How HR Is Making Pensions Portable
Duracell is one of a growing number of companies that's redesigning and simplifying its pension plan to meet the needs of a changing work force—and part of that means making it portable. In the latest twist to pension planning, more companies today are learning that it can be advantageous to allow employees to take their retirement income when they leave and roll it over into a new employer's savings plan or IRA.
For most employers, this represents a major shift in thinking. Formerly, the primary purpose of a pension was to retain workers and reward long-term service. Employers are finding that this equation no longer holds true. Today's reality is that employees are more mobile and less likely to be at a company long enough to benefit from traditional pension plans. For competitive reasons—such as the need for flexible staffing to keep costs down—many businesses are less-in-clined to want employees to settle in for the long haul.
"Companies are taking a hard look at whether their current plans meet their objectives," says Mike Wright, who's a partner specializing in retirement planning at Lincolnshire, Illinois-based Hewitt Associates.
Adds Anthony R. Martin, national director of the defined-contribution practice for Coopers & Lybrand in Chicago, "The old retirement philosophy doesn't work anymore. Originally, companies offered pension plans because they wanted people to be productive and not have to worry about security. But that was when they stayed at one job. Now they don't anymore. Consequently, the trendsetters are looking at portability."
In 1988, for example, The Equitable Life Insurance Company in New York City redesigned its pension plan after discovering through a review of its actuarial assumptions that only 8% of its employees were expected to retire with the company. At the time, the company was offering a retirement package that was designed to reward long-term employees who left the company only after age 55. Given what the company saw happening in the future, this didn't make sense. Consequently, The Equitable adopted a more portable pension plan, which also saved the company a significant amount of money. "We realized that the turnover had accelerated," says Robert Sjogren, the company's vice president of employee benefits. "It didn't seem as if it was going to get any better."
Similarly in 1989, Wendy's International, in Dublin, Ohio, restructured its pension plan, in part to give its key employees—store managers—better retirement benefits. Through informal surveys, management had identified these employees as key to the bottom-line success of the company. If the company could improve the retention rate of these employees even by a year or two, it would help improve productivity and the efficiency of Wendy's operations.
At the same time, management didn't want to kid itself or its employees by coming up with a long-term retirement package. "Most of our managers won't retire here," says Lisa Jones, director of employee benefits at Wendy's. "Telling a 21-year-old, 'You have a benefit that equals 50% of your earnings at 65' isn't going to mean much."
The pension plan that Wendy's settled on was a cash-balance plan that resembled a 401(k), in that employees could contribute part of their pay and receive a match from the company. The idea was to reward service on a real-time basis. "We decided that we weren't going to be able to provide [their] entire retirement income," says Jones, "but we'll make sure that [they] get [their] piece from Wendy's."
It's this type of thinking that's propelling companies to implement portable pension plans. Although the definition of portability varies, a typical plan works like this: Suppose that employee 1 and employee 2 work as engineers for the ABC Co. Employee 1 puts in 35 years of work at ABC. Employee 2 puts in 15 years at ABC and 20 years at four other companies. In a truly portable system, employee 1 and employee 2 would earn approximately the same pension when they retired, provided that they were close to the same income level. Because of the way in which most pension plans currently are set up, employee 2 probably will have a substantially lower retirement income because he has worked for several employers.
Still, for many HR departments, discussions of portability represent nothing short of a revolution. Indeed, some old-line manufacturing companies, such as Midland, Michigan-based Dow Chemical Co., see little benefit in rewarding workers who have short tenures with the company (see "For Some Companies, Portable Pension Plans Aren't Practical," below). Meanwhile, other firms take the approach that portable pension plans are the wave of the future, and they don't want to be left behind.
Employers who opt for portability are finding that they have several choices. The alternatives include:
- 401(k) and cash-balance plans
- Pensions that rely more on age and final pay than tenure
- Other hybrids of defined-benefit or defined-contribution plans.
Which type of portable plan a company selects seems to depend on its particular work force, needs and objectives.
