Judging from predictions 10 years ago, defined- benefit plans should no longer exist. After all, 401(k) plans cost so much less to sponsor and are more appealing to an increasingly youthful and mobile workforce. But a funny thing has happened to traditional defined- benefit plans. A growing number have morphed into a long-standing variation known as cash- balance plans.
Why haven’t most large companies abandoned their defined-benefit plans yet? For one thing, federal pension law makes it difficult for companies to do so. Those that want to pull the plug on a traditional plan must effectively fund all accrued benefits at once. What’s more, those with overfunded plans must pay a significant excise tax, as well as income tax, on the surplus. As a consequence, few healthy companies have ended their defined- benefit plans outright.
Instead, with the demographics of the workforce changing, and with a soaring stock market leading to an increasing number of overfunded traditional plans, more and more companies are converting them to the cash- balance kind. The idea isn’t new: Bank of America is credited with doing the first conversion in 1985. But since then, some 15 percent or more of Fortune 500 companies have switched to cash balance. And today, another 30 percent to 40 percent are considering converting, according to Larry Sher, a principal at PricewaterhouseCoopers Kwasha HR Solutions, in Teaneck, New Jersey.
Cash-balance plans are a hybrid arrangement that combines certain features of traditional pension plans with those of 401(k) and other defined-contribution arrangements. As with other defined-benefit plans, most sponsors of cash-balance plans make all contributions for employees. Funding must meet the minimum requirements of the Employee Retirement Income Security Act (ERISA). And the benefits, which can be paid out as a lump sum or an annuity for life, are covered by federal insurance under certain circumstances.
But unlike a conventional defined benefit, a cash-balance benefit is typically earned more evenly over an entire career, rather than being based on years of service multiplied by the average salary in the final years. As with a 401(k) plan, an account is opened in an employee’s name. Every month the company credits the account based on a percentage of the worker’s pay, typically 4 to 6 percent. Interest accumulates according to a specified return, usually between 5 and 7 percent. Anything earned above that stays in the pension plan to reduce future company contributions. In return, the company shoulders the risk of any shortfall in the promised return. With the market producing gains well above promised returns, sponsors often needn’t contribute a dime to meet minimum funding requirements, at least for a period of time.
No wonder converts, in addition to Bank of America, include such giants as Aetna, AT&T, BellSouth, CBS, Chase Manhattan Bank, Eastman Kodak, IBM, and SmithKline Beecham, as well as smaller companies, such as American President Lines Ltd., a maritime shipping company based in Oakland, California; Niagara Mohawk Power Corp., a New York State utility; and Southwestern Energy Co., of Fayetteville, Arkansas.