Statement of

Patrick J. Purcell

Specialist in Social Legislation

Congressional Research Service

Testimony before the Senate Committee on Finance

June 30, 1999

ACash Balance Pension Plans@

During the 1990s, both the number and proportion of American workers who participate in employer-sponsored pensions or retirement savings plans have increased. Data from the Bureau of the Census show that between 1990 and 1997, the number of workers between the ages of 20 and 64 who participate in such plans rose from 51 million to 58 million, representing an increase in coverage from 47% of the civilian work force to 49%. At the same time, there has been a shift in coverage away from traditional Adefined benefit@ pensions toward Adefined contribution@ plans, such as those authorized under section 401(k) of the tax code. Defined benefit plans typically pay a lifelong annuity based on years of service and final pay. Defined contribution plans operate much like savings accounts in which contributions from employers and employees accumulate on a tax-deferred basis during the employee=s working years. The retirement benefit in a defined contribution plan depends on the value of the account when the employee reaches retirement. According to the U.S. Bureau of Labor Statistics, coverage by defined benefit pensions in firms with 100 or more workers fell from 59% of employees in 1991 to 50% 1997. During the same period, the proportion of workers in these firms who participated in a defined contribution plan rose from 48% to 57%.

What is a Acash balance plan@? In recent years, many employers have modified their traditional defined benefit pensions so that they have some of the characteristics of defined contribution plans. The most common of these so-called "hybrid" pensions are cash balance plans. Press reports over the past several months have quoted industry sources as saying that more than 500 medium and large firms have adopted cash balance plans, covering between 7 million and 10 million workers. What is a cash balance plan? Rather than defining an employee=s accrued benefit as a stream of monthly payments based on years of service and final pay as a traditional plan would, a cash balance plan defines an employee=s benefit as an account balance to which pay and interest credits are periodically contributed by the employer.

In a cash balance plan, the employer contributes a percentage of pay into an employee Aaccount@ and credits interest to the account at whatever rate or index of rates the employer chooses. Many firms peg their interest credits to the yield on 1-year U.S. Treasury Bills or the interest rate paid by 30-year Treasury Bonds. Employees receive periodic statements of their accumulated pay and interest credits, but unlike a defined contribution plan such as a 401(k), these employee Aaccounts@ are merely bookkeeping devices: all of the assets of a cash balance plan are commingled in a pension trust managed by the employer or its designated trustee. Vested employees have the legal right to receive retirement benefits from a cash balance plan, but it is the employer that owns the plan=s assets. Any appreciation of the plan=s assets beyond the rate of interest that the employer has promised to credit to employee accounts can be used by the employer to make future pay and interest credits to employee accounts.

Because the assets of cash balance plans are commingled rather than separated into individually-owned accounts, these plans are classified under federal law as defined benefit pension plans. The Internal Revenue Code designates plans that provide individual accounts for each participant and pay benefits based solely on the contributions to the accounts and subsequent investment gains or losses as defined contribution plans. Any plan that does not fit this definition is a defined benefit plan. The individual accounts in a cash balance plan are merely hypothetical accounts used to describe an employee=s accrued benefit. They are not employee-owned individual accounts.

Reasons for the Growing Popularity of Cash Balance Plans. Cash balance plans have become popular both among employers seeking to reduce their pension-related expenses and among those who wish to spread current pension expenditures more evenly over their work force. Converting a traditional pension plan to a cash balance plan will not necessarily reduce a firm=s pension expenses. Nevertheless, a conversion to a cash balance plan can be designed to result in lower pension expenses if that is a priority for the plan=s sponsor. 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. Funding expenses, therefore, are more level throughout an employee=s tenure. Furthermore, in a cash balance plan the employer promises only to make regular pay and interest credits to the plan rather than to replace a specific percentage of final pay. Employers can set the pay and interest credits at levels that reduce their total expenses compared to their previous defined benefit pension plan.

Another reason that cash balance plans have become popular is an increasing concern among employers that traditional pensions, designed mainly for the benefit of employees who spend 25 or 30 years with one employer, are ill-suited to, and not sufficiently valued by, younger employees in a highly mobile workforce. Cash balance plans can be attractive to younger workers because the benefit is described in terms of an account balance C similar to a defined contribution plan like a 401(k) C and because the sponsors usually pay accrued benefits to employees who depart before retirement in the form of a lump-sum distribution. Moreover, a larger proportion of total lifetime benefits accrue early in one=s career under a cash balance plan than under a traditional pension based on final average pay. Younger workers might therefore place a higher value on a cash balance plan than they would on a traditional pension in which the bulk of benefits accrue in the years just before retirement.

