I. Introduction

Many employers are adopting a new form of hybrid pension plan called a "cash balance" plan. Cash balance plans raise several issues that have led to proposed legislation, discussed at a recent Senate Finance Committee Hearing, to increase disclosures provided by employers that adopt such plans. This memorandum describes the controversy surrounding cash balance plans and the proposed legislation.

There are generally two types of retirement plans provided by employers – defined benefit and defined contribution plans. A "defined benefit" plan is one that pays a benefit to plan participants based on a formula, typically a percentage of final salary (or final average salary) multiplied by years of service (usually subject to limits on the salary amount and years of service that may be taken into account). Because the participant’s benefit is fixed, the investment risk is on the employer. A "defined contribution" plan, on the other hand, is one in which the participant’s benefit is based on the account balance in the participant’s individual plan account, which is determined by periodic employer and/or employee contributions. Because the benefit is not fixed, the investment risk is on the participant.

A cash balance plan is a hybrid of these two types of plans. Legally, a cash balance plan is a defined benefit plan, governed by the same rules that govern traditional defined benefit plans under federal law, because the benefits rather than the contributions are defined under the plan and the investment risk is with the employer, not the participants. However, the benefit is determined differently than under a traditional defined benefit plan. Rather than defining an employee's accrued benefit as a stream of payments based on years of service and final salary, a cash balance plan defines an employee’s accrued benefit as an account balance that annually accumulates pay and interest (or like) credits, similar in operation to a defined contribution plan. Because of the method of accrual, cash balance plan benefits are based on annual salaries over an employee’s entire working career ("career-average" salary) rather than final salary, so that the benefit at retirement typically would be less than under a final average pay plan.

Many employers are making the transition to a cash balance plan pension system in order to better attract talented workers in today's more transient workforce. According to those who have examined the issue:

• The new cash balance plans may be more attractive to employees because they can see their benefits accrue more evenly over their career, rather than having the bulk of their benefits accrue in the years just before retirement.
• Many employees may not see themselves staying with the same company until retirement, and thus may prefer cash balance plans because they are more portable than the traditional plans. Furthermore, a participant in a cash balance plan who changes jobs would likely have a greater benefit accrual by mid-career than would a participant in a traditional plan.
• Cash balance plans are easier to understand than traditional plans because they show benefits in the form of individual accounts, and as such are better appreciated by workers than traditional plans.

Cash balance plans are also popular among both employers seeking to reduce their pension-related expenses and those who wish to spread current pension expenditures more evenly over their work force. Because benefits in traditional defined benefit plans are typically based on final average pay, the cost to an employer of funding these benefits can rise steeply as an employee approaches the plan’s normal retirement age. In contrast, benefits in a cash balance plan accrue based on career-average pay rather than final-average pay, making funding expenses more level throughout an employee’s tenure.

There have been a number of criticisms leveled at cash balance plans, particularly in connection with situations where an employer is converting its traditional defined benefit plan into a cash balance plan.

Employees most concerned with the conversion from traditional defined benefit plans to cash balance plans typically are those near retirement or in mid-career. These employees’ pay and interest credits under a cash balance plan in their remaining years of service may not build up a retirement benefit equivalent to their projected retirement benefit under a more traditional final average pay plan, a consequence of the differences in benefit accrual patterns under cash balance plans versus final average pay plans and the fewer number of years remaining for interest credits to build up in their accounts. The fact is that depending on the design parameters of the new and old plans and the type of grandfathering provisions, employees past a certain age or a certain number of years of employment with the same employer will likely receive lower benefit accruals in a career average pay plan than in a final average pay plan. These benefit accrual patterns are a feature that makes generic cash balance plans less popular with older employees and those with longer tenure.

By law, workers cannot lose any of the benefits that have accrued in the old plan as of the date of the retirement plan conversion. However, the law does not specify that opening account balances must be equal to the present value of accrued benefits under the old plan. If the initial value of a cash balance plan is established at less than the employee's accrued benefit under the old plan, the employee ceases to earn new pension benefits until subsequent pay and interest credits equal the value of the old plan benefit – that is, until the additional credits "wear away" the excess accrued benefit. For example, if an employee had accrued a $15,000 benefit under a traditional pension plan, and the employer set the initial cash balance plan amount at $10,000, then the employee effectively would not earn any additional benefit until his or her cash balance plan account reaches $15,000.

Some employers have set the initial account balance in the cash balance plan equal to the present value of benefits accrued under the traditional plan, thus eliminating the "wear-away" period. Nevertheless, employers have wide latitude in setting initial amounts under a cash balance plan.

With respect to disclosure, some employers have distributed detailed information to their employees describing how the transition to a cash balance plan will affect their individual retirement benefits. Other employers have provided only a general description of the plan amendments.

Proponents of greater disclosure feel that disclosure is necessary to combat the perceived problems that occur upon conversion to a cash balance plan, since employees who know the value of their benefits under the new plan are better able to respond to the change. Also, proponents believe that the disclosure must be provided in a format that can be understood by the average employee to make informed decisions regarding his or her future employment and retirement plans.

