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|ED McCARTHY is a freelance writer in Warwick, Rhode Island, who specializes in finance and technology. His e-mail address is firstname.lastname@example.org .|
ntil recently conversions of defined benefit pensions to cash balance and other hybrid pension plans received little attention. That changed, however, when IBM’s problems captured headlines and landed the company on the cover of Time and other magazines in 1999. IBM’s decision to switch its plan for U.S. workers met widespread employee resistance, ultimately leading the company to modify its original proposal. Criticism of cash balance conversions prompted several members of Congress to introduce legislation that would increase scrutiny of future conversions, and the IRS invited public comment on cash balance plans.
Despite IBM’s travails, other companies have converted their defined benefit plans without negative publicity. “For the most part, conversions have gone extremely well—that’s why these plans were around for 12 years before any issues arose,” says Eric Lofgren, director of the benefits consulting group with consultants Watson Wyatt Worldwide in Philadelphia. “For instance, probably 30 large banks have put in cash balance plans. But have you heard a peep about them?”
Although a plan conversion may generate some employee anxiety, the companies interviewed for this article reported that their transitions went smoothly and resulted in improved employee morale, not turmoil. They achieved this outcome by addressing two critical issues: the wear-away problem and effective communication. (For an explanation of the technical aspects of cash balance plans and how they work, see “Cash Balance Conversions.”)
|Traditional vs. Cash
Balance Plans |
Comparison of Accumulated Single-Sum Values
Source: Copyright 1999 Towers Perrin: Reprinted with permission.
THE WEAR-AWAY PROBLEM
Why did the IBM conversion encounter so much resistance from its workforce? Without specifically mentioning IBM, Lofgren says it takes a unique set of circumstances to rouse employees’ ire. “For a conversion to become a problem, you need a switch that results in an extreme decrease in benefits. Then you need a population that happens to have a large amount of people caught around the 40/20 mark: 40 years of age with 20 years of service.”
Lofgren’s comments point to the Achilles’ heel of cash balance conversions: Although conversions generally benefit younger workers, midcareer employees may experience a reduction in their future retirement benefits under the new plan. As a result, those employees will face a choice: Accept a lesser benefit if they decide to retire in the near future or work longer to reach their previously projected pension levels. The period of time when workers no longer earn additional retirement benefits for their service has been dubbed the “wear-away” period and is a major source of contention in plan conversions.
It’s worth emphasizing that these employees have not lost actual accrued benefits; instead, the conversion results in a reduction in projected benefits. This means the benefits an employee has already earned do not change. What might change are the benefits the employee was projected to earn at retirement. For example, if a 57-year-old employee had accrued a $1,200 benefit starting at age 62, she would receive that amount—starting in five years—if she left the company at 62. If she worked five more years and her salary remained the same her projected benefit under the old plan would increase to $1,500. With the implementation of a cash balance plan, there is no guarantee the employee will see her projected benefit increase to the same level.
“I think some of the news articles have taken the wrong bent by saying people lost pension benefits,” says Ray Berry, an enrolled actuary and employee benefits manager with Grant Thornton in Chicago. “No one has lost benefits. What they’ve lost, if anything, is the right to future benefits accruals at a higher rate. Accrued benefits to date have not been lost.”
MAKING THE TRANSITION
Employers have no legal obligation to provide transition benefits or to replace a terminated defined benefit plan, but industry consultants see a risk in failing to do so. Morale and productivity can suffer, particularly among long-term employees negatively affected by the wear-away problem. There is also the risk of negative publicity, as IBM’s experience demonstrates. “A company must decide what it wants to do about plan provisions,” Berry notes. “Is it going to take a relatively hard-nosed approach and go cash balance only in the future, or will it grandfather in some of the people who are closer to retirement? I think the conversion will go a whole lot better if you grandfather in some of the benefits for those employees closer to retirement.”
Alan Lebowitz, the Pension and Welfare Benefits Administration’s (PWBA) deputy assistant secretary for program operations in Washington, D.C., shares Berry’s opinion. “From what we’ve seen and heard, companies that have willingly given their employees a plan choice, as well as those that have gone the extra mile to help them understand the consequences of their choice have made the change to a cash balance formula without a lot of acrimony.”
Most companies—roughly two-thirds, according to a study by benefits consultants Towers Perrin—do offer midcareer employees some form of transition benefit. “Assuming that a company isn’t making the change to save money, there are three ways you can avoid wear-away,” says Gordon Gould, a principal of Towers Perrin, Denver.
- Offer individuals a choice between the new and old programs.
“This is done with a one-time election. It’s not that common because it tends to be fairly expensive,” Gould says.
- Identify individuals who will be adversely affected by the new plan and grandfather them for a period of time under the old plan.
“Typically, individuals within 5 or 10 years of retirement are offered this protection,” Gould says. “When those individuals leave the company, you calculate their benefits under both plans and give them the greater benefit. There tends to be a time limit on such transitions, so the group that is grandfathered will have 5 to 10 years of protection.”
