New Hope for Troubled Retirement Plans
To understand the magnitude of the dilemma that scores of American businesses face in their retirement-benefits planning, im-agine that you’re the chief financial officer of a fictitious company, Rebus Inc. Like other companies across the nation, Rebus long has relied on a conventional defined-benefit plan that provides retirees with a generous monthly check, based on the average of their best earning years.
But Rebus is finding the expense increasingly difficult to manage in tough economic times, and shareholders are unhappy about the bite that covering future pension liabilities takes out of the company’s bottom line. And younger workers, whom Rebus must attract to stay competitive, don’t find that benefit very alluring. They may be thinking of leaving to pursue career opportunities elsewhere before they rack up enough years of service to become vested. They’re more interested in Rebus’s defined-contribution plan, in which the company matches their 401(k) account contributions, so they can take their savings with them if they hop to another career opportunity elsewhere.
How does Rebus reduce its pension-related financial woes while keeping its promise of a regular, dependable pension check to one age group of employees and offering a portable benefit to another? A few years ago, the answer might have been for Rebus to offer defined contribution only to new hires and convert its existing workforce to a cash-balance plan. Benefits essentially would be based on an employee’s salary average for his entire career. This formula would have resulted in a lower payout, and less expense for the company.
Pension complexities & hope
The harsher economic realities of 2003 are making such decisions vastly more difficult. Today, companies that are rethinking their pension systems are faced with a world of legal uncertainty and possible financial peril. In the wake of a three-year bear market and accounting scandals at Enron and other companies that wiped out many workers’ savings, defined-contribution plans, which once seemed to be the wave of the future, now are viewed with less enthusiasm by employees. The cash-balance conversion, another corporate pension strategy that became popular in the late 1990s, is in legal limbo after a federal judge ruled in July that IBM’s cash-balance plan discriminates against older employees.
None of this leads to clear answers. But while the situation may look forbidding, some pension consultants and other experts offer glimmers of hope. They say that regardless of how the cash-balance controversy ultimately plays out in the courts and possibly in Congress, improved strategies for managing defined-benefits plans may give that old concept new life. They also tout an ingenious new model that would combine some of the most desirable features of traditional pensions and defined contribution, a plan that is dependent on whether the federal government can be persuaded to make it legal.
"We’re really mortgaging our future. Somebody is going to have to support these people. If they can’t do it themselves, younger workers are going to end up paying taxes out the wazoo."
The present logjam over the future of pensions threatens not only companies’ financial health but also the promise of a comfortable old age that generations of American workers have come to view as a quid pro quo for leading the world in productivity. In truth, employees in the United States are facing an ominous retirement future. According to a recent article in The American Prospect, a liberal public-policy journal, just 58 percent of the nation’s private companies offer pension plans. Only 44 percent of workers presently are covered. The Prospect also reported that a disturbing 64 percent of retirees depend on federal Social Security benefits for at least half of their income. Considering that this government safety net is in long-term financial trouble and the number of Americans over 65 is projected to increase from 13 percent today to more than 20 percent in 2029, according to U.S. Census data, what lies ahead is scary, says Brent Longnecker, a Houston-area human resources consultant. "We’re really mortgaging our future. Somebody is going to have to support these people. If they can’t do it themselves, younger workers are going to end up paying taxes out the wazoo."
It’s vital, experts say, to preserve existing pension plans and encourage more firms to offer benefits. When cash-balance conversions appeared on the scene in the mid-1980s, Institutional Investor magazine touted them as "the wave of the future" for companies that wanted to keep providing defined benefits. Since the worth of employees’ retirement accounts was based essentially on the average career salary, companies ended up paying less than they would have with traditional formulas based on the highest-earning years near retirement. (When Delta Airlines switched to a cash-balance plan in 2002, for example, the airline projected $100 million a year in reduced costs.)
Cash-balance plans also tended to reduce the gap between employees with differing tenures, a feature that proponents argued is fairer to younger employees who might not stay as long. Ed Ryan, a vice-president at MassMutual Retirement Services, cites another advantage: Companies could offer workers the choice of using the money to fund an annuity, with payouts based on Treasury bill rates or a similar index, or getting it in a lump sum. The latter had the advantage of taking the retirees’ long-term pension costs off the books.
But older employees soon complained that cash-balance plans were unfair. One disgruntled IBM employee quoted in The New York Times in 1999 characterized it as "an exercise in corporate greed." They got less money than they’d expected to receive under their old traditional plans, and they no longer were rewarded for their longevity with the company, as the old system had promised. Some companies, such as Boeing, tried to fix that problem by contributing a higher percentage of older employees’ pay to the plans. Other companies froze their existing plans and credited older employees with the amount they’d earned up until that point, while covering the rest of their careers with the new cash-balance formula. Nevertheless, more than 800 workers at dozens of companies have filed federal complaints charging that cash-balance conversions are a form of age discrimination, according to a January 2003 letter sent by 271 members of Congress to the White House.
Adding to the confusion over the past several years, the Treasury Department and Congress have vacillated about whether cash-balance plans should be allowed under federal law. In late 2002, the Bush administration proposed new regulations that would have enabled companies to make conversions without the risk of committing age discrimination. The White House then withdrew the proposal in April after critics pointed out that the changes might have the unintentional effect of barring companies from compensating older workers for what they might lose from a conversion.