AFront-loading@ vs. ABack-loading@ of Benefits. Traditional defined benefit pensions are sometimes described as being Aback-loaded@ because they typically compute a retiring worker=s benefit based on his or her final average pay, such as average salary in the last 5 years of employment. In this kind of plan, workers accrue a substantial proportion their pension benefits in the last few years before retirement, and the cost to an employer of funding pension benefits can rise steeply during these years. Retirement benefits under a cash balance plan, in contrast, accrue based on career-average pay, and employer costs rise less steeply over time. The final value of benefits accrued in a cash balance plan depend crucially on the rate of interest the employer credits to the plan and the number of years over which the interest credits are compounded. Because pay and interest credits received early in a worker=s career have more years during which to accrue further interest credits, cash balance plans are in effect Afront-loaded@ pension plans. Workers who are converted to a cash balance plan at mid-career will have spent the early part of their working lives in a back-loaded plan and their later working years in a front-loaded plan, thus enjoying the full benefits of neither. For this reason, some employers who have converted their pensions to cash balance plans have allowed workers with long periods of service to remain under the old plan.

Questions of Age Discrimination. Some pension analysts have raised questions as to whether cash balance plans discriminate against older employees because interest credits compound over fewer years for these workers, resulting in lower benefits at the normal retirement age compared to a younger employee with the same initial account balance. The Employee Retirement Income Security Act (ERISA) and the Age Discrimination in Employment Act prohibit discrimination on the basis of age in employee benefit plans. Neither the IRS nor the Department of Labor has indicated publicly that cash balance plans conflict with these statutes. Moreover, since cash balance plans were first developed in the mid-1980s, hundreds of employers have received determinations from the IRS that their cash balance plans qualify for income tax deductions and deferrals.

Lump-sum Payment Option. An employee covered by a cash balance plan who separates from an employer prior to retirement usually is given the option of taking a lump-sum distribution from the plan. This option gives employees who change jobs the opportunity to re-invest their accumulated retirement benefits. It also relieves the employer of a long-term financial liability, an ongoing administrative expense, and the obligation to pay insurance premiums to the Pension Benefit Guaranty Corporation for former employees. Employers can pay accrued benefits to departing employees as a lump-sum under traditional pension plans, too; accrued pension benefits can be calculated at any point during a worker=s career under both traditional defined benefit plans and cash balance plans. In practice, however, many employers pay lump-sum distributions from traditional pension plans only if the present value of the accrued benefit is less than $5,000. In either a traditional defined benefit plan or a cash balance plan, if the present value of the benefit is more than $5,000 it can be paid as a lump sum only with the written permission of the employee and his or her spouse.

Employer-directed Investment. The investment earnings of the pension trust containing the assets of a cash balance plan may be more or less than the interest rate credited to the employee accounts. If the earnings of the trust are less than the rate of interest promised by the plan, the employer is legally obligated to make up the difference. Thus, as in a traditional defined benefit pension, the employer bears the financial risk associated with unpredictable changes in the value of the plan=s assets. On the other hand, the employer will benefit from rates of return on the plan=s assets that exceed the interest rate it has promised to credit to employee accounts. Any excess over the rate of return needed to credit the employee accounts can be used by the employer to make future credits to the accounts. This contrasts with defined contribution plans, in which the employee bears the risk that the account may lose value, but in which he or she also keeps any investment gains. Moreover, converting a traditional defined benefit pension to a cash balance plan can result in a plan that was underfunded becoming fully funded because of the difference in the expected rate of return on the plan=s assets and the interest rate credited to employee accounts. Some employers who have converted traditional defined benefit plans to cash balance plans have been able to suspend their contributions to the pension plan, making the required pay and interest credits from excess pension fund assets.

Disclosure Issues. Recently, in trade journals and at forums on employee benefits, consultants have emphasized the importance of addressing workers= anxieties about pension conversions by keeping them informed about the process. ERISA requires pension plans to notify participants of any amendment that will result in a significant reduction in the rate of future benefit accrual at least 15 days before the amendment takes effect. Some employers have distributed detailed information to their employees describing how the transition to a cash balance plan will affect their individual retirement benefits, while others have provided only a general description of the plan amendments. Employees who know the value of their benefits under the old plan and the rate at which they will accrue benefits under the new plan are better able to decide how to respond to the change. Some might wish to save more on their own. Others might prefer to move to another job. S. 659, introduced by Senator Moynihan and H.R. 1176, sponsored by Congressman Weller, would expand the disclosure requirements for pension plans with 1,000 or more participants that are amended to reduce the rate of future benefit accruals.

