Yakoboski Morrow, Rebecca. “Conversions To Cash Balance Plans , Paul J. "Salary Reduction Plans and Individual Highlight Im Saving for R portance of De etirement." EBRI fined Contri Issue Brief bution/401(k) no. 155 (Ippolito, 1998). In contrast, the accrual pattern unde does not appear to be any nearly uncom contribution plan. However, the m that im pension accounting and its im incom difference in final-average plans, especially e 80 percent of the plans without a transiti m pact all em from on, private-sector workers m the proceeds of the sale of the house. ploy ers, but it m quantitative assessm pact on pl ight also increase as a direct consequence of providing a m agnitude of the a yan sponsorship m have the option of contributing to the DB plan as well, but their with ent of how on benefit; however, this num a y difference is influenced by The sm oung work force). Although the 150 percent value r a cash balance plan ty aim yallest reduction takes place in the third housing be influenced portant the latter m by international standards. In pically ber decreases to 34 percent plan-specific design i ght be. In this section, does not have a o re level Issues Concerning Sponsoring, Funding, and Providing Benefits Funding flexibility. Finally STATEMENT BY Jack VanDerhei , a cash balance plan may have more funding flexibility than a Figure 8b 15 Endnotes Bibliography 24 Figure 7b 6 Figure 8a Figure 7a Approach.” IOM (EmpFigure 1: Illustration of a conversion from a hypothetical traditional final average defined loyee Benefit Research Institute, Novem A’s Defined Contribution Plan Invest ber 1994). ing. September 1999. ex See Exhi pected rate o bit 2 of Levy f return o and Young (2003) for a com n cash balance pWitness Disclosure Statement, ortfolios will rem parison ainof FR significan S 17, FAS 87 and t tly greater than h th e ie ex nternat pected ional in st terest rate andard, IAS benefit accrual over tim contributions are not given tax-favored status. was eventually equity sudden, rapid increase after attainm the value of longevity when the transition benefits are included. defined contribution plan, depending on the ty 2001 the United Kingdom scenario with the results ranging from increased to 170 percent, it appears th risk transfer is sim e that decreases the “job lock” attributes of the existing plan. adopted FRS 17, a standard th ent of specific age ulated b $747 to $2,492. pe of ased on m com at for m and service criteria. As a result, cash balance plans m at will put the m itm ortality a ent m ny plans the cushion would have been rates, the am ade to em arket value of pension plan ploy ount of retirem ees. Although som ent incom e e parameters. Percentage Reduction For Average Ultimate Present Value Deficit for Massachusetts' Single Female Reduction in Current Dollars for Average Ultimate Present Value Deficit for Massachusetts' Single Percentage Reduction For Average Ultimate Present Value Deficit for Massachusetts' Single Male Retirees, Reduction in Current Dollars for Average Utimate Present Value Deficit for Massachusetts' Single Male Retirees, to Participants and Beneficiaries Under This System Ol Yakoboski sen, Kell, Paul y, and Jack L. VanDerhei benefit plan to a hypothetical service weighted cash balance plan (without transition J. “Male and Female ." Defi Tenure C ned C ont ont inues t ributio on Pl Move i an Dom n Opposi inance Grows Across Sect te Directions.” EBRI Notes ors and Em (February ploy er credited to the em 19. Retirees, If All Retirment Wealth Is Paid Out In the Traditional Manner of a Defined Benefit Plan ployees. pursuant to Clause 2(g)(4) of Rule XI of the Rules of the House: insufficient in the face of a three profit-sharing plans provide for annual contributions th and wealth the individual has at retirem are m assets and liabilities on the corporate balance sheet. U ore attractive to a mobile work force. yTem ear bear m p ent, and th le University arket com e projected expenditures in retirem and EBRI Fellow nder this standard, gains and losses are recognized at are entirely bined with a sustained drop in discount rates. discretionary for the plan sponsor ent. Retirement Female Retirees, If All Retirment Wealth is Paid Out in the Traditional Manner of a Defined Benefit Plan If All Retirment Wealth Is Paid Out in the Traditional Manner of a Ddefined Benefit Plan Figure 3. Percentage of 401(k) participants with If All Retirment Wealth Is Paid Out in the Traditional Manner of a Defined Benefit Plan However, there m Wear-away. ay also be If a final-average plan is converted to short-term abnormalities in the pension cost and/or expense structure a cash balance plan, the initial value of a Em ployees faced with the type of graph shown in Figure 1 are likely 37 to wonder why the shapes look 15 Si 1999). zes, While Mega Defined Benefit Plans R credits) at age 55 emain Strong: Where We Are and Where We Are Going." In Figure 2. HYPOTHETICAL percentage increases in 33 16 incom as they (Allen, Melone, Rosenbloom Figure 7b provides sim e occur, rather than held off the bala and wealth for residents of the state of ilar figures for single fem , and VanDerhei, 1997), a defined benefit plan is the only nce sheet and am Massachusetts born between 1936 and 1965 are projected June 4, 2003 ales. With the exception of the oldest birth cohort, ortized as they are under FAS 87. vehicle that will An i See B mone (1999) for a m m unization program ore com attemp pt ls e t te o descri constr pt uct ion of t a port hfe cal olio of bonds whose m culations required under FASB arket value equal Statem s thent e present No. 87. value 30% While there is little doubt that had these lim participant’ resulting from Higher benefits to employees who do not stay Retirement Income Risk s cash balance account the conversion. In essence, the claim may be set at less than the value of benefits accrued under the previous its not been im with one employer for their entire career s of cost savings from posed in the 1980’ a conversion to a cash balance s, many plans would no . Figure 2 30%different. The difference essentially Alderson, Michael J., and Jack L. VanDerhei lies in the different . "Disturbing the B determ alance i inants of benefit value under each ty n Corporate Pension Policy: The Case of pe of $5,000 1 Dallas L. Salisbury, ed., Retirement Prospects in a Defined Contribution World. Washington, DC: Annuitize Housing Equity at Retirement nearly to age 65 and then paid out in one of two m allow em Annuitize Housing Equity at Retirement all of the dollar figures are larger for fem Annuitize Housing Equity at Retirement ployees to continue their normal benefit accrua ethods. In each case, retirees are assum ales than for m ls while em ales, largely ployer contributions are reduced or as a result of the unisex nature ed to earn monthly $5,000 Portions of this section borrow heavily from Olsen and VanDerhei (1997) for the selected Employers’ Accounting For Pensions set of liabilities and, even if the interest rate changes, whose value will always be at least as great as 34 Although a certain am shows the percentage increases in annual retirem plan m doubt be better funded today plan. However, it is im ay Excess Asset be at least partially annual benefits at NRA Cash Balance vs Final zero exposure to diversified equities: Re ount of experience gains and lo versi portant to note that this m on Legi . due to a tim However if the O slation." ing i Benssue under the accounting and/or funding rules required for efits Qu BRA ' ent bene ay not reduce or take away a sses are allowed to be deferred under a com 87 full-funding lim rterly fits at norm (Third Quart al retirem er, 1991): it was a binding constraint on previously ent age for an em 38–51. 1996 earned benefits. It ploy bination ee in Employee Benefit Research Institute, 1997, pp. 55–92 plan. While the present value of the annual accrual of pension wealth expressed as a percentage of 7 As the authors point out, this is a procedure that can be utilized by plan sponsors with or without a shift to a cash of the annuity Social Security calculation. The reduction when no benefits under the current sy Annuitize Housing Equity at Retirement stem (iliquidation of the housing equity .e., no Social Security reform is assum is assum ed) as well as ed ranges 2 There are m even temporarily any risks associated with partic curtailed. ipants’ assets in retirement savings vehicles: the value of the liabilities. $4,500 $300,000 Never Liquidate Housing Equity $4,500 Allen, Everet Never Liquidate Housing Equity t, Joseph J. Melone, Jerry S. Rosenbloom, and Jack L. VanDerhei. Pension Planning: Pension, Profit- of a corridor approach as well as gradual am Ol em all defined benefit plans (including cash balance plan Life annuities provide a paym sen, Kel ploy Never Liquidate Housing Equity er contribution behavior am ly, Jack VanDerhei and Dal ent on a long well-funded plan aperiodic basis for the life of the par s Salisbury ortization of am . "Defin s). Although the calculations are com ed C s, one would have expected to see a bunching of ont ounts outside of the corridor under FAS 87, ribution Pl ticipant and possibly his or her spouse an Dominance Grows Across Sect plex, one of ors 25% m a hy aypothetical cash balance plan versus a hy mean, though, that initially some workers won' pothetical t accrue any final-average defined benefit plan. The figures in new benefits until the pay and interest com balance pl pensation under a final-average plan at any an. point in time depends on age, service, and pay, it depends 25%Employers must recognize the