For example, Duracell selected a portable cash-balance plan because it wanted to create a plan that was equitable and easy to understand. New York City-based RJR Nabisco, on the other hand, adopted a Pension Equity Plan developed by The Wyatt Company. The plan rewards good performers, even if they don't retire with the organization or joined the organization in mid-career. Lincolnshire, Illinois-based Komatsu Dresser Industries Inc. wanted to create a plan that employees understood and could take with them. That's why the company changed its defined-benefit plan to a targeted-benefit plan, into which the company makes regular contributions. These companies are at the forefront of the move toward portability.
Pensions have evolved toward portability.
Historically, companies set up pension plans to provide security for workers upon their retirement. Under a traditional defined-benefit plan, an employer will pay a specific (or defined) benefit to employees at retirement. Benefits usually are determined by a formula based on the employees' years of experience and pay levels at retirement. Employees contribute the amounts necessary to provide the benefit to a trust fund and bear the risk for providing the guaranteed level of benefits. Because these plans are designed to reward long-term employees, benefits typically accrue slowly during an employee's early years and accumulate rapidly near retirement.
In recent years, more companies have turned to defined-contribution plans. This is caused in part by the complexity of administering defined-benefit plans and in response to a work force that has become more mobile and less likely to benefit from traditional plans.
In defined-contribution plans, employers and, in some cases, employees make fixed (or defined) contributions. Employers must keep individual accounts for participants, who typically can invest contributions in one or more funds offered under the plan. If an employee leaves the company before retirement, the earned portion of the proceeds is portable and can be rolled over into another plan or an IRA. Profit-sharing and 401(k) savings plans are perhaps the most common types of defined-contribution plans.
According to Eric Lofgren, a consulting actuary with The Wyatt Company in New York City, who helped RJR Nabisco redesign its pension plan, one drawback of these plans is that they're tied more closely to investment returns than to job performance. Fast-trackers will have less of their pay replaced upon retirement than they would under a traditional pension plan. As a result, several hybrids have sprung up to address the shortcomings in these plans. "Everyone agrees that some sort of pension portability ought to be done," Wright says. "No one agrees on how it should be done."
Cash-balance plans, such as the one adopted by Duracell, are designed to strike a balance between the portability of defined-contribution plans and the financial security for employees of defined-benefit plans. They're essentially defined-benefit plans that have cash balances and that employees can take with them when they change jobs. The balances are unfunded until the employee leaves the organization.
Here's how these plans typically work: An employee is credited with a certain amount of money each year, based on his or her annual pay. These contributions are compounded, based on a chosen interest rate—such as the rate for five-year treasury bills.
One drawback of these plans is their administration. Because individual account balances must be maintained, the record keeping can be burdensome and expensive. Additionally, it can be difficult to comply with IRS regulations. Several companies, however, have been pleased with these vehicles. "What's driving these plans is a desire to retain younger employees," explains Luke Bailey, a partner with the San Francisco law firm of Greene, Radovsky, Maloney & Share.
Perhaps the newest alternative to pension plans is the Pension Equity Plan. RJR Nabisco was the first organization to have adopted this type of pension plan. C & G Holdings, which is located in Oak Brook, Illinois, is implementing the plan for its salaried employees this month. Three other companies are in the process of adopting such a pension plan.
The Pension Equity Plan offers employees the security of a traditional plan plus portability. Unlike the cash-balance plan, the Pension Equity Plan is a final-average plan with benefits tied more closely to salary at separation from the company.
The plan works like this: Each year, an employee is credited with a percentage of income based on his or her age. The older the employee is, the larger the percentage. To determine the individual's lump-sum entitlement, these percentages are added up and multiplied by the employee's final average pay.
For example, suppose that a participant retires at age 65 with 20 years of service at a final average salary of $50,000. During a 20-year career, the employee accrued lump-sum credits of 220%. These credits are applied to the $50,000 in final average pay. An excess 55% of the credits are applied to pay above the threshold ($20,000 in this example). The final distribution to the worker equals $126,500. This arguably could be converted into a retirement income of 25% to 30% of pay.
The Wyatt Company and RJR Nabisco say that this plan treats all groups of employees equitably. It also doesn't punish fast-trackers and mid-career hires, because it's age-weighted and based on pay, not tenure.
