Court Decision Big Blow to Cash-Balance Plans

Ruling against IBM could scotch them for good. Elsewhere: survey says fallen angels more likely to default than other credit risks. Plus: cost of fiduciary insurance skyrockets. And: is Cap Gemini for sale?


Could this be the death knell for cash-balance defined contribution pension plans?

Late last week, a U.S. district court judge in the Southern District of Illinois ruled that IBM’s revamped pension plan violated age discrimination provisions of the Employee Retirement Income Security Act.

Under IBM’s plan, first changed in 1995, pension benefits would accumulate steadily each year, rather than growing slowly early in employees’ careers and accelerating rapidly in their final years of employment.

“This ruling affects not just IBM’s pension plan, but the pension plans of more than 400 major U.S. companies,” said J. Randall MacDonald, a senior vice president (human resources) at IBM.

Mind you, Big Blue is not the only high-profile corporation that has moved to a cash-balance plan over the past few years. Other reported embracers of cash-balance plans include AT&T Corp., Eastman Kodak Co., Cisco Systems, Microsoft Corp., and Electronic Data Systems Corp..

In fact, in a press release, IBM management cited Federal Reserve Board data showing that cash balance plans account for 25 percent of all participants in defined benefit plans and 40 percent of all assets invested in defined benefit plans.

About 19 percent of the 1,000 largest U.S. companies had such plans in 1999, according to the Associated Press, citing a federal government report. Last year Watson Wyatt Worldwide found that 33 of the largest 100 corporations have instituted such plans.

In court, lawyers for IBM argued that the company switched to a cash-balance pension to help keep pace with the shifting career patterns of the technology industry’s younger and more mobile workforce.

IBM announced it will appeal the decision. “IBM’s plan always provides older employees with benefits of equal value or greater value than the benefits earned by younger employees,” the company’s management asserted in a statement. “Neither the plaintiffs nor the judge ever disputed that fact. To call such a plan age discriminatory makes no sense and ignores the fundamental principle of the time value of money.”

Under traditional pension plans, the retirement benefits of workers increase at a much faster rate during their last years of service because workers generally make more money near the end of their careers. The big criticism of cash-balance plans is that if such plans are instituted right as experienced workers approach retirement age, companies will deprive those employees of anticipated gains and leave them without enough working years to accrue equivalent cash balance benefits.

But pension experts say the ruling by the federal court could severely undermine the U.S. pension system.

“This ruling has the potential to cause great harm to the U.S. private pension system,” claims Eric Lofgren, global director of the benefit consulting group at consultancy Watson Wyatt Worldwide. “Moreover, two other district courts and the U.S. Treasury Department have previously reached the opposite conclusion concerning the validity of cash balance plans.”

According to Logren,, one of two possible scenarios will likely occur. Most likely, the U.S. Appeals Court will reverse the ruling. Barring that, a large number of plan sponsors will freeze their defined benefit plans and offer their employees only a 401(k) plan.

Of course, as Lofgren points out, a mass movement to DC plans would shift all of the investment risk onto employees. “Tens of millions of employees could ultimately have reduced benefit security if this verdict isn’t corrected,” argues Lofgren.

I’ve Fallen, and I Can’t Get Up

Apparently, inertia applies to credit risk as well as heavenly objects.

At least, that seems to be the takeaway from a new study conducted by Moody’s Investment Services. According to the credit rating service, when “fallen angels” (issuers that lose their investment-grade status) first become speculative grade, they are more prone to defaults — and further downgrades — than issuers that have always carried speculative-grade ratings.

In fact, an initial downgrade to below a Ba rating can be a signal that a credit is more likely to default and less likely to ever recapture investment grade standing, Moody’s research found.

The freefall does not last forever, however. If a fallen angel goes two years without defaulting or withdrawing from the long-term debt market, the company’s credit rating is likely to rebound, the study revealed. In fact, such businesses are more likely than other non-investment-grade companies to move to investment grade status.

Says Moody’s analyst Christopher Mann: “Data show that fallen angels that survive the distress that prompted their downgrades often possess the franchise strength and the business incentives needed to restore their profitability and to repair their balance sheet.”

The survey also found that a fallen angel’s relative likelihood of defaulting or returning to investment grade is strongly correlated with the rating assigned on the day the company was first downgraded from investment grade to speculative grade. “Issuers that fall to lower ratings or those that fall further tend to have higher default rates,” notes Mann.

Not surprising given the three-year weak economic environment, fallen angels comprise a growing portion of the junk bond market.

In 2002, for example, $201 billion in new speculative debt came from fallen angels. Conversely, only $61 billion came from new junk bond issuance.

Among the current fallen angels with large amounts of outstanding debt: Calpine, Fiat, Vivendi, Xerox, and Lucent.