economic value of future promises in their financial statements. Income • The Witness: from any defined benefit m $1,869 to $3,990. There is less of a reduction (and in one case there is actually onthly payments that may be accrued from their employers. They an increase) for will also Average Plan: impact of job tenure 35 17 Sharing, and Other Deferred Compensation Plans. Eighth edition. New York, NY: Irwin/McGraw- Hill, and Employer Sizes, While Mega Defined Benefit Plans Remain Strong: Where We Are and Where We som 3 credits to their hy the driving forces behind this short-term plans at the full-funding lim this figure are tabulated from See Sher (1999, p. 22) for an illustration of how the As m 1. e com ent Replacem ip oned above, t anies are said to have attem pothetical accounts bring the account balances up to the value of the old protected ent rate inadequacy he Pensi itation threshold after the a CRS report to C on Benefi . p t Guarant ted to contro cost reducti ongress that includes calculations for two ty y C increasing or decreasing the current 30-year Treasury bond orpor on involves the com l this volatility constraint had been in place for several y ation insures prom by shifting asset allocation away putation of the cost of accruing a ised benefits (subjectpes of to a m ears. axi from mum predom inantly on pay and service (and a lesser extent on age) under a cash balance plan. Therefore, even $4,000 $4,000 statem Jack VanDerhei ent accounting affects reported earnings, and this Liquidate Housing Equity When Needed, is a faculty member at Temple University affects profitability 's School of Business and M and the value of the com anagement (Departm pany ent . Never Liquidate Housing Equity Liquidate Housing Equity When Needed, Keep as There is often a mistaken notion that a DC plan will commit the employer to a specific contribution (typically a Liquidate Housing Equity When Needed, Keep as fem accum $250,000 ales when the m ulate individual account balances from odel assumes housing equity defined c is annuitized at retirem ontribution plans, cash balance plans, and IRAs ent as a result of their lower 16 Mr. Chairman, and members of the Committee. I am Jack VanDerhei, Temple University and research Keep as Lump Sum 1997. 50% Are Going." In Retirement Prospects in a Defined Contribution Worl Lump Sum d, Dallas Salisbury, ed. Washington, m rate by 1 percent can im onthly limit) when a bankrupt pact the rela plan sponsor i tive compari s unabl sons bet e tow pay een an exi all the prom sting t is red benefi aditional defi ts from ned benefi an underfunded pl t plan and a new an. stocks to m em benefits. benefit based on career-average pay Instead, Ippolito (2001) shows that by ployees: (a) one who enters the em ore stable investments that would allow som (the cash balan ploy 1995 there had er’s plan at age 25 and rem ce plan) for one based on final-average pay already e degree of im been a m am ins in that plan for 40 y aunization jor shift of plans with funding against movem ears and (b) under the ents in if the overall generosity of R Potential Limitations of a Conversion From Lump Sum isk, Insurance, and Heal of a plan rem thcare Maains the sam nagement), and e after conversion to a cash-balance form also is Research Director of the Em a Defined Benefit to a Cash Balance Plan ployee Benefit ula, higher 20% percentage of com Balance sheet accounting affects the em pensation) each year. Whploy ile this is true of one type of DC er’s liability and assets, thus the net worth of the enterprise plan (a money purchase plan requires 20% $3,500 sim (both from u2. Longevity lated net housing equity regular contributions as well as rollovers). . on average. Similar to single m The sim ales, the sm ulation mallest reduction takes place in the odel also estimates the value of $3,500 director of the EBRI Fellows’ Program Allen, Jr., Everett T., Joseph J. Melone, Jerry 33 . S. Rosenbloom and Jack L. VanDerhei. Pension Planning: Pensions, T – 139 DC: Employee Benefit Research Institute, 1997, pp. 55-92. cash balance plan. 45% 18 one who changes jobs every ratios in excess of 150 percent in 1986 to far less th interest rates. A disadvantage of this strategy Research Institute (EBRI) Fellows’ Program 10 years (Purcell, 1999). , W is that the sponsor gives up the opportunity ashington, an that value. He hy Com DC. EBRI is a private, nonprofit, nonpartisan public paring the two sets of bar graphs, one can see pothesizes that another to produce accruals for y previous plan (Dem oung em byploy , June 1999). ees m Liquidate Housing Equity When Needed, Keep as Lump Sum eans that accruals for older em ployees will likely decrease unless some Although using a cash balance plan to provide benefits that are easily communicated, typically provide no and its ability the sam $200,000e contribution each year unless th 80% to borrow money. In short, accounting e plan is amended or term for benefit prom inated), em ises as they ployer contributions are earned, rather than to a DC plan Milliman USA (2003) reported similar results in a survey of 100 of the largest companies with the largest defined third housing equity While m net housing equity ost press coverage of wear-away , if any scenario, with the results ranging from , at age 65. has focused on its potential duration, Clark and Schieber (2000) $799 to $2,726. Profit Sharing, and Other Deferred Compensation Plans. Eighth edition. Homewood, IL: Richard D. Purcell, Patrick. “Pension Issues: Cash-Balance Plans.” CR S Report for Congress (May 24, 1999). $3,000 36 potentially additional investm 3. policInvestm y research organi significant im 40% ent risk. ent incom zat pact on pension contributions for well-funded plans was a series of excise taxes ion based i e (assumn ing a positive equ Washington, DC. Founded i ity premium n 1978, i ) for the plan that can help reduce ts mission is to contribute to, to that for a hypothetical individual staying at the same job for his or her entire life, the cash balance plan ty investm ma pe of grandfathering or transiti y be m ea nt risk to em de as a percent ploy age of profi ees, and m on provisions (explained below) are provided to older workers. For ts, a percent aintain the fundi age return on i ng flexibility nvestment inherent in a defined benefit plan m or equity, or as a discretionary amount a y $3,000 only when they are paid (or when the contributions are made), has significant economic implications and benefit plans: a funding ratio of 82 percent with Although the EBRI/ICI Participant-Directed R89 percent of the com etirement Plan Data C po anies in a deficit position. llection Project has asset allocation 15% 15% Irwin, Inc., 1997. point out that the rate of wear-away is also important and they compute the potential cumulative wear- Brown et al (2000) classified em It is my pleasure to appear before y ploy ou today ers who shifted from to discuss Strengthening Pension Security traditional pensions to hybrid plans into three : Examining the Quick, Carol. “An Overview of Cash Balance Plans.” EBRI Notes (July 1999): 1–8. encourage, and to enhance the development of sound employee benefit programs and sound public policy $150,000 provides a larger benefit after the first 10 and 20 y on em future pension contribution and/or provi decided annual ployers that term ly. Usually inated their defined benefit DC plans allocate t de for increased pension benefits. he contribut ears plans and reverted the ex ion as a percent of service. But, by age of em age 55, the final-average plan cess assets back to the firm ployees’ earnings or savings. $2,500 exam appeal to m ple, an em any35% em ploy ploy ee participating in the hy ers, cash balance plans also present several tradeoffs: pothetical final-average defined benefit plan in Figure 1 im info plications for em rmation60% on millioploy ns ofer decision on whether individual employees, noor not to provide defined benefit plans. such data exists for retirees. 19 Auer, Mary Jane. “A Mixed Bag for NationsBank.” Institutional Investor. Vol. 33, no. 1 (January 1999): 126. Figures 8a and 8b provide the sam away Once individuals reach age 65, they 4. as a percentage of pay Inflation risk. at base age for a sty e results as Figures 1a are assumed to retir lized individual under two scenarios: (1) a transition to a e and in each y and 1b, however, in percentage term ear for the remainder of their lives, s instead of R groups: cost reducers, cost neutral shifters, and cost ajnes, David. "An Evolving Pension System: Trends in increasers. When looking at the changes m Defined Benefit and Defined Contribution Plans,” ade only EBRI $2,500 Health and Future of Defi However, the full-funding lim ned Benefit Pension Plans. it based on 170 percent of cu I will address that topic by rrent liability is reinstated pursuant to the general providing some through objective research and education. EBRI does not lobby and does not take positions on legislative is slightly after paying the em more valuable, and by ployees their prom retirem ised benefits. These “reversion” taxes started at 10 percent in 1986 ent age the benefit derived from the final-average plan would be would have a present value from 4 his or her defined benefit plan at age 55 of approximately $95,000, as Smaller accruals for older workers 30% . As mentioned earlier, unless some type of transition 37 Blitzer, David M., Robert E. Friedman, Howard J. Silverblatt. Measures of Corporate Earnings. Standard & Poor’s, $2,000 Flat-benefit formulas are often encountered under collectively bargained plans. 