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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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