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Companies May Convert to 'Cash Balance' Plans

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Greetings,

You may not be familiar with "cash balance" pension plans, 
but many employers have been changing to it from a 
traditional pension plan. Learn more about these pension 
plans in today's issue.

Best,
Mandi

P.S. You can discuss this issue or any other topic in the 
new SoHo News & Tips forum. Check it out here...

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Companies May Convert To 'Cash Balance' Plans 
By ELLEN E. SCHULTZ AND THEO FRANCIS
Staff Reporters of The Wall Street Journal 

If you're covered by a traditional pension plan, 
the odds that your employer will change to a "cash 
balance" pension plan have just increased.

These new-style pensions, which currently cover 
roughly a quarter of the 22 million private-sector 
workers with pensions, have been controversial 
because switching to them reduces pensions for 
older workers -- sometimes significantly. This has 
led to lawsuits and proposed legislation to slow 
their spread, causing some employers to hesitate 
about changing. 

But last week, a federal appeals court ruled that 
International Business Machines Corp.'s cash-
balance pension didn't violate age-discrimination 
laws. Just days before that, Congress approved a 
measure that would deem cash-balance plans legal. 
While the ruling will be appealed, and the bill 
has yet to be signed into law by President Bush, 
employer groups say the recent actions are a 
green light for employers to change their pensions.

For employers, switching to a cash-balance pension 
plan reduces future payouts and boosts earnings. 
That, in turn, can result in big gains in executive 
incentive pay, which is tied to earnings.

Researchers at Cornell University, the University 
of Colorado at Boulder and the University of 
California at Irvine examined hundreds of companies 
that converted their pensions to a cash-balance 
formula, and they found that the average incentive 
compensation for the chief executive officers 
jumped to about four times salary in the year of 
the pension cut, from about three times salary the 
year before. Companies that didn't change their 
pensions saw little change, says Julia D'Souza, a 
Cornell associate professor of accounting and lead 
author of the study, which is currently under 
review by an accounting journal.

For example, filings show that when Cooper Tire & 
Rubber Co. converted its pension to a cash-balance 
plan in 2002, the CEO's incentive pay rose to $1.5 
million -- the highest level in a decade -- from 
$702,000 the year before. After a similar move by 
Clorox Co. in 1996, the incentive compensation for 
G. Craig Sullivan, its chief executive, jumped to 
$5.6 million from $961,000 the year before.

A spokesman for Cooper Tire called any correlation 
between its CEO's pay and its pension changes 
"completely coincidental." Clorox didn't respond 
to requests for comment.

The bottom line is that companies can boost their 
profits by converting to cash-balance plans and 
now face little legal risk in doing so. Unless you 
have already retired -- in which case your pension 
won't change -- here's what it may mean for you:

What is a cash-balance plan?

Cash-balance plans are pensions in which you have 
a hypothetical account that grows by an annual 
credit, say 3% of your pay each year, plus interest. 
When you leave your job, you usually can roll the 
amount into an individual retirement account or 
cash it out. If you're joining a company with a 
cash-balance plan, the mechanics are simple. But 
if you're at a company that switches from a 
traditional pension, things can get complex.

What happens to my pension when it's changed to a 
cash-balance pension?

Most traditional pensions are designed so that if 
you work a full career at a company, the pension 
will replace about a quarter of your final pay 
when you retire. While formulas vary, a plan might 
give you an annual benefit starting at age 65 equal 
to 1.5% of pay for each year of service. So, if 
you've worked 20 years at the company, and your 
average salary was $50,000, that's a pension of 
$15,000 a year (.015 x $50,000 x 20).

When your employer converts to a cash-balance 
formula, the first thing it does is "freeze" the 
pension you've earned under the old formula. (This 
means it doesn't grow any more.) Your employer 
then calculates what this frozen pension would be 
worth if it were paid out in a lump sum of cash. 
This frozen pension value becomes the "opening 
account balance," which will grow with future 
contributions and interest.

Note that a cash-balance account is only virtual,
or hypothetical. The pension plan hasn't changed 
-- it's the same pool of money, which your employer 
funds and manages. A cash-balance "plan" is simply 
the same old pension plan, with a new formula for 
determining your benefit.