10% 10% dollar values. Even though the dollar value of longevity hy the m If all sm brid plan at age 54 and (2) that which inherently odel sim Issue Brief oothing devices for pension accounting were e ulates whether they no. 249, September 2002 (W continue to live anot ashington, DC: exists in a traditional plan age 55. Figure 6 shows the her y lim risk transfer was ty inated, the relative advantage of sponsoring Em ear and, if so, what their expenditures will be ployee Benefit Research Institute). pically larger for females, it to defined benefit plans, they found that 56.4 percent of the plans they studied fell into the cost reducing background, context, and recent research on “DB” sunset Sim $100,000 proposal ilar inform provisi s. on of EGTR ation for m RA arried couples for years begi will be available once inform nning after 2010. pension plans, as well as current trends. ation is obtained with respect to utilization Accounting procedures for pension plans consist of th ree components, each of which is controlled by a 30 percent larger than the cash balance benefit. Ho and eventually 5. Private plan sponsor bankruptcy increased to 50 percent in 1990, m risk (for DB pl ean wever, this “one-job-for-life” scenario only ing that any an benefits in excess of Pension Benefit Guaranty excess assets would be taxed at about 85 applies to opposed to approximately $135,000 for a similar employee who had participated in the hypothetical cash $2,000 benefits are provided, older em 40% ployees are likely to receive smaller accruals for their remaining years, May 14, 2002. 25% Rappaport, Anna M., Michael L. Young, Christopher A. Levell, and Brad A. Blalock. “Cash Balance Pension provides a sm 5 cum for the y defined benefit plans would likely ulative distribution function of the potential cum ear. Retiree expenditures are assum aller percentage reduction due to the larger decrease for som ed to be e both determ u sponsors as they lative wear-away absolute values of deficits sim inistic (the am would either be fearful of the based on their com ount spent on housing, ulated for fem putations. In ales. of joi class; 20.5 percent adopted changes that were cost nt-and-survivor options for qualified plans. 20 neutral; and that 23.1 percent increased their pension 20 $1,500 separate Financial Accounting Standards Board (FASB) Statem ent. FASB Statement No 35, Accounting Under the latter formula, an employee would receive the same benefit at retirement regardless of the number of percent (corporate tax plus reversion tax). Corporation [PBGC]-covered maxim He estim ums). ates the impact of reversion taxes on pension a sm For m all percentage of the work force (Yakoboski, 1999) ore detail on the process of reversions see VanDerhei. Em (1989). ployees are more likely to have four, if not balance plan for the sam regardless of whether a “wear-away e period of 30 y ” provision (described below) exists. ears. However, if the hypothetical final average plan were then Bone, Christopher M. Statement before the ERISA Advisory Council Working Group on Hybrid Plans. U.S. $50,000 Plans.” In M 20% ichael Gordon, Olivia S. Mitchell, and Marc Twinney, eds., Positioning Pensions for the nearly increased volatility half the cases, em in the pension expense and/or need ployers structured the new plans to m to increase expected contributions in the future if ake the wear-away issue moot. In the utilities, etc. each year is assumed to be known and will be a function of the retiree’s income, family 5%When the m cost in the shift to hy odel assum brid plans. Next, they es no liquidation of the housi considered changes m ng equity, the percentage value ranges from ade to plan sponsors' one job defined 13-26 $1,500 5% and Reporting by Defined Benefit Pension Plans, establishes financial accounting and reporting standards years worked (typically subject to Subcom some m miittee on Em nimum threshol ploy d such as 10 y er-Employee Relations 1 ears). Under the former, an employee $1,000 m funding, holding constant pension f ore, jobs during their careers. The second set of bar graphs show that in those cases, the series of cash unding limits, plan maturity and other confluences of time trends, and converted to the hy 21 Department of Labor, Sept pothetical cash balance plan without ember 9, 1999. the provision of any type of transition credit, the An Overview Preretirement income replacement 20% of the Defined Benefit Pension Plan System . Although their understanding of current pension wealth and Twenty-First Century. Philadelphia: University of Pennsylvania Press, 1997. Replacement rate inadequacy risk Portions of this section are based on VanDerhei deals with the possibility (1999). that the combination of Social Security, • rem status, and location) and stochastic (e.g., in m theya T assum ining plans, the cum he Organi e a less risky 15% zation: asset allocation. ulative wear-away that work ost years the retiree will not require nursing hom ers faced was generally not as great as it was in the e care; percent for m contribution plans adopted in conjunction with the shif ales but only 6 to 14 percent for females. The sm t to a hybrid plan. Adding in these changes, they allest percentage reduction takes place in for the annual financial statem typically earns more benefits for every year of additional service. ent of a defined benefit pension plan. FASB Statement No. 87, Employers’ four jobs Brown, Kyle, Gordon Goodfellow, Tom balance plan benefits dom found strong evidence in favor of the inate those accrued under the ereversion-tax theory ka Hill, Richard Joss, Richard Luss, Lex Miller, and Sylvester Schieber. final-average plans at every of defunding. age, and the final employ $0 ee would not benefit from the rapid escalation in pension wealth from age 55 to 65 that is $1,000 Schultz, Ellen E. “IRS Tells Field Offices to future increments will no doubt improve vis-à-vis the previous final-average plan, em Hold Off on Clearing ‘Cash Balance” Plans. Walploy l Street ees actually Journal $500 The Education and Research Fund (ERF), established in 1979, performs the charitable, educational, and 22 prior plans being replaced. however, for y employm ent-based retirem ears when it is sim ent incom ulated to be e, and individual sav utilized the am ings will be insufficient to m ount spent on this service could be aintain the same found that 44.9 percent of sponsors reduced costs in th 10% e shift to their new pension package, 17.9 percent 0% 28 the third housing equity Accounting for Pensions 6 Introduction 25 26 27 28 29 30 31 scenario, with the results ranging from (FAS 87) establishes financial reporting and accounting standards for an 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 849 -20 percent for m 50 51 52 53 54 55 56 a 57les and 4 58 59 60 61 -11 percent 62 63 64 65 0% Although this testimony focuses exclusively on cash balance plans, hybrid arrangements that combine traditional The Unfolding of a Predictable Surprise: A Comprehensive Analysis of the Shift from Traditional Pensions associated with the final average retirement benefits are approximaplan. Instead, during the final 10 y tely 40 percent larger. ears he or she would experience a m Em ay be m ploy(Int ees’ cont ore uncertain about how their future benefits e 0% ractiv rie Edi butions t tion), 17 Sept o DB plans are onl ember 1999. y granted tax-favored st will relate to their future earnings after conversion atus in public plans. scientific functions of the Institute. EBRI-ERF is a tax-exempt organization (under IRC Sec. 501(c)(3)) catastrophic in value). standard of living a preretiree enjoy 1936-1940 1941-1945 ed when he or she 1946-1950 retires. While in the past this risk could be caused 1951-1955 1956-1960 1961-1965 adopted changes that were cost neutral, and 37.2 $0 Funding Requirements percent adopted changes th Age at increased costs. On $500 1936-1940 1941-1945 1946-1950 1951-1955 1956-1960 1961-1965 for fem em A defined benefit (DB) plan is a retirem ploya er that offers pension benefits to its em les. Com 25 mittee on Education and the Workforce ent plan in ployees. Closely which benefits are calculated according to a form related to FAS 87, FASB Statement No. ula or defined benefit and defi 5% ned contribution concepts include pension equity plans, age-weighted profit sharing plans, Source: Author's tabulations based on assumptions in Purcell (1999) with the following modification: the benefit accrual rate was decreased to 0.91 percent to allow for benefit to Hybrid Plans. Bethesda, MD: Watson Wyatt, 2000. As pointed out in testimony to the ERISA Advisory Council Working Group studying hybrid plans, Sher, Larry. “A Workable Alternative to Defined Benefit Plans.” Contingencies. (September/October 1999): 20–26. to a cash balance plan. For exam 7 ple, a final-average plan that pays 2 percent of an employee’s average slope of the accrual path similar to that experienced by the participant who remains under the cash supported by contributions and grants. EBRI-ERF is not a private foundation (as defined by IRC Sec. 1936-1940 35 1941-1945 45 1946-1950 Birth Cohort 55 1951-1955 65 1956-1960 1961-1965 by financial instability of an employer sponsoring a private pension plan, today PBGC will pay benefits Bodie (1990) devel equivalence of the two programs assuming 40 years of participation in the same program. ops t21 he first four and also includes a fifth risk: Social Security cuts. The latter refers to the average, they found pension costs were reduced by an average of only 1.4 percent in the shift to the new 88, rule. Form new co Employer’s Accounting for Settlements and Curtailm mparab ulas are m ility plan os, flo re com or-o m ffset p on and are usually United States House of Representatives lans, new comp based arability p on either y ent of Defined Benefit Pension Plans and for rofit-sharin ears of service and a percentage of pay g plans and target plans (Campbell, Burkholder, Steve. “FASB 0% Adds Limited-Scope Project On Pension Disclosures to Agenda.” BNA Pension & Towers Peri benefit form n. “The C ulae that end up resulting in periods w ontroversy Over Cash Balance Plans.” ith no new accruals for som Hot Topics. 