Some weeks ago the business press reported that IBM had revised its intention to switch employees from a traditional defined benefit pension plan to the newer and more controversial cash balance system.
IBM’s action was provoked by massive and very public protests from older employees who claimed that the move to cash balance accounts would mean a loss in the value of their pensions. By adopting a pension system that benefits young workers at the expense of older ones, these employees said, IBM was guilty of age discrimination.
Knowledge at Wharton asked Olivia Mitchell, executive director of Wharton’s Pension Research Council, for her analysis of cash balance pensions and their impact on both companies and employees. The topic was highlighted in her recent book, Positioning Pensions for the 21st Century, co-edited by Michael S. Gordon, Mitchell, and Marc M. Twinney (University of Pennsylvania Press, 1997).
Knowledge at Wharton: What exactly is a cash balance pension?
Mitchell: A cash balance pension plan is one where participants are told how much will be contributed to the plan each year of their employment, and the employer provides a guaranteed rate of return on that contribution. Employees thus accumulate a steady ‘cash balance’ as they go along. Under U.S. law this is considered a defined benefit plan.
The traditional defined benefit plan, unlike the cash balance plan, is somewhat backloaded. By that I mean the value of the pension rises quickly when an employee is five to 10 years from retirement, as opposed to rising smoothly over the employee’s whole career. In a cash balance plan, by contrast, benefit values rise gradually over the worklife. Each year the employee’s contribution goes into the plan and each year the funds earn a guaranteed rate of return.
So the people who benefit from being moved to a cash balance plan are younger employees who get a higher accrual earlier in life. The people who do not benefit typically are within five to 10 years of retirement.
One thing that struck me while I watched the Congressional hearings on the IBM case last month was that all parties seemed to agree that cash balance plans – which already exist in about 300 companies – have merits. What was at issue in the IBM case was how people were treated in the switch from the old plan to the new one. It wasn’t that employees hated the new plan or that they were losing any of their past benefits. Rather, certain people felt they were losing future pension promises as a result of the transition.
Knowledge at Wharton: In the IBM case, do you agree that these employees had a legitimate complaint against the company?
Mitchell: We must recall that under U.S. pension law, only past pension benefits already earned are protected. Put another way, people who had accrued a benefit based on their past service and salary are guaranteed to receive those promised payments when they retire. What IBM changed by adopting a cash balance system is the formula by which future benefits will be computed. That is completely legal under ERISA (the Employee Retirement Income Security Act).
Despite the fact that the company’s action was apparently consistent with the law, workers became upset about the transition process. Many people don’t realize that IBM originally offered 30,000 employees close to retirement the option to stick with the old plan or move to the new one. But even younger employees realized that they were going to be looking at a flatter accrual profile in the future, and they discovered that in other companies which switched to cash balance, employees 10 to 15 years from retirement had been allowed to take whichever benefit proves to be greater.
Following media criticism fed by a barrage of e-mail, IBM subsequently increased the number of people offered the choice from 30,000 to 65,000 – essentially anybody who was 40 years or older who had at least 10 years of service.
What is dramatic about this gesture is that by grandfathering employees from the age of 40 and up, IBM has now contracted to deliver a huge benefit to some 65,000 workers who previously did not have this guaranteed pension promise. By doing so, the company moved beyond guarantees of past pension accruals – required under ERISA – to firm contracts for future pension accruals. This represents a tremendous change in the way employers think about the long-term pension promise made to young employees.
Knowledge at Wharton: We know why older employees might not like the transition to a cash balance pension. What about younger employees?
Mitchell: One reason some of the older, larger companies are switching to cash balance plans is they are being pressured to by their employees. Workers in traditional defined benefit plans see their friends with 401k plans making money in the stock market, and they too want access to an account that accumulates. While a cash balance plan does not permit participants to select their own investment portfolio, it does give employees the sense of fund accumulation, and with this a sense of participating in their pensions, which many like.
Also, a cash balance system allows some portability. If you work with a company for a few years and then leave, you can roll the money over into your new employer’s pension plan or into an individual retirement account. This is different from the old defined benefit plan, which discouraged job change by cutting benefits for those who switched firms.
Knowledge at Wharton: IBM’s experience aside, will more companies offer cash balance pensions in the future?
Mitchell: Most firms sponsoring cash balance plans today are the large Fortune 500 firms companies with old, overfunded, defined benefit pensions. I suspect that as long as the stock market does well, defined benefit plans remain overfunded, and companies need a young, more mobile employee population, the trend to cash balance plans will continue.
Knowledge at Wharton: From the company’s point of view, are cash balance plans a good strategy?
Mitchell: Companies like cash balance plans for several reasons: One, they are easier to explain to employees than the traditional benefit-formula plans. Two, they do not "tie" older workers to the job, which helps when firms need to downsize. Three, the cash balance plan is easier to value in a merger/acquisition situation than a traditional defined benefit plan (because fewer actuarial assumptions required). Four, if a firm has an overfunded pension and converts to a cash balance pension, it can use the excess cash toward a retiree health insurance program without triggering excise taxes that would occur if the firm terminated the plan altogether.
Knowledge at Wharton: News reports talk about threats to cash balance accounts from many fronts, including the IRS and the EEOC. Are these serious threats and what do they mean for employers?
Mitchell: The IRS testimony before the Senate panel reviewing the IBM case did not sound like age discrimination was going to be a big issue. On the other hand, one reason IBM probably extended the transition benefits to people over 40 is that this is the cutoff for protected groups under the age discrimination act.
Knowledge at Wharton: From our discussion of the IBM situation, it sounds like you think the company did the right thing in grandfathering the 65,000 employees. Is that correct?
Mitchell: Time will tell if IBM did the right thing. It does seem clear that more could have and should have been done in terms of communicating to employees what was happening to their plan, and how.
This case brings home the essential importance of getting workers better informed about, and involved in, their benefit plans early and often! Certainly this IBM experience is making many more people – both employees and managers – develop a keen interest in benefits, which is useful for increasing peoples’ literacy level regarding pensions. The typical American family faces a large retirement income gap, as I’ve shown in the Pension Research Council’s newest book, Forecasting Retirement Needs and Retirement Wealth, coming out at year end. We show how the concept of retirement itself is changing, and how this in turn influences what assets we should hold on to and how we should manage them during the ever-lengthening retirement period. One important lesson is that better financial education must be sought and provided, particularly in the area of company-sponsored pension plans.