conversions of traditional defined benefit plans to cash balance plans. My testimony will appear in a slightly different form as an article in Contingencies, a publication of the American Academy of Actuaries, where it will be titled "Retirement in the Balance: Some Serious Questions About Cash-Balance Plans."

Let me begin my critique of cash-balance plans with a confession: I don't really believe that there is anything inherently sinister about the concept of a cash-balance plan. It is a merely one of many types of plans through which employers can help their employees save for retirement. Moreover, if the goal of retirement plans is to force people to defer some current income for their retirement, cash-balance plans have a serious edge on 401(k) plans: participation in a cash-balance plan does not depend on the propensity and ability of an individual employee to save voluntarily for retirement--the employer pays the full freight on these plans, without giving the employee the option of cash now or retirement income later. And unlike true defined-contribution plans, cash-balance plans are insured by the Pension Benefit Guaranty Corporation and are a departure from the trend in the defined-contribution universe of saddling often untrained employees with the responsibility of making critical investment decisions. Moreover, because cash-balance plans are defined-benefit plans, they provide the employer with funding flexibility and permit the award of past service credits to employees and creation of early retirement window benefits.

As someone who tries to evaluate plans in terms of their value to the employee, I even see in cash-balance plans a creative opportunity to counter the unfortunate bias that some participants in self-directed defined-contribution plans demonstrate toward safe, fixed-return investment vehicles. To counter such caution, an imaginative employer could adopt a cash-balance plan with an offset for accumulations in a self-directed defined-contribution plan. With the cash-balance plan offering the assurance of at least a guaranteed return, even a cautious participant should be willing to invest in diversified equities, which history has repeatedly demonstrated will outperform fixed-income instruments.

So I am not opposed to cash-balance plans in any deep structural way. Cash-balance plans are merely tools that, like most tools, can be put to good or ill use. The locksmith and the safe-cracker pack their kits with similar implements.

The problem with cash-balance plans is the use to which they've been put in the real world. Employers who have adopted them have not adopted them because they wanted a plan that combines the look and feel of an old-fashioned defined-contribution with the security and funding flexibility of a defined-benefit plan. Rather, employers have adopted cash-balance plans because adopting them is cheaper and less likely to arouse employee opposition than what the employers would really most like to do: terminate their traditional defined-benefit plan and replace it with a defined-contribution plan.

Indeed, I am unaware of a single employer who adopted a cash-balance plan as its first qualified plan or as a new secondary or tertiary plan. Nor am I aware of any employer replacing a defined-contribution plan with a cash-balance plan. The "adoptions" of cash-balance plans are, so far as I can tell, always conversions of existing traditional defined-benefit plans.

If I am right, this raises two questions: first, why do employers want to end traditional defined-benefit plans and replace them with defined-contribution plans; and second, why don't employers just terminate their existing traditional defined-benefit plans and replace them with new defined-contribution plans.

The advocates of cash-balance plans have been pretty forthcoming with their answers to the first question. Stung by newspaper articles critical of cash-balance plans, industry-group supporters of cash-balance plans hosted a private Capitol Hill lunch briefing for key members of Congress to defend cash-balance plans. Notably absent from the luncheon, by the way, were any critics of cash-balance plan conversions.

At the meeting, representatives of a group calling itself the "Cash Balance Practitioners Group," explained why employers want to get out of traditional defined-benefit plans. Traditional defined-benefit plans, because of final pay formulas and the effects of the time value of money, generally provide accrued benefits whose value is tied to the employee's age: the older the employee, the more valuable the annual benefit accrual. This leads to two employer concerns. First, the traditional defined-benefit plan becomes more expensive as the workforce ages. And with the baby-boomers beginning to enter their fifties, the workforce is certainly aging, and defined-benefit plans are becoming more expensive to maintain. Second, in today's labor market, employers are often competing for younger workers, who earn larger benefits from defined-contribution plans and whose financial tastes, in any event, seem to run toward retirement plans in which they can "see" their money grow. For these reasons, younger employees prefer defined contribution plans to traditional defined-benefit plans. An employer who does not accommodate the preference may find itself at a competitive disadvantage in the labor market.

Before turning to the question of why some employers decide to convert an existing defined-benefit plan into a cash-balance plan rather than to terminate the plan and then to adopt a new defined-contribution plan, it is important to understand why either strategy can have tragic consequences to a firm's older, long-serving employees.

Under a defined-benefit plan, the value of a dollar of promised future retirement income is directly related to the length of the discounting period, i.e., the interval between benefit accrual and retirement. Thus, the older the employee, the shorter the discounting period and the greater the value of a dollar's worth of benefit. In addition, most defined benefit plans are based on a multiple of years of service and final pay with the employer; for example, 1% of final pay times years of service. Thus, an increase in compensation in one year increases the value not only of that particular year's benefit accrual, but also of the benefit accruals for all prior years.