1999. e employees have been a Cash Balance Plans Qualified defined benefit plans m Source: EBR-ERF Retirement Income Projection Model. ust satisfy a complex set of m 8 inimum funding requirements that have earnings during his or her last three y balance plan for the entire 40 y $0 509(a)(3)). -20% ears. As a conse ears of service, by quence, the participant will not end up with the sam definition, replaces 50 percent of preretireme ent Source: EBR-ERF Retirement Income Projection Model. p (subject to prescribed lim olitical risk that the financial p its) for m roblem os cu st private DB plans rrently facing the So whose sponsors are unable to m cial Security system may be resolv eet plan ed by cutting back In the baseline case, it is assumed that all defined benefit plan benefits are paid in the form of an annuity package 1996). Termination Benefits Potential Advantages: Cash Balance vs. Defined Contribution Plans Benefits Daily cash balance (service weighted) , establishes standards for an em , March 14, 2003. traditional final average defined benefit plan ployer’s accounting for settlem conversion at age 55 (without transition credit) ent of defined or a negotiated flat-dollar amount (Allen et al., 1997). 29 Benefit levels, as determined by the formula used, U.S. Senate Committee on Finance, Statement of Henry Eickelberg, staff vice president for benefit programs for 1936-1940 1941-1945 1946-1950 1951-1955 1956-1960 1961-1965 practice approved by been adopted by Congress in an attem the Internal Revenue Service fo pt to assure that r m the vast m any years (Cham ajority of plans will have sufficient assets bers, 1999). Often plan changes, financial position at age 65 but, barring any 20s transiti 30s on provisions, would experience a decrease in pension 40s 50s 60s earnings after 25 years of service. However, to understand the extent to which cash balance benefits on benefits currently scheduled to be paid. See Olsen, VanDerhei, and Salisbury (1997) for a more complete obligations due to bankruptcy while individual accounts are spent as needed to pay . As a result, plan sponsor bankruptcy the simulated expenses. It is assum risk among private plans today ed any account is 17 Burlingam 23 e, Harold W., and Michael J Gulotta. “Casestudy: Cash Balance Pension Plan Facilitates Restructuring benefit pension obligations are guaranteed as a stated retirem (such as purchasing annuities for retirees), for curtailm ent income commenci ng at a specified age. Although retirem ent of a defined benefit ent benefits Conclusion Source: EBR-ERF Retirement Income Projection Model. General Dynamics Corp., on behalf of the American Benefits Council, hearing on “The Funding The recent trend am such as updating plan m to pay All assum the prom ptions for this chart repli ised benefits when they ong large em ortality assum ploy cate those in Purcell (1999) with the ex ers toward c p becom tions, the resultant e due. onversion of traditional final-average and career- A detailed description of these requirem standardization of disparate pension plans as a ception of the benefit accrual rate which ents is Clark and Schieber (2000) dem EBRI-ERF has a number of program onstrate that a signifi s: 36 cant portion of benefit reductions that do occur result will replace preretirem Of course, an em wealth of approxim -40% ploy ately er that sponsors a final-averag ent earnings is far m 23 percent. ore difficu e plan also has the alternative of term lt, since cash balance plans are a type of a career- inating the discussion of this issue. 2 lim balances autom ited to the risk of losing benefits above the am atically earn 5 percent per year, but when the account has been depleted the retiree m ounts guaranteed by the PBGC, should the employer go ust the Workforce at AT&T.” Compensation and Benefits Review (November/December 1998). Source: EBR-ERF Retirement Income Projection Model. are usually pension plan (e.g., closing of a pl Chal expressed as a life annuity lenge: Keeping Defined B ant), and for term enefi , lum t Pep nsi -sum on Pl distributions are increasingly ination benefits. ans Afl 34 oat,” March 11, 2003. available. While DB bey average defined benefit plans to cash balances has rai result of m was decreased t ond the scope of this testim ergers and acquisitions, or even revising o 0.91 percent American Savi to al ngs Educat ony low for benefi but several ion Ctounci equi recent papers provide ex val l a plan to m esed a controversial and com nce of the t eet new statutory wo program cellent background on funding s assum requirem pilex set of issues. A ng 40 ye ears of nts (such as directly from eliminating early retirement subsidies. Figure 4 shows the effects of the shift to hybrid existing defined benefit plan (assuming it is adequately funded) and setting up a defined contribution plan average formula that provides interest N.B.: approximately 1/2 of these participants have credits that are likely tied to some external financial market vehicle 8 bankrupt. Campbell, Sharyn. "Hybrid Retirement Plans: The Retirement Income System Continues to Evolve." EBRI Issue exist solely on the annuity paym ® ents from Social Security and the defined benefit plan (if applicable) until _____. Statement of Christopher W. O’Flinn, chairman of the ERISA Industry Com 22 mittee, hearing on “The plans are alway Another significant difference between a traditional defi For an exhaustiv se l designed as retirem ist of plans speci Attained age (entry age = 25) fical ent vehicles, certain defined contribution (DC) plan ty ly excluded fro Hearing on m coverage by ned benefit plan and a cash balance plan concerns the PBGC, see pages 278-279 of Al pes and len et Whether the longevity risk transfer inherent in the standard type of defined benefit plan design will have participation in the sam Choose t e program o Save. The pay Education Program credits vari ed as follows: years 1-10: 4 percent, 11-20: 5.5 percent, 21- legislative changes to the Sec. 401(a)(17) limits earlier this decade) can result in periods without new requirements (Joint Committee on Taxation, 2003), the financial condition of the Pension Benefit cash balance plan is a “hybrid” type of pension plan —i.e., one that takes on the characteristics of both a While the im through which to provide benefits for future service. plans for three hy pact of the statem pothetical workers. In every ents has come under case reflect considerable criticism However, several considerations m ed in the figure, the m in the financial press recently ajority of the hy ay make this brid plans and/or index. Brief no. 171 (Employee Benefit Research Institute, March 1996). further savings may be set aside. In the alternative case, it is assumed that all individual account wealth is al., 1997. Funding Challenge: Keeping Defined Benefit Pension Plans Afloat,” March 11, 2003. Nesbitt, Stephen L., the inherent uncertainty involved in estimating the nominal amount of retirement income. Traditional designs have features that resem 40: 7 percent. ble capital accumulation plans (i.e., plans used for savings, not value to an individual em Source: EBRI tabulations based on tables from Patrick Purcell, P C exposure to company stock and/or balanced funds onsumer Heal ployee will obviously th Education Counci depend, l inter alia, on their actual life span. As this will ension The second risk—longevity risk—can be defined in several ways. One definition (Bodie, 1990) defines it Guaranty accruals. Corporation and possible reforms (Kandarian, 2003), and problems in pension funding rules due defined benefit plan and a defined contribution plan. Legally, a cash balance plan is a defined benefit as the bear m option problem reduced benefits for the prototy arket caused increasing atic: pical workers by skepticism with respect to the re less than the amount of the reduction that would have ported numbers, it is important to Lump-sum distributions. Due to the increased likelihood that participants in a cash balance plan Chambers, Robert. Testimony on behalf of Association of Private Pension and Welfare Plans. paid out in the traditional m 2003 Corporate Fundia ng Survey nner of a defined benef on Pensions (FASB it plan. This is accom 87), Wilshire Associ plished by ates Incorporat assum ed. M ing an annuity ay 14, 2003. 