Setting the Initial Account Balance. ERISA prohibits employers from reducing pension benefits that have already been accrued, but they may reduce the rate at which future benefits will accrue. Consequently, the employer can set the initial value of a cash balance account at any amount, provided that separating employees who take a lump-sum are paid the greater of the present value of their accrued benefit under the old plan and the present value of the cash balance account. Some employers set the initial value of a cash balance account equal to the present value of the benefits an employee had accrued under the firm=s traditional defined benefit plan. However, 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 equalize the value of the two plans. Pension analysts call this period when no new benefits accrue a Abenefit plateau@ or Awear-away@ because even if the employer begins to apply pay and interest credits to the cash balance account immediately, employees must Awear away@ the difference between the starting account balance and the value of their benefit under the old plan before new benefits begin to accrue. Why would an employer set the opening value of a cash balance plan lower than the present value of the benefit accrued under the firm=s old plan? By setting a low opening balance, the employer can apply future pay and interest credits to employee accounts from money that is already in the pension fund. In such cases, an employer might go several years without making additional contributions to the plan.

If an employer sets the opening balance of an employee=s hypothetical cash balance account equal to the present value of benefits accrued under the traditional plan, there is no Abenefit plateau,@ and the employee begins to accrue new pension benefits immediately. Employees also will begin to accrue new benefits immediately if they are all given an initial cash balance account of zero. Some firms that have followed this method have put the benefits that employees accrued under the old plan into an interest-bearing account so that these benefits, too, will continue to increase in value. Even without this so-called Abenefit plateau,@ employees who are converted to a cash balance plan at mid-career can suffer substantial reductions in the pension benefits that they will have accrued by the time they reach retirement age because they will not experience the rapid accrual of benefits in the years immediately before retirement which typically occurs in traditional defined benefit plans.

Choosing an Interest Rate. When choosing the rate at which interest will be credited to employee accounts in a cash balance plan, an employer will likely consider several factors:

Several recent articles in trade journals of the pension industry have noted the criticism that the rate of interest credited to participants in cash balance plans can be significantly less than the actual rate of return on the assets held in the pension trust. This arrangement has been defended by some plan sponsors as reasonable because the employer bears the risk that actual returns could be lower than the interest rate promised to participants, in which case the sponsor is legally required to make up the difference from its own resources. Some other sponsors, however, have responded by adopting amendments that promise plan participants at least a specified minimum rate of return plus a share of any return on the trust=s assets that exceeds that minimum.

Valuation of Lump-Sum Distributions Because cash balance plans are not individual accounts owned by the employee, the value of a vested employee=s accrued benefit C and the amount of a lump-sum distribution from the plan C is legally determined by the sections of ERISA and the Internal Revenue Code that govern defined benefit plans. The difficulty in valuing lump-sum distributions from cash balance plans is that the federal statutes governing these plans describe the accrued benefit in very different terms than the plans themselves use. Whereas cash balance plans describe accrued benefits in terms of an Aaccount balance,@ the relevant federal statutes describe accrued benefits in all defined benefit plans in terms of an Aannual benefit commencing at normal retirement age.@ The law requires that any other form of payment must be Athe actuarial equivalent of such benefit.@ Determining the value of a lump-sum distribution from a cash balance plan in compliance with ERISA and the tax code, therefore, depends on the meaning of the terms Aaccrued benefit@ and Aactuarial equivalent of such benefit@ as they apply to cash balance plans.

ERISA protects departing vested employees who receive lump-sum distributions from being paid less than the present value of the benefit that would be payable at the plan=s normal retirement age. Federal regulations prescribe the methods for valuing lump-sum distributions from traditional DB plans and the IRS has published regulatory guidance for valuing lump-sum distributions from cash balance plans. Under the regulatory guidance published by the IRS, the employer must project the cash balance account forward to the plan=s normal retirement age using the interest rate or index of rates set forth in the plan documents. This amount must then be discounted to the present, using the interest rate paid by 30-year U.S. Treasury bonds in the month prior to the distribution. A departing employee must be paid the greater of the present value of the cash balance account as determined by this method and the present value of benefit that he or she had accrued under the old plan.