IBM employees sue
At the end of July, cash-balance plans ran into a brick wall in federal court. In a class-action suit by IBM employees, a federal judge in Illinois ruled that IBM’s 1999 cash-balance plan--and also an interim system adopted in 1995--discriminated against older workers because its formula left them with smaller benefits than younger workers would earn in the course of their careers. The decision clearly has cast a pall over the future of cash-balance plans. Mercer Human Resource Consulting recently conducted an unscientific poll of several dozen companies that had been considering a switch to cash balance, and learned that nearly all had put their plans on hold, says Jerry Levy, a Mercer actuary and pension expert. In the meantime, some pension experts complain that the standoff in the courts and federal government over cash-balance plans is hindering innovation. Others say that regardless of how the issue eventually is decided, additional strategies may help companies to solve their pension woes, and save defined-benefit plans from extinction. "There may be be some employers who’ll want to continue with defined benefits," says Syl Schieber, VP of research and information for the consulting firm Watson Wyatt Worldwide. "They may think it serves their interests, despite the cost, because it helps them to attract and retain the particular sort of workers they want."
One potential method for rescuing defined-benefits plans is to reduce the cost through better management, rather than just paring benefits. About 13 percent of corporate plan sponsors, for example, now outsource the actual management of their plans, according to research by MassMutual Retirement Services. MassMutual offers a "bundled" package of services, in which its staff handles everything from record-keeping and regulatory-compliance issues to answering employees’ pension-related questions. The firm actually hires independent managers to invest the money, so that it can oversee them without conflict-of-interest problems.
"If you’re a company trying to manage its own plan, you might have a person who tries to keep an eye on the portfolio by looking at the quarterly reports," says Vern Meyer, MassMutual vice president and managing director of investment strategy. "We can monitor the investment managers on a daily basis, looking at what stocks they buy, watching to spot problems or a drift from the investment philosophy." As a result, Mass-Mutual says, its clients typically are able to reduce their administrative costs by 25 to 40 percent.
But defined-benefits plans might be even more attractive if companies didn’t have to shoulder the entire cost. Jack VanDerhei, an instructor at Temple University’s graduate business school and research director of the fellows program at the Employee Benefit Research Institute, conducted a study in the 1980s of a dozen companies that started defined-contribution plans. He found that management was attracted primarily by the chance to utilize employees’ own pretax contributions to help finance the benefits. "I’ve always thought that if you want to keep the DB plans viable, we have to give employers the same advantage," he says. "They ought to be able to tell employees: ‘We want to keep offering you the same generous lifetime pension that we’ve always had, but we’re going to need you to chip in something--and by the way, you’ll get a tax deduction for doing it, just like you would with a 401(k).’ "
The American Academy of Actuaries, a professional association of business statisticians, is touting its "DB-K Plus" plan, which would combine the most desirable features of defined benefits and defined contribution in one program. Like a traditional pension, a DB-K Plus plan would offer retirees the security of a regular stipend for the rest of their lives. But instead of the company bearing the entire cost, the money that it put into the plan would be augmented by voluntary contributions from employees that would be tax deductible, in the fashion of a 401(k). The DB-K Plus could combine all that money into one pool for investment purposes, while keeping it segregated in individual accounts on the books, so that employees would have some say about how their money is invested. Employees who made bigger contributions would get more of a payoff in retirement, but all would be guaranteed at least a certain income.
John Parks, vice president of the academy’s pension practice council, says DB-K Plus would be more affordable for companies than traditional pension plans. It would also offer numerous advantages to workers that either a traditional pension or defined-contribution plan doesn’t provide, even the opportunity to have both a separate pension and a 401(k). It would cut management’s cost of complying with regulations, he says, while simultaneously reducing the investment fees and costs that now come out of employees’ 401(k) earnings. Because the new plan would provide benefits that appeal to both younger and older workers, it could eliminate age-discrimination problems. Parks also says that "You wouldn’t have to worry about having to leave at a time when the stocks in your 401(k) are down."
There’s one big drawback to such a hybrid. It’s not legal under present federal regulations. The rules now require companies that offer conventional pensions and 401(k) plans to run them as completely separate entities, and don’t confer tax-deferred status on voluntary employee contributions to defined-benefits plans. "Admittedly, we’d have to rewrite a ton of laws," says Parks, who also would have the federal Pension Benefit Guarantee Corp., which at present insures only traditional defined-benefits plans and cash-balance hybrids, cover DB-K Plus plans as well. "The PBGC probably would have to charge a higher premium for DB-K Plus plans, but even so, I think companies would still end up saving money," he says. In any case, corporate pension plans are overdue for sweeping reform, says pension-policy expert Paul Weinstein, a senior fellow at the Washington, D.C.-based Progessive Policy Institute. "We’ve got a system that was designed for the economy of 40 years ago," he says. "But it doesn’t work for the very different set of circumstances we have today. We need to make big changes across the board, and really rethink how we can best help people. What I’m really afraid of is that, as with the savings-and-loan crisis in the early 1990s, we’ll wait until we have a financial disaster before we do anything. It doesn’t have to be that way."
Workforce Management, October 2003, pp. 53-56 -- Subscribe Now!