9 defined benefit plans are not typically thought of in this regard since the amount is specified in a formula necessarily for retirem Defined C ent). Traditionally ontribution Research Program , DB and DC pl Felans have different features associated with each. lows Program 24 not be known in advance, this analysis measures the lifetime deficit reductions simulated to occur when Issues: Cash-Balance Plans, CRS Report for Congress, May 24, 1999 as the risk that the retiree will outlive the am to Treasury bond rates becoming inordinately ount sav low (Ged for retirem ebhardtsbauer, 2003; O’ ent. A prim Flinn, 2003; Eickelberg, ary rationale for paying plan. A cash balance plan offers som An individual can use self-annuitization as a strategy to ensure that he e of the popular advantages of a defined benefit plan but is designed or she does not outlive a particular amount occurred if they had simply eliminated their early retirement subsidies. For any of the cases where the realize that FASB’s objectives when the rules were C For exam lark, Robert pl, and Sy e, age-wei lvght este ed pay r Schi credi eber. “An Em ts under t pi hri e cash bal cal Anal designed in the 1980’s was to inject into pension y ance pl sis Of The Transi ans and earlty ion To Hy retirement bri provi d Pensi sions under t on Plans In The he will end up with a LSD as opposed to a lifetime annuity, it is more likely that they will face a longevity _____.. Statement of Ron Gebhardtsbauer, FSA, MAAA, Senior Pension Fellow, American Academy of Actuaries is purchased at age 65 based on unisex m Disclosure requirements. Recently ortality , som rates and a 5 percent discount rate. e have argued for the need to disclose to each employee Health Confidence Survey Program For exam and (with the exception of certain integrated plan Ease of conversion vs. new plan establishment ple, DB plans usually pay benefits in the Strengthening Pension Security: s) can be directly form of life annuities, whereas DC plans ty . Whereas a conversion from computed once the average a final-average pically pay all retirement plan wealth is assumed to be paid out under a defined benefit type annuity and pools the retirem 2003). of principal. This m ent plan benefits in the form ay be accomplished by dividing the acc of life annuities is ount balance each year by his to insure against this risk. Hence, this risk can be or her life expectancy at to look m final-average plan. Uni ore like a defined contribution plan, with ted States,” Nov. 22, 2000 Revision. an individual “hypothetical” account that appears to accounting a way worker is assumed to retire at age 55, less than 16 pe to more meaningfully measure pens rcent of the plans would reduce benefits by ion expense and to introduce balance sheet item more s risk in addition to a post-retirem CommittSource: ee on Fi 401(k) Plan Asset Allocation, Account Balances, and Loan Activit nance, before t ent investm he Senat ee nt ri Cosk. It should be noted, however, that with som mmittee on Finance, hearing on “The Fundi y by Jack VanDerhei, ng Chale le nge: the differences in his or her accrued benefits under the previous plan formula and his or her initial account return Health Security/Quality Research Program lum com defined benefit plan to a cash balance plan only p p-sum ensation and y s. However, one fundam ears of participation are known. Ho ental difference betw requires a plan am een DB and DC plans exists. Under a DB plan, a wever, it appears that an increasing percentage of endment (Rappaport, Young, Levell, results across all m Examining the Health and Future of Defined Benefit Pension Plans embers of each birth cohort. In all cases the defined benefit plan design results in a 13 that point in time and limiting annual consumption to the amount determined by the calculation. This step is insured against through either the DB or DC approach only if benefits are paid in the form of an annuity accum Congelu , C late assets for each participant. Cash balance olleen T. “Cash Balance Plans Rep. Sanders Repeat plan accounts are a record-keeping feature only s Call for Review of Cash Balance Age- , as (including footnotes) helpful to financial statem 25 than the elimination of the early Russell Galer, Carol Quick, and John Rea, Joint EBRI/ICI publica retirement subsidies. ent readers. The overall im tion, January 1999 pact of the rules varied exceptions, cash balance plans are required to offer Keeping Defined Benefit Pension Plans Afloat,” M annuities as an option to their participants, and it arch 11, 2003. balance under the cash balance plan. Moreover, they have argued that the wear-away period (if any) There is no doubt that recent reports paint a gloom In both cases, deficits are recorded in any Note that they will n Policy Forum ot be exactly eq s ual give y n 9ear that that the p ythere is insufficient retirem picture of the financial health of the single-em ay credit differs from the assu ent incom med interest cred e to meet that itedploy to ther e defined benefit participants are now receiving their di and Blalock, 1997), terminating the same plan and setting up a successor defined contribution plan m stributions in the form of lump-sum distributions ay form typically repeated each year, and the ula guarantees the final benefit level; in a DC pl annual amount will vary from an, a form year to ula stipulates how funds are allocated to year depending on investment income positive reduction. In percentage terms the results vary from a low of 8 percent to a high of 26 percent or if participants effectively self-annuitize. Discrimination Issues.” BNA Reporter. Vol. 26. No 35 (September 6, 1999): 2179 these plans are funded on an actuarial basis, in the same way that defined benefit pension plans are _____. St among em atem ploy ent ers depending on plan design, the age of the work force, actuarial assum of Steven A. Kandarian, Executive Director, Pension Benefit Guaranty Corporat ptions, and the ion, hearing on appears that there is an increasing propensity for traditional final-average defined benefit plans to offer 3 cash balance plan (5.6 percent). Retirement Confidence Survey Program defined benefit sy during a conversion should be expl year’s simulated expenses and there is not a suffici stem. In fact a report released l ained, and a mast m eaningful com ent am onth by ount in the individual account balances or retiree Wilshire (Nesbitt, 2003) proclaim parison should be provided to each ed that (LSDs) – a form Transition/grandfathering. that can provide great uncertainty Several transition m to eme ploy thods are availa ees with respect to the am ble to a sponsor that chooses to ount that they will individual accounts. trigger a reversion excise tax of either 20 percent or and changing life expectancies. Because so few fundamental differences exist between plan ty Testim 50 percent (Alderson and VanDerhei, 1991). If the ony of pes, employers have for single males depending on birth cohort and housing equity assumption. Similar analysis for females Demby, Elayne Robertson, “Cash Balance Converts.” Plan Sponsor (June 1999): 22-30. funded. Therefore, at any “The Funding Chall point in tim enge: Keeping Defi e, the benef ned Be its prom nefit Pensi ised to a participant are based on the plan on Plans Afloat,” March 11, 2003. plan’s financial status at the time of transition to the new rules. Nevertheless, it appears safe to say that LSDs and for participants to choose them Retirement Security Research Program when offered (Watson Wy att, 1998). Also, even though cash corporate pension funds suffered their worst y The third risk— worker of projected benefits under the am 26 savings to cover the difference. If additional m investment risk—is a relatively ended plan co ear ev one straightforward (alb yer. Based on 10K filings from becom mpared with benefits that would have been earned es available later in the retiree’ eit often misunderstood) concept. 320 com s life, the panies in the mitigate the financial impact that may result in a switch from a traditional final-average plan to a cash 10 significant leeway receive due to fluctuations in the relevant discount defined benefit plan was overfunded, the surplus in a to design individual plans tailore rates (Bone, 1999). In contrast, cash balance plans d to their specific objectives. Recently conversion to a cash balance plan would be used to , an increasing ranges from Employee Ben a low of 4 percent to a high of 14 percent. efit Research Institute. Cash Balance Debate Heats Up.” EBRI's Washington Bulletin. Vol. 11, no. 18 In addition to these retirement plan-specific reasons, there may also be overall compensation or administrative VanDerhei, Jack L. "The Recapture of Excess Pension Assets." Benefits Quarterly. Vol. 1, no. 3 (Third Quarter form There m ulae and not on the assets in his or her “account.” ay be second order impacts to consider. For example, a sponsor that has had extraordinarily favorable the latitude for management discretion in pension accounting was greatly reduced. The sponsor is no balance plans com Social Security Research Program municate benefits in terms of a lum p-sum account balance, at least some of them limit S&P 500 Index that m under the previous plan form While m excess is recorded as a negative deficit up to the am any equate this term aintain defined with variation in re ula. This appears to benefit plans, the ratio of assets to liabilities fell from tirem be based on a belief that it is critical for plan ount ent benefits resulting from of the then existing cum fluctuations in the ulative deficit. Any 104 percent to num provide LSDs that are stabilized, but annuity reduce future contributions (as it would under the balance plan (Rappaport, Young, ber of employers have used this leeway Levell, and Blalock, 1997): to com values under these arrangem traditional plan); if it was underfunded, the unfunded bine traditional DB plan features with features usually ents may be subject to concerns t (Sept hat are speci ember 3, 1999). fically addressed through a conversi on. Two of the more common reasons include 1985): 1–13. 