If the interest rate credited to a cash balance plan by an employer differs from the 30-year Treasury bond rate, then the present value an employee=s accrued benefit can be more or less than the nominal value of pay and interest credits that have been allocated to the employee=s account. If the employer credits interest to a cash balance plan at a higher interest rate than the plan is required to use for valuing lump-sum distributions, then the present value of the accrued benefit will be greater than the nominal account balance. The plan must pay the greater of these two amounts if a departing employee takes a lump-sum distribution. If interest is credited to the plan at a lower rate than is used for lump-sum valuations, then the present value of the accrued benefit will be less than the face value of the account, and the employer can legally pay the lesser amount as a lump-sum distribution. A pre-retirement lump-sum distribution from a cash balance plan will need to be the same as the face-value of an employee=s cash balance account only if these two interest rates are equal.

Employer valuations of lump-sum distributions from cash balance plans have been the source of at least two lawsuits recently decided in federal courts in Vermont and Georgia. In both cases the plaintiff claimed that the distribution was less than the amount owed by the plan and in both cases the Federal District Court ruled in favor of the employer. The value of lump-sum distributions from cash balance plans is likely to be a continuing source of disagreement because the pertinent statutes were written with reference to traditional defined benefit pensions. Moreover, the Federal District Court in Atlanta, while dismissing the plaintiff=s claim for a larger lump-sum distribution from a cash balance plan, ruled that the relevant Treasury Department regulations are Aunreasonable.@

IRS Notice 96-8 An accrued benefit and its actuarial equivalent under a traditional defined benefit plan can be determined for an employee of any age by applying the plan=s benefit formula and the prescribed interest rate and mortality assumptions. The Internal Revenue Service has addressed the issue of lump-sum distributions from cash balance plans in Notice 96-8, published in February 1996. The notice states that the accrued benefit under a cash balance plan includes the value of interest credits up to the plan=s normal retirement age. These interest credits comprise part of the nonforfeitable portion of the present value of the employee=s accrued benefit, as interpreted by the IRS. In other words, when determining the present value of an employee=s accrued benefit (the present value being the Aactuarial equivalent@ of an annuity beginning at the plan=s normal retirement age) the employer must project the account balance forward to the plan=s normal retirement age, including the periodic interest credits that have been promised to plan participants. The present value of the accrued benefit will be same as the nominal value of the cash balance plan only if the same interest rate is used to project the account forward to normal retirement age and discount it back to the present. The interest rate credited to employee accounts is chosen by the employer, but the discount rate is prescribed by federal law. Consequently, there may be many instances in which the two rates differ.

The practical effect of the IRS regulation prescribing the method for valuing lump-sum distributions from cash balance plans is that any employer who credits interest to a cash balance plan at a rate higher than the rate paid by 30-year Treasury bonds may be legally obligated to pay a pre-retirement lump-sum distribution that is more than the nominal value of an employee=s cash balance account. Conversely, an employer who credits interest to a cash balance plan at a rate lower than the rate paid by 30-year Treasury bonds may legally pay a pre-retirement lump-sum distribution that is less than the nominal value of an employee=s cash balance account. Such differences between the nominal value of a cash balance account and the value of a lump-sum distribution from the account will occur whenever the interest rate credited to participants by the employer differs from the rate at which employers are required by law to calculate the present value of an employee=s accrued benefit.

Many employers may be unaware that in some instances they may be obligated to a pay lump-sum distribution in excess of the nominal value of a cash balance account, and that in other situations they may legally pay a lump-sum distribution that is less than the nominal value of the account. Most employees in cash balance plans likewise have yet to discover that if they separate from their employer prior to retirement and elect to take a lump-sum distribution they may in some circumstances be entitled to receive more than the amount of pay and interest credits attributed to their Aaccounts,@ while in other cases they may legally be paid less than this amount. That there is any uncertainty about the amounts that employers are legally obligated to pay as lump-sum distributions from cash balance accounts C and that vested employees are legally entitled to receive C results mainly from the application to these plans of statutory language that was developed with reference to traditional defined benefit pensions. In light of the rapid adoption of cash balance pension plans by employers, and given the likelihood of future litigation between plan participants and pension administrators, many observers have called for legislation that would clarify the meaning of pertinent sections of ERISA and the Internal Revenue Code as they apply to these plans.