How can a cash-balance plan reduce my pension?

Because traditional pension benefits build up 
fastest in the later years, as much as half of a 
person's pension may be earned in the final five 
years on the job. When this older formula is 
frozen and the employee's pension grows only with 
the annual "interest" credits, the pension in 
retirement can be 20% to 40% lower than if the 
prior formula had remained in place.

Your pension could be reduced even further. Some 
companies lowball the opening account balances, 
giving someone an "account" worth, say, $100,000, 
even if the frozen pension is worth $120,000. As 
a result, you'd have to wait until your annual pay 
credits and interest build your "account" back up 
to $120,000 before you begin building any addition-
al pension.

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This is one reason older employees complain of age 
discrimination; however, the bill Congress passed 
would ban some of the more-controversial practices.

Why do employers change to cash-balance plans?

Companies can save money and boost profits. If a 
company has a pension surplus (most that converted 
in the 1990s did, and some that are converting 
today do), it can use the surplus assets to "fund" 
the contributions to workers -- offering the 
company a cash savings for a 401(k)-like benefit 
that it wouldn't have if it actually switched to a 
401(k).

What's more, changing to a cash-balance plan
reduces pensions, and thus a company's pension 
obligation. Under accounting rules, companies 
calculate how much they expect to pay out in
pensions over the lives of their employees -- 
including amounts workers haven't earned yet -- 
and then reflect that amount as a liability on 
their books. When the pensions are cut, the 
estimated amounts that will no longer be paid out 
instead get added to income.

What kinds of companies change to cash-balance 
formulas?

Companies with work forces closer to retirement 
were more likely to change from traditional 
pension to cash-balance formulas, Ms. D'Souza 
found.

If you're a salaried worker, your pension is more 
likely to be changed. If you're covered by a 
collectively bargained contract, your employer 
typically must negotiate with your union before 
changing to a cash balance plan.

Since the early 1990s, roughly 400 companies -- 
commonly utilities, defense contractors and 
manufacturers -- that together have at least 
1,200 pension plans have shifted to the new-style 
pensions.

Are cash-balance plans better for younger workers 
and job-hoppers?

Employers say cash-balance pension plans are better 
for younger and more mobile workers because these 
workers can build up a better benefit than under 
traditional pensions, and take it with them when 
they leave. But last year, the Government Account-
ability Office concluded that most workers -- 
regardless of age -- get lower retirement benefits 
when employers switch from traditional pension 
plans to cash-balance plans.

What's more, workers get nothing if they leave 
before they are "vested," which usually takes five 
years. The GAO says more than one-third of workers
in both traditional and cash-balance plans fail to
vest, making cash-balance plans no better for job-
hoppers than traditional pensions. (And most 
companies automatically cash out pensions with 
values below $5,000, effectively already giving 
young mobile workers pension portability.)

What steps can I take if my pension is converted?

About half of employers making the switch provide 
a transition period to protect older workers, such 
as letting them stay under the prior formula for 
five years.

But some older workers choose the cash-balance 
option, because they like the idea of walking away 
with a lump sum. This is almost always a bad deal.
Lump sums are often worth less than what you could 
get with a monthly pension at retirement age -- 
especially if you're in your late 40s to late 50s 
and have been at the company for many years.

Before deciding, ask to see the value of your 
pension in all possible forms: not just the cash-
balance account, but the pension you'd get at age 
65 if you chose to remain in the old plan, and 
that value converted to a lump sum.

Remember, your employer can still cut a cash-
balance pension. In coming years, it can reduce 
the annual pay credit, or even freeze the plan. 
Sears Holdings Corp. and Verizon Communications 
Inc. froze their cash-balance plans this year, and 
IBM announced it will freeze its plan at the end 
of 2007.) So you need to save as much as you can 
in a 401(k) account or elsewhere.

Cash-balance plans could be even riskier going 
forward, because the new pension law would allow 
companies to use an interest crediting rate that 
could turn negative, potentially wiping out all 
the interest credits previously earned.

So what did you think about this issue? Drop me a line and let 
me know at mailto:mandi@gophercentral.com 

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