Several bills that have been introduced in Congress, or that are expected to be introduced in the near future, would require employers to provide information to plan participants about any reduction in future benefits that would result from the conversion of a traditional defined benefit plan into a cash balance plan. While federal law currently requires that participants be notified in writing of a plan amendment significantly reducing future benefit accruals at least 15 days before it becomes effective, many in Congress and the Administration believe that additional disclosures are necessary for cash balance plan conversions.

The Pension Right to Know Act (S. 659), introduced by Sen. Moynihan (D-NY) and discussed at the recent Senate Finance Committee hearing, would require employers converting their traditional defined benefit plans to provide employees with individual statements estimating their present value of retirement benefits in the old plan and the new plan at the time of the plan conversion, as well as the projected present value of accrued benefits after three, five, and 10 years, and at normal retirement age. This expanded disclosure requirement would apply to pension plans with 1,000 or more participants.

By requiring plan sponsors to predict future benefits for each participant under both the original and the new plan, the bill would have them predicting future salary adjustments for each employee as well as the future interest rates on which cash balance accounts would grow and on which lump-sum distributions from traditional plans would be determined. Opponents of the bill argue that this process could add to the cost and administrative burden for employers that make the conversion. Thus, they argue, this burdensome process could reduce each plan participant's retirement benefit if plan sponsors adjust participants' opening cash balance account balances or reduce pay and interest credits to make up for this added administrative cost.

At the other end of the spectrum is H.R. 1102, introduced by Reps. Portman (R-Ohio) and Cardin (D-Maryland), which would require notice to be sent to plan participants 30 days before an amendment is implemented, along with a copy or summary of the plan amendment replacing the defined benefit plan with a cash balance plan. This would not require much more than current law, the principal change being to require 30 days’ notice rather than 15 days. However, some of the House members view this provision only as a starting point, so that it could be subject to further amendments as the bill moves through the House. The bill of which this provision is a part was approved by the House Education and Workforce Committee on July 14.

Going beyond the Portman-Cardin proposal, but not as far as the Moynihan proposal, is an "enhanced disclosure" proposal being advanced by several lawmakers (principally Rep. Matsui, D-California) and supported by the Administration. It would require employers with 100 or more employees to give affected workers a clear and complete explanation of any benefit reductions at least 45 days before the changes take effect, describing the reduction and providing examples illustrating how the amendment would affect different groups of workers. While it would not require participant-specific examples of the benefit reductions, like the Moynihan bill, it would require that participants be furnished with a description of the old and new benefit formulas, so that they could make estimates similar to those in the general examples based on their personal information. The notice would indicate whether any class of workers will have a freeze on benefit accruals until they "wear away" their current accrued benefits. The proposal has not yet been drafted as legislation.

The advantage of this proposal over the Moynihan proposal is that it would involve a much reduced burden for employers. However, it still would pose the problem of requiring employers to project assumptions on salary and interest rates in preparing examples, an issue that is still under discussion.

There also are variations of these proposals that have found their way into the Republican tax bills that were recently passed by the Senate and House. The Senate tax bill, introduced by Sen. Roth, would require that an initial disclosure be sent to participants 30 days before a plan amendment reducing future benefit accruals becomes effective, with a full description of the amendment and how it would affect various groups of employees. Within six months of the plan amendment, employers would be required to send out a more specific explanation to individual participants describing the participant’s pre-amendment benefit and post-amendment benefit as of the date of the change, and provide a way for individuals to calculate their future benefits under the amended plan. Details would be developed through Treasury regulations. The House tax bill, H.R. 2488, would require a plan with more than 100 participants to provide written notice of a change within a "reasonable" time to be defined by Treasury regulations. The Conference Agreement adopted a modified version of the House provision that incorporates the time period and information requirements of the Senate provision, including the additional notice to be provided within six months.

While each of these disclosure proposals is directed at cash balance plans, most take the form of amendments that would apply more broadly. Consequently, they would place additional burdens on all defined benefit plan changes, not just cash balance plan conversions, an issue that raises some concern in view of the decreasing popularity of defined benefit plans.

Disclosure provisions are not the only proposals circulating in Congress related to cash balance plans. Sen. Harkin (D-Iowa) recently introduced S. 1300, which would prevent the "wear away" of an employee’s accrued benefit through adoption of a plan amendment reducing future accruals – a measure aimed at cash balance plan conversions. He and other members of Congress also have written to the IRS to request that it stop issuing determination letters for cash balance plans until the IRS resolves the potential age discrimination issues (an alleged consequence of younger employees accruing benefits at a faster rate than older employees closer to retirement).

It is not clear at this time whether any of these provisions is likely to pass, given the complex nature of the issues involved. The one with the greatest chance is the Portman-Cardin proposal in H.R. 1102, since H.R. 1102 is a comprehensive pension reform bill. However, even the drafters view that proposal as a starting point, not a solution. Consequently, as more companies seek to convert their plans to cash balance plans (some recent examples include IBM and Montgomery Ward), there is likely to be much more discussion on cash balance plan issues.