In Just a Year, Cash-Balance Plans Go From Panacea to Pariah

Not long ago, companies considered cash-balance pension plans ideal for limiting financial liability and providing a more portable retirement program to today’s mobile workforce. The plans, a cross between a traditional defined-benefit plan and a defined-contribution plan, have been adopted by hundreds of major U.S. corporations since the 1980s, including IBM, Federal Express, Eastman Kodak and Delta, and cover an estimated 7 million workers. Hundreds more businesses looking to exit traditional defined-benefit plans were preparing to convert, according to government and industry experts.

    But in the space of a year, cash-balance plans turned from panacea to pariah. The turning point: a federal court’s landmark ruling in July 2003 that IBM’s cash-balance plan violated age-discrimination laws, throwing into question the legality of all such plans. In February, the same judge ordered IBM to pay back benefits, which plaintiffs in the class-action suit estimate could amount to $6 billion, a claim the company denies.

    Anxiety over cash-balance plans doesn’t end there. Proposals for federal regulation of cash-balance plans have rattled around Capitol Hill for years but remain just that–proposals. In February, the Treasury Department issued its latest proposed guidelines, only to be met by criticism from employer and employee groups. Interested parties now doubt that Congress will act on the matter before the November presidential election. Meanwhile, the Equal Employment Opportunity Commission has logged 950 consumer complaints about cash-balance plans, according to an agency spokeswoman. Karen Friedman, policy strategies director for the Pension Rights Center, a Washington, D.C., retiree lobby group, sums things up, saying simply: “The cash-balance situation is at a standstill.”

    The uncertainties have companies on edge. Some are waiting things out, sticking with existing defined-benefit or cash-balance plans. Others have frozen cash-balance accruals and switched to defined-contribution plans such as 401(k)s. Consultants report that a handful of clients have discontinued pension plans altogether.

    One company typical of those leaving behind cash-balance plans is Avaya Inc. On January 1, the $4.3 billion communications services business froze accruals for both a cash-balance plan and a traditional defined-benefit plan that together covered the company’s 7,500 U.S. salaried employees. In their place, the Basking Ridge, New Jersey, business installed an enhanced 401(k). An $800 million pension-fund deficit prompted the change. But the possible liability associated with cash-balance plans was a major factor, says Mike Harrison, Avaya’s vice president of global benefits and compensation, who spearheaded the overhaul. The IBM lawsuit specifically pushed the S&P 500 company away from cash-balance plans, Harrison says. “We didn’t want to go down that road.”

    Avaya isn’t alone. According to a Deloitte Consulting pension-plan survey released in May, more companies are shifting away from defined-benefit plans. Deloitte polled 125 companies with a median $1 billion revenue and found that 27 percent had recently changed plans. Of that number, 38 percent had moved to defined-contribution plans, says Brian Augustian, head of Deloitte’s retirement practice and the survey’s author. Avaya inherited a portfolio of pension plans when it spun off from Lucent Technologies in October 2000. Salaried employees who’d started at Lucent before 1999 received 1.4 percent of their average earnings from 1994 to 1998 for every year they’d worked before 1999, and 1.4 percent of earnings for every year worked after. Lucent employees hired after 1999 were covered by a cash-balance account, in which the company contributed 3 percent to 10 percent of their annual earnings, depending on the employee’s age. Hourly workers were covered by yet another plan under a union collective-bargaining agreement.

    At the time of the 2000 spin-off, the existing pension plans covered 14,200 U.S. salaried employees, or about 42 percent of the new company’s global workforce. In the ensuing years, Avaya restructured extensively, shedding business units and cutting the total number of worldwide employees by more than half. At the same time, the stock market crash and low interest rates took their toll on Avaya’s pension fund, by 2003 creating an $800 million shortfall in the $3 billion fund. To stem the losses, Avaya used $105 million from a September 2003 stock offering of $352 million to help pay down the pension fund’s liability. At the same time, Avaya announced the switch to a defined-contribution plan.