A third alternative is the targeted-benefit plan, adopted by Komatsu Dresser last year. This plan is a defined-contribution plan that's designed to resemble a defined-benefit plan. The targeted-benefit plan often works well in organizations that have traditional work forces that are accustomed to a defined-benefit plan.
Here's how this type of plan works: The employer comes up with a benefit that it believes its workers should earn at retirement, based on their pay levels and years of service. Using actuarial tables and certain interest-rate assumptions, the employer then backs into the amount it would have to contribute annually to accumulate the benefit by retirement.
The advantages of this plan are:
- The employer knows what its contribution must be.
- Employees have the certainty that their pension is being funded.
Additionally, the plan can avoid the regulatory requirements for defined-benefit plans. One drawback is that employers must maintain individual account balances.
A portable pension plan positions RJR Nabisco to attract qualified employees.
For RJR Nabisco, the road to a more portable pension plan began in 1991. As Vice President of Benefits Gerald Angowitz explains, that's when the company began taking a hard look at its current pension coverage. Its goal was to make sure that it was positioned properly to attract and retain the most-qualified employees in what was shaping up to be a very diverse work force in the 1990s and beyond. After the merger between R.J. Reynolds Tobacco and Nabisco Foods Group, the company continued to look for ways to streamline its entire operation.
At the time, the company had two pension plans and two very different work forces. R.J. Reynolds Tobacco had an older work force that included many career employees. Management always had received positive feedback from employees on its pension plan. It was a defined-benefit plan that provided little buildup of value in the early years, but offered retirement income at 65 that was a percentage of final average pay.
At the other end of the spectrum was the Nabisco Foods Group, which tended to have younger, more mobile workers. Although Nabisco's salaried employees had a cash-balance plan that was designed for a mobile work force, record keeping and administrative costs were steep. Another problem was that not all of the employees were mobile. Many workers had been there for 20 or more years. Management worried that it was rewarding some underperformers because the benefit was linked to career average pay as opposed to final pay. In addition, the cash-balance plan wasn't as attractive to mid-career hires—the people who had the expertise and experience that the company hoped to woo.
To come up with a new plan design, the organization created two working groups—one for the tobacco company and one for Nabisco. Each team comprised six employees from the human resources department. The groups met every three weeks or so, usually with one of the firm's outside pension consultants.
Their mandate was clear-cut: devise a pension plan that would suit their needs best. After meeting for six months, the groups came up with their recommendations. In the end, neither group voted to keep its existing pension. "There were really enough flaws in both plans to warrant making a change," says Angowitz. "We also wanted to create something new. The feeling was that if we didn't, employees on the plan that wasn't chosen would feel that they were losing something."
The plan that both groups agreed on and put into effect on January 1 of this year turned out to be what Angowitz considers a combination of the best features of both: the Pension Equity Plan. It provides for a lump-sum benefit for each worker based on age-weighted percentages.
From the organization's viewpoint, there are several benefits to the new pension plan. Because the actual payout is based on final average pay, it seems to management to be more tied to performance. Also, the old Nabisco plan had rewarded slow-trackers more than it did fast-trackers. Under the new plan, the two groups of workers will receive comparable benefits. Because the payout is based on final average pay and an age credit, mid-career hires will have time to accumulate a better pension than they did under the old plan. The new plan also provides portability by allowing employees to take the benefit with them when they leave. Under the old plan, employees had to wait until they retired to access the funds, and they were penalized for early departures.
Another benefit of the Pension Equity Plan is the simplification of the work that benefits-department staffers must do to prove to the federal government that the plan doesn't discriminate in favor of more highly paid employees. Under the old plans, staffers had to calculate benefits for employees who had many different positions. Now Angowitz and the company's actuaries say that they'll be able to prove that the plan is fair by explaining the formula.
Angowitz says that the new plan has been a success. From the organization's standpoint, it's already working as a recruitment tool. Mid-career hires have commented to him and to other managers on the generosity of the plan, which is simple to switch to from another company's pension plan.
Angowitz expects to wring some savings from decreased administration, and the time-benefits staffers will save time because the plan is simpler to explain. Employees have told the benefits department that they like being able to find out how much money they have accrued in their pensions so far. "There's no question now that they understand how this plan works," Angowitz explains. He already has noticed a reduction in calls to the benefits office.