Since 1982, 1,035 companies have tumbled from investment-grade status to speculative grade, according to Moody’s.

Year-to-date, 136 fallen angels have defaulted, while 285 have regained their to investment grade rating.

On average, fallen angels are downgraded almost two rating notches as they enter speculative grade, fall another notch during the ensuing two years, and rise back up a fraction of a notch over the next three years, Moody’s discovered. By the end of the fifth year, ratings are only slightly lower, on average, than their initial speculative-grade rating.

The findings are consistent with previous Moody’s studies showing that recently downgraded companies display “ratings momentum” — that is, they are more vulnerable to further downgrades and default than comparably rated corporations that have been at the same rating level for a while.

Fiduciaries Face Rising Insurance Costs

It’s becoming very expensive to serve as a fiduciary in this brave new world of Sarbanes-Oxley.

Insurance premiums for certain lines of fiduciary liability coverage have surged as much as 500 percent, according to the most recent RIMS Benchmark Survey.

Fiduciary liability insurance includes coverage for trustees of pension funds and trusts, as well as coverage for directors and officers of corporations.

One example: the price of policies that cover pension fund trustees have risen as much as 150 percent, according to RIMS.

Premiums for directors and officers liability insurance are up over 200 percent against last year, the third straight year of extraordinary increases.

The RIMS researchers did find, however, that the number of policy counts (which reflects the number of policies required to complete a desired level of insurance coverage), rose only slightly. “That small increase suggests that even though the costs of these policies are increasing, the supply may be catching up to demand, creating greater equilibrium in the market compared to previous quarter,” RIMS officials noted in a statement.

Other insurance categories, which have been experiencing accelerated costs over the last months, continue to see low double-digit growth. Meanwhile, some costs — including retentions or deductibles in property insurance — remained unchanged.

“The increase in fiduciary liability costs is startling, even in this hard market,” said Christopher Mandel, RIMS vice president and chief risk officer and secretary. “With the spate of lawsuits against these trustees, the resulting effect on insurance prices is understandable, but this increase is dramatic.”

The results represent data compiled from over 750 corporations.

Is Cap Gemini for Sale?

Is Cap Gemini Ernst & Young, Europe’s largest computer consultancy, about to be sold?

That’s what European investors seemed to feel when Cap Gemini’s stock price closed up 2.87 percent on Friday, after shooting up by as much as 6.2 percent.

The Cap Gemini takeover rumors have been around for awhile, with International Business Machines Corp. most often mentioned as the likely buyer. IBM bought PricewaterhouseCoopers Consulting one year ago.

The latest Cap Gemini rumor was fanned by a report last week by what Reuters referred to as a French tip sheet, called “La Lettre de L’Expansion,” which claimed that management at HP-Compaq was looking for an acquisition and might be targeting Cap Gemini or rival Accenture.

Cap Gemini management refused to comment, according to Reuters. “The group will comment on the development of its business in various regions when it publishes its half yearly results,” a company spokeswoman told the wire service. Cap Gemini releases first-half earnings on September 4.

Short Takes

  • The Financial Accounting Standards Board said companies don’t need to disclose the impact of changes in assumptions used to calculate pension income or costs on earnings, arguing that existing and other proposed disclosure requirements are enough, according to published reports.
  • Management at drug wholesaler Cardinal Health Inc. said its board approved a $1 billion share repurchase program. The company indicated it will use the shares for general corporate purposes, including acquisitions and to issue upon exercise of stock options.
  • In an initial public offering that hit the street late last week, Citadel Broadcasting Corp. sold 22 million shares at $19 per share (at the top of the expected range of $17 to $19). Citadel, the sixth largest owner of radio stations in the U.S., raised $418 million in the IPO. Underwriters included Goldman, Sachs & Co. and Credit Suisse First Boston.
  • According to a filing with the SEC, International Steel Group Inc. is preparing to go public. The company, now the second largest integrated steel producer in North America after acquiring the assets of LTV Corp., Acme Steel Corp. and Bethlehem Steel Corp., is backed by buyout firm W.L. Ross & Co. The planned IPO should raise around $250 million.
  • RedEnvelope Inc., the online retailer of upscale gifts, said it plans to sell 2.2 million common shares for $12 to $16 apiece in an IPO.
  • U.S. junk bond mutual funds suffered $1.1 billion in cash outflows in the week ended July 30, according to AMG Data Services.
  • Dynegy Holdings Inc., a unit of power company Dynegy Inc., raised $1.45 billion from the sale of three-part notes in the private placement market. The Dynegy borrowing includes paper that matures in five years, seven years and 10 years. All three tranches are rated B3 by Moody’s and B-minus by Standard & Poor’s.

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