- Freeze current benefits under the existing arrangement.
“Under this option no one has wear-away,” Gould says. “Whenever the employee leaves, he or she collects that frozen benefit. In addition, the employee receives credit for future service under the cash balance plan, effectively receiving his or her retirement benefit in two pieces. That doesn’t mean the individual will receive as good a benefit in the future as he or she would have had the traditional plan continued, but the employee will continue to see the benefit increase at all times in the future.”
SELECTING AN OPTION
A company’s first step in selecting a transition method is to analyze the potential impact of the new plan on employees—without considering transition benefits. That analysis will show which individuals will suffer a loss under the new plan. Specifically, a company should look at how many employees have the age and years of service combinations that are likely to cause a reduction in benefits. Employee turnover is another factor a company should consider. If annual turnover is high, it’s likely a larger percentage of the adversely affected employees will leave the company within a few years. Armed with this information, a company can decide how best to assist affected employees.
After analyzing its workforce, Northern States Power in Minneapolis realized its average worker was age 46 with 18 years of service. The utility decided to offer employees a choice between the old and new plans. “When we looked at our existing workforce and the long service employees had in the plan, we decided the easiest way to make the transition and minimize disruption was just to offer everyone the choice of which plan to stay in,” according to Kevin MacAfee, manager of retirement plans. “So in 1998 we offered the choice to the nonunion employees, and in 1999 we offered it to our union employees.”
Rhodia, Inc., a specialty chemicals producer in Princeton, New Jersey, followed a similar process but offered employees a different choice. “One reason it took us two years to select a plan design is that we spent almost a year on the grandfathered group issues,” says Diane Audette, the company’s director of benefits and human resource systems. After completing the analysis, Rhodia chose a limited-period grandfathering clause for its plan. The company devised a formula for employees age 40 and older with at least 10 years of service, a group comprising one-third of the salaried workforce.
If an employee’s age and years of service added up to 65, that employee was to be grandfathered. For an eight-year window following the new plan’s adoption, grandfathered employees leaving Rhodia receive the better of the old plan or the new one. After eight years, the old plan formula stops and all employees fall under the new plan.
Companies have used other transition options besides those described above. Some pay higher credits to long-term employees’ cash balance accounts for several years after the transition. Others increase the initial postconversion balance in the employee’s account. The pension plan is only one part of the benefits package, however. Companies that wish to shift the emphasis away from retirement benefits can offer increased access to stock options, performance pay bonuses and a greater employer match in the 401(k) plan, for example.
The second element in a successful conversion is effective communication, so employees understand how the changes will affect their retirement plans. “We worked with Ernst & Young to develop two series of seminars,” says MacAfee. “The first focused on general financial concepts such as saving for retirement and the key issues in retirement planning. Employees were encouraged to bring their spouses and financial planners. The second series of meetings focused on the two choices they had. We went through all the different provisions of the plans.”
Northern States Power employees were to receive personalized statements showing their projected benefits—including from the company’s 401(k) and employee stock ownership plan—on three dates: the beginning of the current year, at age 62 and at age 65. The company also worked with Watson Wyatt Worldwide to create a retirement planning software program that was available on the Internet and on the company’s intranet. Employees could model their benefits based on their pay and service terms for any future date. MacAfee reports that the program was a success: During the 60-day period in which the company’s 6,700 employees could choose between the two plans, they ran almost 23,000 pension projections.
Rhodia spent a year on its communications efforts. “The plan went into effect in January 1998, but we started communicating the impact by letter in April and May of 1997,” Audette says. “We had a staggered approach where we gave employees preliminary information in April and detailed information in July and August and held employee meetings in September. We also gave them personalized benefit statements in early 1998 that showed the actual value of the old plan and how we converted everything.”
The PWBA also wants to ensure that employees receive adequate information about a conversion’s impact. Leslie Kramerich, deputy assistant secretary for policy, says the agency is reviewing this issue. “Advance disclosure has been a big focus for us, largely driven by questions we’ve received from individual employees. Earlier this year we worked with the other agencies that regulate pensions to develop a proposal requiring advance disclosure of coming conversions and to require greater notice of what that disclosure would mean for participants.” The PWBA, Kramerich says, is specifically looking at what it can do to “help participants facing a conversion understand the questions they need to ask their plan administrator to get helpful information.”
PAY ATTENTION TO THE FUTURE
Ultimately, the cash balance plan conversion decision and the steps a company takes to implement the change depend on its unique circumstances, in particular the age and length of service of plan participants. But as the experiences of the companies cited in this article demonstrate, it is possible for a company to convert while still maintaining good relations with current—and prospective—employees. As Scott Weatherby, CPA, the assistant controller of Northern States Power, points out, a plan conversion has long-term implications. “When you talk about benefits design, it’s not just this year that counts. You’re setting policies that will affect people for years and setting the standard for potential employees who are making the decision on whether to join the company.”