A targeted-benefit plan streamlines the pension plan.
When benefits manager Patricia Hanrahan helped introduce a new pension plan at Komatsu Dresser last fall, she was unsure how employees would accept it, but she had to do something.
Like many U.S. corporations, the heavy-equipment manufacturer has spent the last couple of years streamlining its operations. But until recently, its pension plan escaped any attempts at modernization. The traditional, defined-benefit plan had grown unwieldy and cumbersome, mostly because of a series of mergers. Each time that Komatsu Dresser (formerly part of International Harvester) changed ownership, it inherited a new pension plan. At the same time, employees were grandfathered in by provisions of the old pension. Calculating benefits for even one employee involved looking back through all the pension agreements.
"We were always getting complaints that employees didn't understand the plan," says Hanrahan. In addition to performing the manual computations required to arrive at estimates, benefits personnel had to show that the plan didn't discriminate and make filings with the government.
Given the state of manufacturing, employees also were growing increasingly nervous about their jobs and pensions, Hanrahan remembers. "The whole thing was confusing to employees, and they were worried," she says. At the time, Komatsu Dresser was in the process of laying off some employees. With so many companies going out of business and so many newspaper reports about underfunded pension plans, many employees were afraid that they might lose their pensions. Although Komatsu Dresser's pension isn't underfunded, the organization wanted to stop rumors before they started.
At benefits meetings, the employees started asking questions. Why couldn't they have more information about their pensions? Why couldn't they get their pensions in a lump sum when they left? Were the pensions stable?
"I kept thinking that there has to be a better way to do this," says Hanrahan. The question was how? Back in 1988, the company had implemented a 401(k) savings plan that appeared to be working well. Employees liked the idea of being able to see their balances. Hanrahan wanted to develop something similar—something that would become a substantial benefit by retirement age but wouldn't be a defined-benefit plan.
The solution was a targeted-benefit plan. This hybrid of a cash-balance plan essentially works like a 401(k), only it's entirely company-funded. Employees receive a credit annually that builds to a certain target benefit at retirement. The company has the advantage of knowing its liability on a real-time basis.
For Hanrahan, the plan means fewer calls to her office from frustrated employees, because it's simple. It's also portable, which met another HR goal. After five years, employees can take the payout in a lump sum and roll it over into a new pension plan or IRA. "When they quit or retire, they can take the money and run," says Hanrahan. "It's the kind of thing they could take to an investment advisor and say, 'Here's how much I have; what should I do with it?'"
The plan was designed for Komatsu Dresser's 1,300 salaried employees. The biggest challenge, says Hanrahan, was switching the older employees over to the new plan. No employees actually lost their deferred benefits, but they did have them frozen to age 65. Everyone cashed out of Komatsu Dresser's plan. They received a lump sum, which they could roll over into a 401(k) or the new target-benefit plan. Although all employees were enrolled in the new plan automatically, very few put their funds from the early retirement plan into it. Instead, they opted for the more familiar 401(k).
There was enough conflict along the way to make Hanrahan wonder if the plan would work. After the company started notifying employees about the new plan in September, a handful of workers who thought that the company was taking advantage of them when the other plan terminated wrote to the IRS. Hanrahan disputes the charge, but says that she can't discuss the matter while the complaints are pending.
At the moment, she's looking at part two of her push for portability. By early 1994, she hopes to spin responsibility for investing money in the plan off to the employees. Komatsu Dresser already has set up an investment committee, composed of the top financial officers of the corporation, to select investment vehicles for the plan. The idea is to give employees more selection than the standard family of mutual funds. Her biggest challenge now is finding an independent financial expert to educate employees about investments.
In the meantime, Hanrahan says, it's too early to know how the new pension plan is going over. "My guess is that once we get the first quarterly reports out, employees should start coming around. Hopefully, then we can put the trauma behind us," she says.
A cash-balance plan helps unify the work force.
When Duracell began looking for a new kind of pension plan, it initially was looking for simplicity and equity, more than portability. Duracell recently had been through a leveraged buyout. Company chairman Bob Kidder emphasized that the workers were a part of a new company, and that he wanted a unified company.