    Under the new plan, Avaya stopped funding its existing plans, which means that when existing employees retire they’ll get whatever was in their pension fund as of December 31, 2003. In its place, Avaya created an enhanced 401(k) for existing employees and salaried workers hired on or after January 1, 2004. In the enhanced 401(k), employees automatically receive 2 percent of their annual salary and bonus, a 100 percent company match for the first 2 percent they contribute and a 50 percent match for the next 4 percent they contribute.

    After less than five months, Harrison says that changes in the fund had “significantly reduced” future cash-flow requirements and expenses. He declined to elaborate. Avaya uses Fidelity Investments to run the 401(k) program, giving employees 26 options for investing in mutual funds, bond funds and company stock. To help employees understand the change, Avaya held educational seminars from January through April, though Harrison admits the classes weren’t as well attended as he would have liked.

    Even so, Harrison believes that employee dissatisfaction with the new plan is minimal. “We were very up-front about what we were doing, starting with our CEO,” he says. “People understood what we were doing and why we were doing it, and it was consistent with other actions we were taking to manage cash flow and our financial position.”

    Restructuring pension plans at other companies hasn’t gone as smoothly. In February, U.S. District Court Judge G. Patrick Murphy, in the Southern District of Illinois, found IBM liable for retroactive pension benefits. Translation: IBM may have to recalculate benefits for 140,000 employees and retirees. The suit is pending, with both sides preparing damage estimates. IBM maintains that it doesn’t owe anything and has previously stated that a loss won’t materially affect its operations.

    IBM isn’t the only company on the losing end of a cash-balance lawsuit. In February, Georgia-Pacific settled a seven-year-old suit for $67 million that alleged the company underpaid workers who took lump-sum pension payments upon retirement. In November 2003, Xerox settled a similar suit for $239 million, a month after the U.S. Supreme Court refused to stay an appellate court ruling against it. Xerox took an $183 million charge to help cover the costs. As of early May, plaintiffs’ attorneys were determining how many retirees would receive settlements, and how the money would be divided. Cases against AT&T and CIGNA Corp. are pending.

    Meanwhile, the Treasury Department’s February proposal attempts to clear up companies’ concerns about the legality of cash-balance plans. The proposal came three months after federal lawmakers voted down a Bush-sponsored amendment to an annual spending bill that would have limited cash-balance conversions.

    Treasury’s latest proposal provides five years’ worth of transition relief to workers after a company converts to a cash-balance plan. Under the plan, employees would receive the better of what the benefit was under the traditional plan or the cash-balance plan. It would ban so-called “wear away,” in which employees accrue fewer benefits under a cash-balance plan than under a traditional plan. To discourage companies from converting to a less generous plan, it would impose a 100 percent excise tax on the difference between the traditional pension benefit and the lower cash-balance. Finally, it would clear cash-balance plans of violating age-discrimination tests if they met certain funding tests.

    Employer and employee groups aren’t taken with all aspects of the plan. If forced to continue an old plan for five years after converting to cash balance, most employers would just switch to a 401(k) plan, which doesn’t require a five-year conversion period, says Ron Gebhardtsbauer, senior pension fellow with the American Academy of Actuaries in Washington, D.C. However, employee groups want an even longer conversion period, he says.

    The sooner that groups come together to iron out their differences, the better, says Janice Gregory, senior vice president of the ERISA Industry Committee, a Washington, D.C., employer lobby group. A major obstacle: getting lawmakers up to speed on the issue.

    To that end, Sen. Tom Harkin (D-Iowa), an advocate of employee pension rights, has been working to schedule a summit for interested parties to hammer out policies acceptable to all that he could potentially introduce as legislation. “We’re at a crossroads,” one Harkin aide says. “This is a point where we can move.”

Workforce Management, June 2004, pp. 81-82 — Subscribe Now!