Under a defined-benefit plan, then, the bulk of a long-service employee's benefits are "earned" in the last years of the employee's service. Indeed, an employee who spends most of his working life with a single firm will typically earn more than half of his final defined retirement benefit during the last ten years of employment. When an employer terminates or converts a traditional defined-benefit plan, then, the long-tenured employee can lose much of his anticipated retirement benefit. A 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.

But the law pretty clearly permits employers to terminate defined-benefit plans, regardless of the harm to older, long-tenured employees. Advocates of conversions argue that the harm of a conversion is certainly no greater than the harm of a termination. Thus, if employers are permitted to terminate plans, certainly they should be able to take the less destructive step of converting them into cash-balance plans.

But this brings us to the second question: why employers convert a defined-benefit plan into a cash-balance plan rather than terminate the plan and adopt a true defined-contribution plan. Advocates of cash-balance plans might claim it is because some employers prefer the cash-balance format. And at the beginning of this article, I indicated that certain attributes of cash-balance plans are attractive to those who think about pension policy--particularly that they are neither 401(k) plans where participation is dependent on an employee's willingness to contribute, nor self-directed defined-contribution plans. But these attributes are not driving the mass conversion of traditional defined-benefit plans into cash-balance plans. If employers in today's market perceive cash-balance plans as more attractive than real defined-contribution plans, why can't we find at least a few employers who adopt a cash-balance plan without transmogrifying a traditional defined-benefit plan? The answer is that all other things being equal, employers prefer true defined-contribution plans to true defined-benefit plans. True defined-contribution plans are, from the employer's perspective, cheaper, simpler, less risky, and more effective as recruiting devices than cash-balance plans.

So why conversions rather than terminations and adoptions (or expansions) of true defined-contribution plans? Here again, the Cash Balance Practice Group, in their private briefing memo, gives us an answer, or rather a partial answer. In its briefing memo, the Group says a major part of the reason is financial. An employer who terminates an overfunded pension plan and establishes a new defined-contribution plan is subject to income and excise taxes. An employer who undertakes a conversion is not.

But this is hardly a good policy reason to permit tax-free conversions. In only the most formal of worlds could an employer argue that the termination/establishment approach is sufficiently different from a conversion to have such different tax results. The effect on the employer's compensation structure, and on the older employee's retirement expectations, is virtually identical. Seen in this light, the conversion is little more than a tax dodge.

But tax avoidance is not the only unsavory explanation for why employers prefer conversions to terminations with replacement by defined contribution plans. 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. Employees are told that the cash-balance plan is better for most employees, which is sometimes true, but the problem is that the employees who are hurt--the older, long-turned employees--are hurt badly and sometimes don't even know it. And it is not only the lack of future accruals that leads to harm; cash-balance plans also can be used to silently destroy subsidized early retirement and social security-bridge benefits.

Employees' failure to understand the effects of a conversion is seen as an important advantage of the plan conversion over the plan termination/replacement route. Wall Street Journal reporter Ellen Schultz recently reported on tapes of actuarial conferences that tout this feature of the conversion. An actuary at Pricewaterhouse Coopers, for example, extolled cash cash-balance plans because they "mask a lot of changes . . . There is very little comparison that can be done between the two plans." And at another conference, a Watson Wyatt actuary observed that "It is not until they are ready to retire that they understand how little they are actually getting." And another actuary, this one from Mercer, piped in, "Right, but they're happy while they're employed."

So two important reasons for employer enthusiasm for conversions of traditional defined-benefit plans into cash-balance plans are avoiding tax and misleading employees.

Cash-balance plans are also touted for some other features, which are barely legal if that. When an employer converts a traditional defined-benefit plan to a cash-balance plan, an employee's traditional benefit is frozen. When the employee retires or separates from service, he or she will be entitled to the frozen traditional benefit or the cash-balance benefit, whichever has a greater value. When a cash-balance plan is set up, the employee is generally given a starting account balance. Oftentimes, this starting balance is lower than frozen traditional benefit, especially for older employees. The net effect of this can be that for several years the older employee will not accure any new benefit until the cash-balance account "catches up" to the value of the traditional frozen benefit. I strongly suspect that this is illegal age discrimination, and if it is not it should be.

Of course, not all employers do this: some employers--most prominently Kodak--have protected their older employees, giving them a choice between the new and old plan. But few employers have gone as far as Kodak, and unless there are changes in the law, I suspect few will do so in the future.

So should the law permit conversion of traditional defined benefit plans into cash-balance plans? Sure, but it should treat them as what they are in substance: terminations of existing plans and establishments of new plans. Employees should be entitled to meaningful disclosure about how the change in plan will affect them and their retirement expectations. Employers should pay the taxes that attend plan termination. And if Congress wants to add a little bit of substantive protection for the older, long-tenured employee who absorbs the greatest financial hit from the termination of a traditional defined-benefit plan--well, that would be fine with me and with hundreds of thousands of participants who have loyally served their employers only to find that the pot of gold at the end of the rainbow has been emptied just before they got there.