30 investment experience in recent years may be more likely to provide future benefit improvements or ad hoc cost-of 18 longer able to choose an actuarial cost method that provides the desired stream of pension expense over Education Programs?Policy Forums, Briefings, Round Tables the ability of employees to cash out their accounts. participants to have an appropriate financial markets, investment risk m opportunity ay also refer to to (a) voice their concerns regarding plan am the risk that investments will underperform endm the rate of ents so 83 percent with 89 percent of amounts not spent from the annuity the sponsors now underfunded. payments are also assumed to be earning 5 percent per y ear until they In a typical cash balance plan, a participant’s retirement account grows by earning annual credits that may support Gale, W fluctuations in annuity liability ing a t illiam is am o , Leslie Pap tortized in the norm al compensat purchase prices although it appears som ke, an ion phi d Jack la ol fashion (Warshawsky sophy VanD ierh n th ee cont i. “Unext derstan of a new perform d , 1997). ing the e Sh emift To ploy ance-based arrangem ers are willing to hold annuity ward Defined Con etnt rib wi utio th em n Plan ploy s.” ees associated with traditional DC plans, and vice versa. (Many of these arrangements are called hybrid plans, _____. "An Economic Perspective on the Pension Accounting Controversy." Benefits Quarterly. Vol. I, No. 1 (First living adjustments (COLAs). time and the range of acceptable discount rates for de • Pay the greater of the benefit that would have term been paid under the old plan and the benefit due ining the present value of pension obligations Publication Programs?printed and online Jack L. VanDerhei, Ph.D., CEBS return needed for sufficient retirement income. Indeed, underperformance may arise from down-side that em are needed to pay ployers are fully future expenses. aware of them and (b) alert regulators to issues surrounding cash balance be based on a flat percentage of pay Paper presented at the Brookings/ but that m TIAA-Ci R ght be EF Insi integrated with Social Security tute/SIEPR conference, ERISA af benefits (Quick, ter 25 years: A and provi purchase rates constant in the plan (Gebhartsbauer, 1999). ding a platform for merging disparate pension plans as a result of merger and acquisitions activity (Towers and are discussed later.) As a result, the differe Quarter 1985), pp. 36–45. nce between DB and DC plans is becoming more 11 While these numbers have caused concern for the future of the single-employer defined benefit system, was implicitly under the new form narrowed. ula for a subset of the employees (either for a limited time period or until Guarantee of employee participation EBRI Issue Briefs, EBRI Notes, EBRI Databook on Employee Benefits, . The noncontributory nature of most (if not all) cash Temple University and EBRI Fellow Note that this is not the same as guaranteeing the standard of living will not be impacted. For an interesting conversions that they fluctuations in financial m Key Issues Framework for Eval deem a uat im rkets, but it also st ing Pensi portant (White, 1999). on Reform em , Sept s from em investing in low-risk assets that do not earn ber 17, 1999. 1999). However, it is also possible to provide ag Perrin, 1999). e or service-weighted pay credits under these plans. nebulous. _____. "Pension Plan Surplus: Revert, Transfer, or Hold?" EBRI Issue Brief no. 88, March 1989 (Washington, DC: there are three points that need to be considered when contemplating a legislative reaction: 10 termination or retirem EBRI Health Benefits Databook, Fundamentals ent). of Employee Benefit Programs, Policy Studies balance plans eliminates the need to worry about employees who choose not to participate or make de discussion of the possible application of this concept to retirement plans, see Merton (1983). adequate return rates. While a DB plan offers Gebhardt The value of net housing equity sbauer, Ron. “Testimony on C , if any ash B , can m alance Pl no direct investm ake ans, a significant difference in a retiree’s ability Conversions and Di ent risk to participants, sclosure.” For the U.S. Depart the am to m ount of eet ment Cash balance plans also provide a y 27 Employee Benefit Research Inistitu eld on the hy te). pothetical account that is typically defined as either the It appears that a current concern with respect to FA S 87 is its lack of transparency for at least some However, others in the pension policy In recent y Using botears, there has been a flurry h administrative records and worker report com of press munity accounts, court cases, and legal and regulatory s have questioned the logic in providing estim of pension provisions. activities ates under minimis contributions in a 401(k) arrangement (Yakoboski, 1994). As a result, employees are guaranteed Potential Advantages: Cash Balance vs. Final-Average Plans 14 12 of Labor ERISA Advisory Council, May 6 and June 9, 1999. this risk participants are exposed to under a DC a 1. The self-correcting mechanisms in the pension pproach is often m funding requirem isunderstood. Many ents have already assum comee that DC into play _____. “Key expenses later in life. However, there appears to Issues in the Cash Balance Debate,” ACA Journal be no consensus opinion on when, if ever, retirees will (Fourth Quarter 1999), pp. 7-16. 30-year Treasury rate or the one-year T-Bill rate plus a stated percentage (Gebhardtsbauer, 1999). investors. See C • lark, Al Provide extra account balances at transition to m In an attem len, and Sum pt to im ner (1983) for a survey prove investor understa of pract nding of corporate earnings reports, Standard & ices am ake up for the greater benefit which would have ong private sponsors. a benefit plan that no longer exists and have warned that Congress should proceed very cautiously in with respect to cash balance plans, specifically 28 as they relate to conversions from existing final-average Before discussing key Ip a benefit under a cash balance plan without needing to polito, Rich Benefit Calculation and Plan Funding ard, A. Pen public policy sion Plans and issues and the po Employee Performssible ram an actively ce: Evid choose to participate in the plan, and the en ifications of m ce, Analysis an odify d Poing the existing licy. Chicago: In the case of the job-changer, it is assumed that the full am Washington, DC ount of any cash balance proceeds would be investm VanDerhei ents are risky , Jack L., and R because asset allocation choices ussell Galer, Carol Quick, and John R may be subject to wide m ea. 401(k) Plan Asset Al alrket fluctuations. ocation, Account liquidate the equity with aggregate contributions for these plans increasing from in their house or in what form. Therefore, the model produces three different $12 billion in 2001 to $41 billion in Poor’s (S&P) released a set of definitions last y been available at early retirement. ear to be used in generating core earnings figures. The 13 • adding to the already plans. This section of the testim Contracts: substantial burdens of adm ony provides som inist e insi ering a cash balance or other defined benefit plan ght into each of these in an attempt to clarify some Prior to 1980, employer pension accounting was governed by Accounting Principles Board Opinion No. 8, plan is protected from University of C possible disqualification due hicago Press, 1998. insufficient participation among lower-paid workers. legislative and/or regulatory reinvested in a tax-deferred reti landscape, it m rement savings account ay be help and ful to consider why earn an average annual a sponsor of a final-average rate of return of 8.65 percent, Balances, and Loan Activity. Joint EBRI/ICI publication (January 1999). However, m scenarios with respect to housing equity 2002. any DC plan sponsors provide guaranteed : investment contracts (GICs) and/or stable value definitions include pension costs but exclude pension gains. S&P’s rationale for this asymmetric When establishing a DB plan, employers usually choose between flat benefits and pay-related benefits. A EBRI does not have any contracts with the federal government in 2003, and di26 d not in 2002 or 2001. (Metras, 1999). Em of their more complex a ploy nd controversial concepts. ers may be unreceptive to projecting future benefits due to the extremely Accounting for the Cost of Pension Plans. This opinion replaced the previous discretionary method of accounting Ippolito, Richard. “Reversion Taxe • Provide extra account balances to m s, Contingent Benefits and Th ake up for the fact that final-average earnings will not be e Decline in Pension Funding.” Journal of Law while the employee covered by a final-average plan would remain in a terminated vested status and not receive VanDerhei, Jack, and Francois Joanette. "Economic Determinants for the Choice of Actuarial Cost Methods." defined benefit plan may be interested in converting to a cash balance plan: funds as investm 1. Retirees are assum ent options, which provide som ed to never liquidate their housing equity e degree of assurance that participants’ . investments will Fundamental Economic Distinction Betw 35 een Final-Average and Cash Balance Plans treatm flat benefit formula ent was: Retirement pattern predictability bases benefits on a flat-dollar am . Investment risk is ty ount for each y pically ear of service recognized under the directly borne by employers under for pensi 2. on cost One needs to keep in m s with a possible range of m ind that the “perfect stor inimum and maxim mu ” scenario of a sustained three-y m annual costs based on a number of approved ear bear market sensitive nature of the estim and Economics 44 (Apri ates. l 2001), 199–232. lump-sum directly distribut used in the form ions. ula. Journal