Part of that meant eliminating the class distinctions that came from having two separate pension plans at the battery manufacturer. The plan for salaried workers was a defined-benefit plan that was calculated on final average pay and years of service. The hourly plan also was a defined-benefit plan, except that the payout was based on a less-generous formula and on career wages. The company had grandfather clauses from more than three previous pension plans. This turned the computing of the final values into a major undertaking. Benefits workers had to find out how many other plans the employee had participated in and then use each of those formulas as well as their current plan formula.
"Some of these were four and five levels deep," explains David Lutterbach, director of benefits and human resources systems for Duracell. "As a result, nobody was ever in a position to know what their pensions were worth because the computations were so complex." To help with both recruiting and retention, the company wanted to create a pension that was portable and equitable, and offered some value to all the employees. "A final, average pay plan is hard for younger employees to understand," says Lutterbach. "We knew that we needed to recognize that not everyone has been with us for 30 years. We started thinking that maybe our plan shouldn't be so skewed."
Another inducement to change the plan was the 1986 Tax Reform Act, which was making it more complicated to prove that a plan wasn't discriminating in favor of more highly paid employees. The new regulations were pushing companies to close the gap between pensions for hourly and salaried employees. Lutterbach remembers Sec. 89, the overturned measure that pushed for equity in welfare plans, and wouldn't be surprised to see the government do the same in the future with pensions.
Before the government made any new mandates, Duracell had wanted to even out the situation. Previously, the plan for salaried workers had higher benefit differentials. Lutterbach didn't think that the company could justify these inequities anymore. Although the employees hadn't complained, the benefits department was starting to get questions from workers about why some employees' benefits were higher than other workers' benefits. Skilled mechanics, who were hourly, would have lower pensions than salaried secretaries.
Another significant factor was employee perception. Although the existing pensions usually provided a better benefit, employees perceived the supplemental 401(k) savings plan as being more generous. Yet Duracell's cost for both pensions was roughly the same. In Lutterbach's opinion, they were shelling out money for a better pension, but this gesture and the expense were wasted because the employees didn't understand it.
"In the first five years, there was a lot more to communicate about the 401(k)," he says, because employees took part in investing and saw the savings accumulate in statements. Meanwhile, in the company's other pension plan, in which employees couldn't see the buildup, "the first five years were nothing to beat our chests about," says Lutterbach.
The company chose a cash-balance plan. That way, employees could watch their accounts build up, and they could take them with them if they left the company.
Initially, says Lutterbach, response to the plan was lukewarm. Employees suspected that the change might have been a cost-cutting move. A small group of older employees were affected by grandfather clauses from the former pensions. The majority of employees had their pension amounts converted into lump sums and transferred, to become the beginning balance in their new accounts. However, as soon as workers started getting their statements, Lutterbach says that reactions became more enthusiastic. "Once they actually could see the funds building, they started to see that the pension was worth something," he says.
The new plan actually ended up costing Duracell slightly more in dollars, primarily because hourly workers had been added to the plan. The company was able to offset the increase for hourly workers somewhat by scaling back salaried benefits and reducing benefits for new hires. Contributions are on an aggregate basis, not by what Duracell contributes to the individual accounts. Any differences between what the company earns on investments and the rate used to credit participant accounts can be used to offset further contributions.
Lutterbach also expects the new plan to pay off in the future in terms of recruiting and retaining employees. "Having a unified work force is always going to cost more, but our main goal was to treat people in a fair fashion," he says.
No matter what benefits an organization offers its employees, there's no guarantee that workers will stay. The fact is, the work force has become more mobile. Chances are good that mobility only will increase with time. Even if workers choose to leave Duracell, Lutterbach says that the company's new pension plan is serving its purpose in terms of motivating and attracting the employees that Duracell needs to remain competitive. If companies are going to spend the money on a pension plan, he explains, "it's important that employees understand what they're getting and can see where the money is coming from."
Kathleen A. Murray is a free-lance writer based in Corona del Mar, California.
Personnel Journal, July 1993, Vol. 72, No. 7, pp. 36-46.