Pension Act Tilts to Cash-Balance Plans

But employers still might want to shun old-style defined-benefit plans for the comfort of a 401(k).

By boosting the volatility of the cash demands that traditional defined-benefit plans place on employers, the new pension reform law makes cash-balance plans all the more alluring, retirement plan experts say.

Indeed, some foresee a sizable up-tick in the number of conversions from old-style pension plans to cash-balance programs. A major reason is that the Pension Protection Act of 2006 reins in employers’ ability to “smooth,” or average over time, the interest rates used to gauge the assets and liabilities of traditional pensions. Before President Bush signed the act into law on August 17, plan sponsors could smooth the interest rates they used for assets and liabilities over five years and four years, respectively. The act changes smoothing to a two-year time period for both.

That change puts DB plan sponsors much more at the mercy of real-world interest-rate fluctuations, producing greater volatility on corporate financial statements. Under the tightened smoothing strictures, employers are “going to contribute a whole lot more to the plan” over shorter periods, said Jan Jacobson, director of retirement policy for the American Benefits Council, an employer advocacy group.

Not so for cash-balance pensions, which are also known as “hybrid” plans because they’re DB plans that look like defined-contribution plans such as 401(k)s. Unlike traditional plan sponsors, employers who supply cash-balance plans don’t have to worry about estimating their future outlays on the basis of fluctuating, market-driven interest rates.

Instead, cash-balance sponsors provide each worker with a hypothetical “account” into which the employer allots two kinds of credits: a “pay credit” (a percentage of current salary) and “an interest credit” (a percentage of the previous year’s pension balance). Those credits are calculated to provide a defined benefit at the end of each employee’s career.

Thus, “while with a hybrid plan [employers] know what their obligations are, with a traditional plan it’s difficult to do forward planning,” observes Jacobson. The increased volatility will make it even more difficult.

Still, many defined-benefit plan sponsors worried about volatility might still be wary of moving to cash-balance plans if the act hadn’t made them so appealing. After all, hybrid plans had been in hibernation since 2003, when a federal judge ruled in Cooper v. IBM that the company showed a bias against older workers by converting from a DB plan to a cash-balance plan.

But barely ten days before the new law was enacted, an appeals court overruled the previous decision. “An employer is free to move from one legal plan to another legal plan, provided that it does not diminish vested interests,” the appeals court judge for the Seventh Circuit ruled. Experts feel that the decision sets a precedent in favor of existing cash-balance plan conversions that may hold sway in other circuits.

Soon after, the pension act erased all doubts about future conversions by making the design of cash-balance plans legal. Now, employers mulling a conversion know that “it’s not something they’re going to get penalized for after the fact,” says Jonathan Waite, chief actuary for SEI, an outsourcer of asset-management services.

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