By David L. Wolfe and Gary W. Howell
The gap between the "traditional" pension plan and the "new" defined benefit plans still probably can be accomplished most effectively through hybrid pension arrangements such as cash balance or pension equity plans. However, cash balance programs in particular have drawn the negative attention of some. Consequently, in analyzing the possible utility of these hybrid arrangements, employers should keep the new cash-balance developments discussed in this article firmly in mind.
Originally published in the November, 2002 issue of PlanSponsor magazine.
As the stock market "correction" continues, post-Enron shakeout reverberates throughout the 401(k) industry, and baby boomers continue their inexorable march toward retirement, the focus on adding a defined benefit plan element in addition to an existing 401(k) plan is growing at many large employers. However, the funding cost, administrative burden, and benefit complexity of traditional final-average-pay pension plans have all caused employers to shy away from such plans during the past two years.
The gap between the "traditional" pension plan and this "new" need still probably can be accomplished most effectively through hybrid pension arrangements such as cash balance or pension equity plans. However, cash balance programs in particular have drawn the negative attention of some. Consequently, in analyzing the possible utility of these hybrid arrangements, employers should keep the following new cash-balance developments firmly in mind:
Workers are more aware and concerned, particularly about pension change. Employees have become more activist-oriented in interacting with their employers on cash balance plan issues, especially where an existing final-average-pay pension plan is being converted to a cash-balance plan.
This activism is manifesting itself, in part, through the implementation of employee Web sites where issues of common interest are circulated and debated. This development is based partly on adverse press reports concerning cash balance plans in recent years, and it should cause employers to be especially sensitive in developing an early and comprehensive employee communication program in the plan-conversion process and in anticipating and reacting to employee inquiries or concerns. Information should be provided to employees regularly from the beginning of the project and difficult questions should be addressed directly and candidly.
Heightened government scrutiny of these programs remains a threat. The U.S. Department of Labor recently released a study of 60 cash balance plans and announced that 13 of them were paying out benefits at a rate less than the plan’s benefit promise.
This is causing an increased level of benefit scrutiny in such plans. For existing cash balance plans, a limited legal compliance review focusing on this issue may be appropriate. If problems are uncovered voluntarily in this manner, there is more flexibility in correcting them on a cost-effective basis outside of the litigation or audit context. For a new plan, it is critically important to develop administrative systems that calculate the level of promised benefit accurately and pay the appropriate amount systematically from the plan’s inception.
Worker choice can be a formula for success. New cash-balance plans often provide full grandfathering of the former final-average-pay benefit to older, longer-service employees in conversions from such plans to cash-balance plans, so that such employees receive the higher of the two benefits in all cases.
A recent alternative strategy is to provide such participants with a choice between the final-average-pay formula and the new cash balance benefit. This choice may be one time only at the time of conversion or on a continuing basis at least for a period of several years. The "choice" conversion model presents very challenging participant disclosure issues so that participants are able to make informed decisions. Both the full grandfathering and choice models may increase the overall plan cost significantly. It is critical to develop accurate costing models for these benefits to ensure that negative funding surprises do not arise.
Cash balance plans have drawn class-action suits. A series of class-action lawsuits have been filed recently by experienced plaintiffs’ legal counsel. These cases generally are based on theories under which cash balance plans are claimed to have underpaid participants. One common theory is based on age discrimination claims. A second is the so-called "whipsaw" issue discussed in the following paragraph. It is clear from these complaints that class-action plaintiffs’ counsel are scouring public records to find cash balance plans that conceivably violate one of these rules. These tend to be high-profile, costly cases with very large possible monetary exposure, especially for first- and second-generation cash balance plans that were established 10 or more years ago. Strategic and litigation defense techniques may be utilized to reduce this exposure significantly, however, as noted below.
The "whipsaw" effect remains an issue. Recently, two well-publicized U.S. Court of Appeals cases have been decided against cash balance plans on the "whipsaw" issue. The U.S. Supreme Court has agreed to hear one of the cases. Potential liability of a particular cash balance plan depends on numerous factors, including: when the plan was established, or converted to the cash balance format; how plan provisions describe the "accrued benefit" and lump-sum payment; the plan’s interest crediting rate; when the plan adopted the "GATT" interest and mortality factors; how lump sums were calculated and administered; whether the IRS requested specific information about "whipsaw" when the plan was submitted for a determination letter; and what participants were told (in summary plan descriptions or otherwise) about lump sum payouts.
Cash balance plan sponsors are addressing possible legal exposure through plan amendments, use of voluntary IRS compliance resolution procedures, and legal compliance and fiduciary reviews.
Conversions will require additional disclosure. Plan conversions are now subject to more detailed participant disclosure rules under Section 204(h) of the Employee Retirement Income Security Act of 1974 (ERISA), as amended by the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). The Treasury Department is in the process of filling in the substance of those rules through regulations that it recently proposed. Earlier and more individualized employee communications will be required under these rules and much more detail will need to be disclosed.
The impact of these developments is to make the administration of cash balance plans more complicated and the underlying benefits more costly. Nevertheless, cash balance plans can still be cost effective and tie very well to an employer’s existing 401(k) plan. As the clamor for defined benefit plans intensifies based on market conditions, Enron fallout, and the aging of our population, cash balance or similar hybrid plans remain the most viable defined benefit delivery vehicle for 2002 and beyond.
Reprinted with permission from PLANSPONSOR magazine and plansponsor.com. ©Asset International, Inc. All rights reserved.