of Risk and Insurance. Vol. LV, No. 1 (March 1988), pp. 59–74. June 4, 2003 4 not decline in value. While m Do Cash Balance Plans Result in Cost Savings to any might assume that these options entail no investm the Sponsor and/or Benefit Reductions to the ent risk for 2. Retirees are assumed to annuitize housing equity immediately at retirement (e.g., purchase a a cash balance plan and by employees under a defined contribution plan (see Auer 1999, however, for one plan (e.g., $400 in annual retirem ent multiplied by years of service). Pay-related benefits can be divided actuarial cost Ease of communication vs. invisible plan syndrome. methods. However, the relevance of this methodology Sponsors of traditional defined benefit was questioned after the enactment of the Johnson, St coupled with abnorm even B., and Jack VanDerhei ally low interest rates is . "Determinants of Pensi an extrem on Account ely unusual situation and a convincing ing Choice Prior to FASB 87: Evidence Some may be concerned that pension income is excluded from Core Earnings, while pension costs are 29 Under either the final-average or cash balance plans VanDerhei , Jack. "Employers Accounting for Pensions and Ot illustrated in Figure 1, an em her Post-Employment Benefi ploy ts." ee starting at age 25 EBRI Issue Brief no. participants because the principal will typically not decline by more than a de minimis amount, choosing Participants? reverse annuity It is certainly mortgage). possible for conversion to a cash balance plan to result in lower long-term The cal • Provide a supplem culation is obviously ental additional benefit. more complicated in an integrated plan. into two variations, based on the definition of pay notable exception). As a result, the employer is better able to predict retirem . Career-average formulas ent patterns under a cash define pay as all earnings Em ployee Retirement Income Security Act (ERISA) in 1974. FASB therefore added two pension projects to its plans often bem and Public Po oan the lack of recognition they licy Implications." Studies in Employee Benefit Topics receive from their employ . Brees, even though substantial ookfield, Wisconsin: International included. This apparent conflict is in reality no conflict argument could be put forth that this would not be the proper baseline to use to establish new at all. The two are not parallel because they arise in 83, October 1988 (Washington, DC: Employee Benefit Research Institute). will obtain the same benefit value at age 65 if he or she remains with the same employer for a full career. Importance of Pooling of Longevity Risk such investments may entail investment risk if the rate of return on these investments is lower than that pension expense, depending on the gene 3. Retirees are assumed to liquidate the housing equ rosity of the new plan relative ity only when they to the existing plan. In essence, needed to pay expenses and 30 agenda: during plan participation in balance plan, since retirem one for the pension pl ent incom an i order to calculate benefits. tself (FAS 35) and one e will not be susceptible to m to cover account Final-average formulas arket fluctuations. Under a defined ing by plan sponsors for pensi define pay as only on benefi those ts. Foundation of Employee Benefit Plans, Inc. (December 1987), pp. 49–65. sums of money are contributed and/or accrued annually. When the quality of workers' information W For exam ang, Jenni different places from federal requirem ple, at AT&T, em fer, and Jack L. VanDerhei ents with respect to pension funding. ployees can receive a cash different activ . “The Im ities. Pension costs are part of pact of Pri paym mary ent for the entire am Pension Trends on R employee com ounte in their accounts if the tirem pensation and arise ent Income: A Re- A PricewaterhouseCoopers survey Nevertheless, the accrual rates under each plan differ of about 75 cash bala fundam nce conversions reveals that in alm entally. The annual increase in benefit value ost all cases needed to grow a sufficient retirem this is no different than switching from they keep the proceeds as a lum ent nest egg. a defined be p sum. nefit to a defined contribution plan, and similar 27 The latter project yielded an interim statement (FAS 36) in 1980 that was later replaced with FAS 87. The new Joi earnings received during an averaging period just prior to retirem contribution plan, em nt Committee on Taxat ploy ion., “Present ers may face unexpected increases in early Law and Background Relating tent. o Em retirem Career-average formula ployer-Sponsored Defi ents during a strong bull ned B s have two enefit difference bet because people are hired to work examw in een t ation h o e account f Define bal d Ben ance and t efit/Defin and, hopefully, produce revenues and Co he hi ed Co ghest ntrib year of el ution Tren igib dl.e ” (fo payrth is $30,000 or l cominre Earnings. Pension gains, in g) Bene ess. Ot fits Qu herwi arterly. se, regarding traditional pension offerings was evaluated, about one-third of workers queried were unable the employer provided transition provisions beyond the legally required minimums (Sher, 1999). (viz., how much additional retirement income an employee will earn by working one more year) tends to Although defined benefit plans are not necessarily more or less generous than their defined contribution projections would need to be applied to determ 3. An underfunded plan is not a problem as long ine if this were the case (VanDerhei 1985). However, as the sponsor remains financially solvent. accounting requirements mandated by FAS 87 were phased in over several years. The income statement provisions market and unexpected delay Plans and the Financial Po s of retirem sition of th ent during a e Pension Ben ma erket correction (especially fit Guaranty Corporation (PBGC).” Su if it is prolonged). bmitted before em variations. Final retirem ployees are lim contrast, have not ited to a cash ent benefits hing t p oa do wi ymen can either equal: (a) the sum t eq th th ue corporat al to one year's wo ion's core rth busi ofn th ess or t of a percentage of salary eir hig hh e creat est elig ion of C ible pay, with ore Earni earned each thngs. The si e rest paid as ze Warshawsky, Mark J. “Funding of Defined Benefit Pension Plans.” In Michael Gordon, Olivia S. Mitchell, and The fourth risk—inflation risk—can only be directly addressed by the plan sponsor in DB plans, and is to answer any questions about early retirement requirements, and about two-thirds of those who offered be much higher for young employees under the cash balance plan and much higher for older employees plan counterparts with respect to the amount of wealth generated by retirement age for an individual even if such a calculation was perform were to be applied for fiscal years Figure 7a presents the reduction (in current dolla beginning after Decem ed on two re rs) for the average present value deficit for tirem ber 15, 1986 while the ba ent plans, it would not necessarily lance sheet provisions were to be indicate the In 88 percent of the plans exam the Senate Committee on Fi ined in Clark and Sc nance, hearing on “The hieber (2000), the plan sponsor provided som Funding Challenge: Keeping Defined Benefit Pensi e form on a m year recognized by onthly an Marc Twinney, eds., annui d timtin y (B g o the plan (e.g., the sum url f pie ngam nsion Posi e g and Gul ain tis reflect th oning Pensi otta 1998). of 2 percen e sk ons f ill o or t f th he Tw e p t of annual pay orent tfoy lio -Fi m rst an C ag e for each y e nt rs en ury.g Ph agilad edear of service) or (b) the to elp m ha ia: Un nage th ive p ersity o ensio fn plan perhaps the m One obvious solution to the problem ost difficult to deal with in the private sector. Social Security of insufficient funding that has at least tem and m porarily any of the public DB been adopted is answers about early retirement were wrong (Mitchell, 1988). In contrast to explaining the complex benefit under the final-average plan. This is true even though the cash balance plan illustrated in this figure employee, there are fundam Retirement benefit predictability ental differences in the pay . Since employ out stage at least for those defined benefit plans ers directly bear investment risk under cash The views expressed in this statement are solely those of the author and should not be attributed to Temple applied for fiscal years beginning after December 15, 1988. For additional detail on the evolution of pension extent of cash balance savings, if any Massachusetts' Plans Afl single m oat,” Ma arch 11, 2003. le retirees when accum , since any u savings due to cash balance plan conversion m lated throughout their simulated life span if all 19 ay be of transition benefit for some workers affected. Figure 5 shows the potential effect that hybrid plan and t Pennsy he foresi lvania Press, 1997. ght of the pension plan sponsor in establishing the investment policy and hiring the portfolio 31 average of all annual salaries recognized by the plan multiplied by a percentage (e.g., $30,000 in average 23 pension plans have the perceived resources to com the repeal of the full-funding limit for plan years beginning in 2004 and thereafter. mit to some type of guarantee that inflation’ The full-funding s impact on formulas used by traditional defined benefit plans, conveying information through theoretical account For example, Eastman Kodak reportedly will introduce a 31 first time match to its 401(k) plan to counterbalance adopts a service-weighted pay University or the Em balance plans, they need not worry ployee Benefit Res credit schedule. about overly earch Institute, its officers, trustees, c onservative worker-investors. Figure 3 below shows sponsors, or other staff. The Employee that do not offer lum accounting standards see VanDerhei p-sum distributions to their em 5 (1988). ployees at retirement. When defined benefit payouts Levy, Jerrold and Michael Young. “Caution: Accounting Changes Ahead!” Benefits Quarterly (Fourth Quarter, retirement wealth is paid out in the traditional manner of a defined benefit plan as opposed to the baseline offset by m other increases in benefits or com anagers. Both the gains and the costs are related pensation. to the pension, but the similarity en 11 ds there. (Blitzer, conversions would have had on worker Watson-Wyatt. “Choosey Employees Choose Lum s who were 50 y p Sums!" Watson Wyatt Insider ears old at the time of conversion with 25 y . Vol. 8, no. 4 (April 1998). ears of pay multiplied by 50 percent). DB plans typically retain an actuary to annually assess plan obligations balances under cash balance plans facilitates em lim the purchasing power of this com it has been in effect since ERISA and has provided a m ponent of retirem ploy ent incom ee appreciation of both curre axim e will be m um limit on the deductible contributions a itigated. nt pension wealth and However, private losses from its conversion from a final average plan to a cash balance plan (Morrow, 1999). Benefit Research Institute is a nonprofit, nonpartisan, public policy research organization. the 1996 percentage of 401(k) participants with zero exposure to diversified equities by age cohort are offered in the form of an annuity to all retirees, two of the risks mentioned in section one of this 14 2003). Friedman, Silverblatt: 2002.) situation where individual account balances are allowe Weil, Jonathan. “Pension Accounting Rules Led to Overvalu d to be spent when n ed Stock, Fed Says.” Wal eeded. In each case, the l Street Journal, March 28, service under their old plan. Distributions of the benefits as a percent of prior benefits that would have A difference in accrual rates between older and y based on the plan’ A recent study by two Federal Reserve Board staff m s specified formula and to determ ounger workers upon conversion from em ine the am bers concludes that stocks ounts the plan sponsor should place in the of those sponsors reporting a final-average to plan sponsor could m sponsors generally have not been able ake in a year. This was rarely to cope with this problem a binding constraint until it was m other than to hold out the possibility odified by OBRA of the annual pay and interest credits that increase pension value over time. Assum 32 ing such a calculation was performed, the cash balance plan may also prove to be more expensive testim M (VanDerhei, Galer, Quick, and Rea, 1999). Although etras, R ony it are retained by a D. Testimony for t the em he Heari ploy ng on Pensi er instead of being transferred to the em on Refoapproxim rm Legislat aitely on. U.S. Senat one-half of these individuals in each ploy e Cee: investm ommittee on Fi ent risk and nance, June In addition to the potential cash flow problem 2003 s arising from increased LSDs under cash balance plans, the liability difference is largest when no liquidation of the housing equity is assumed and the values range from 12 an been payable at various ages under the pre-conversion plans are presented for three different retirement substantial earnings from pension plans were systematically overvalued in recent years as a result of the accounting a cash balance plan is likely pension fund in order to com to exist whether or not ply with funding requirem a so-called wear-away ents. (These amounts are based on the selected provision (explained later) is 'providing ad hoc increases in pension pay In March of this y 87 to add a new requirem ear the FASB decided to add to ent: plan assets (as defined ments on a som its agenda a lim in the Internal Revenue Code) could not exceed 150 ewhat periodic basis. ited-scope project intended to im prove than originally calculated if turnover is higher than assumed. This would result from plan assets being 30, 1999. longevity age cohort have som risk. e equity market exposure through company stock and/or balanced funds, a significant White, Elizabeth A., “Cash Balance Plans Attorney Urges IRS Rules to Clarify Age-Discrimination Issues in durations of cash balance plans appear to be between seven to eight years as opposed to the 12- to 20-year durations average of $1,671 to $3,863. The reductions are sli No magic numbers of age and service. Final-average defined benefit plans often require ghtly smaller when the model assumes housing equity rules (W ages (55, 60 and 65) for estim eil, 2003). The authors of the ates with and without study conclude that invest the transition benefits. The transition benefits ors tend to apply the same P/E multiples to pension included in the plan. The difference is conceptually actuarial valuation method and appropriate actuarial si assum milar to the effects of changing a final-average plan ptions.) The plan sponsor is then ultimately percent of the plan’s current liability (including the current liability normal cost). In essence, this limited pension plan disclosures. While this procedure may yield draft rules in a few months, FASB opted not to reduced below expected levels, and the spread between the accrual in the plan and the actual fund Milliman USA. Pension Fund Survey, www.milliman.com/eb/pension-fund-survey/ percentage of them may be subjecting themselves to expected rates of return too low to generate sufficient typically calculated for traditional fina Conversions. Vol. 26, No. 32 (August l average plans. Although 16, 1999): 2407 the eventual impact (once the various transition is annuitized at retirem employees to satisfy som ent due to the fact that e combination of age and servi in some cases retirees who otherwise would have outlived ce before they are entitled to retire with an early earnings as they do to earnings from the sponsor’s core operations. provided in the shift to hybrid plans appears to significantly mitigate the adverse effects of the plan responsible for making required contributions as well as ensuring that the fund’ 32 s assets are invested and to a career-average plan or, more drastically, terminating a defined benefit plan and establishing a defined the am embark on a com ount of assets to a value based on the plan’ prehensive project on pension acc s ounting that m termination liability ight have entailed substantive as opposed to an ongoing liability Mitchell, Olivia S. “Worker Knowledge of Pension Provisions,” Journal of Labor Economics. Vol. 6, no. 1 performance may be a factor in increased costs. Turnover could increase due to future labor patterns W provisions allow m retirem illiament incom son, Christin e o at norm re of the liabilities to be generate e. “Stock a Allo l retirem catioent age. n Hikes Predicted d via the new cash balance com as Defined Benefit Plans Sh ponent) of the decreasing ift to Cash Balance.” The value of the investment risk transfer is well known as is the fact that defined benefit plans (when not retirement subsidy, and the magnitude of the dollar loss from leaving prior to that time can be substantial their individual account balances and been left with insufficient monthly income will now have additional changes. For example if this stylized worker retired at age 55, there would have been a reduction for benefits are paid; however, these responsibilities are often delegated to third parties. Although it is (the form modification of the sm (January er does not project for future wage growth 1988): 21–40. oothing mechanisms in FAS 87 while the latter does, which can produce a significant (Burkholder, 2003). However, the future of U.S. Pensions & Investments, (September 6, 1999):1ff. liability durations on the plan sponsor’s asset allocation is debatable (Williamson, 1999) it would appear that the taken in the form of lump-sum distributions) eliminate the risk of outliving your income; however, there 20 22 21 16 13 11 20 18 14 15 12 10 19 17 9 3 6 4 2 7 8 5 Figure 6 Figure 5 Figure 4 Benefit Reductions at Age 55 Attributable to the Elimination of Early Retirement Subsidies in Potential Wear-Away for a Worker Age 54 With 25 Years Service in the Transition Benefits Under Hybrid Plans Relative to Prior Plans, For Workers Age 50 With 25 Years of Service With Salary of $60,000 at Conversion to a Hybrid Plan, Compared With a Comparable Worker in the Prior Plan the Shift From Traditional Pensions to Hybrid Plans (Percentage of Plans) 100% 100% 90% At Age 62 80% 80% Hybrid and Transition 70% Benefits as a Percentage of Prior 60% Plan Benefit 60% At Age 60 50% 150% or More 40% 125–149.9% 40% 30% 100–124.9% Potential Cumulative Wear-Away in Transition to Hybrid Plan at Age 54 75–99.9% 20% At Age 55 50–74.9% 10% 20% Potential Cumulative Wear-Away in Traditional Plan at Age 55 Less Than 50% 0% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100% 0% 55, Hybrid Only 55, Includes 60, Hybrid Only 60, Includes 65, Hybrid Only 65, Includes Age 30, 0 Years, $40K Age 40, 10 Years, $50K Age 50, 20 Years, $60K Transition Transition Transition Potential Cumulative Wear-Away as a Percentage of Pay at Base Age (Percentage) Source: Clark and Schieber (2000) Source: Clark and Schieber (2000). Source: Clark and Schieber (2000) 0% 0.1–24.9% 25.0–49.9% 0–74. 50. 9% 75.9–99.9% 100.0–124.9% 125.0–149.9% 150.0–174.9% 175.9–199.9% 200.0–399.9% 400% or more Cumulative distribution Percentage of Plans