Lee D. Gold Denver Cash Balance Plans State Association of County Retirement Systems – Educational Symposium 2007 February 6, 2007

Lee D. GoldDenver

Cash Balance Plans

State Association of County Retirement Systems – Educational Symposium 2007

February 6, 2007

Mercer Human Resource Consulting 2

Agenda

Cash Balance Plan defined

How cash balance plans work

Why the interest?

How are employees impacted?

IBM’s troubles

Public Sector application

Information presented here represents the experience and opinion of the presenter and does not represent in any way an official viewpoint or position of Mercer Human Resource Consulting


Cash Balance Plan DefinedIs it complicated?

Higher level math (as illustrated here) will not be needed to understand cash balance plans!


Cash Balance Plan DefinedLike a DC Plan…but not exactly

Similar to a defined contribution plan

– Account grows with pay credits and earnings

– Benefit is expressed as a lump sum

Different than defined contribution plan

– Cash balance account is a “paper account” only

– Employees do not control investment options (rare exceptions)

– Annuity options

Often called a “hybrid” plan because it has features of both defined benefit and defined contribution plans


Cash Balance Plan Defined

Career accumulation plan

– Hypothetical account for each participant Assets in the plan may be more or less than the sum of the

individual accounts at any point in time.

– Benefit is defined as the accumulated value of annual allocations plus interest credits

Legally, Cash Balance plans are defined benefit plans, not defined contribution plans

– Assets of plan available to pay benefits to all employees

– Annual contributions to the plan are not equal to the annual allocations


How the Plan Works

Annual allocation Rate can be a single rate (expressed as a percentage of pay) for all employees or graded by age, service, etc.

Annual Allocation is the annual allocation rate multiplied by eligible earnings

An Interest credit is provided each year and represents interest earned on the hypothetical account for the year

– Usually tied to U.S. Treasury rates (e.g. 10 year, 30 year)

– Not specific to employee elections (rare exceptions)


How the Plan WorksExample

Simple Cash Balance plan that provides an annual allocation of 5% of the employee’s pay. Interest credit for the year is determined as the rate of return on 10-year US Treasuries on the last business day of the prior year.

Year #1Cash Balance

AccountBeginning of Year -$ Annual Pay $40,000Annual Allocation Rate 5%Annual Allocation $2,000 $2,000Interest Crediting Rate 4.50%Interest Credit on Beginning of Year Account Balance -$ -$

End of Year 2,000$

Year #2Cash Balance

AccountBeginning of Year 2,000$ Annual Pay $41,600Annual Allocation Rate 5%Annual Allocation $2,080 $2,080Interest Crediting Rate 4.75%Interest Credit on Beginning of Year Account Balance 95$ 95$

End of Year 4,175$


How the Plan WorksPayment Options

At retirement, benefit usually paid as a lump sum, although annuity option is available

Plan could be designed to only offer an annuity with the value of the annuity determined directly from the cash balance account value

Benefit payout could be restricted to commence only after reaching early retirement age

– If “portability” is desired, this feature defeats that goal


How the Plan WorksRisk Allocation

Investment: Benefit is a lump sum or equivalent annuity and is not based on the performance of plan assets. If assets invested in a diversified portfolio, assets may exceed or fall short of the hypothetical account values in any given year. Sponsor will be responsible for making up any shortfall.

Pre-retirement Inflation: Prior year benefits only grow with interest credit, not with changes in salary. However, interest crediting rates generally are related to inflation.

Longevity: If Employee takes lump sum (most do), the employee assumes all the risk of outliving his/her assets

Risk

Investment Pre-retirement

Inflation Longevity Final Pay Plan Sponsor Sponsor Sponsor

Cash Balance Plan Sponsor Employee/Sponsor Employee


History

First developed for Bank of America in 1985

Lots of interest during the late 1990’s

Interest has waned due to IRS moratorium on determination letters and law suits

Will interest rise again due to “blessing” of Pension Protection Act of 2006?

Source: GOA report on Cash Balance Plans September 2000.


Why the interest in Cash Balance Approach?

There is no single reason that applies to all conversions to a cash balance plan, but here are some you might see:

– Benefit is easy to communicate Benefit statements read like a bank statement

– Portability was seen as an important design element Seen as a better fit for a mobile workforce

– Limits the sponsors risk of having retirees who live a long time (longevity risk)

– Limits pre-retirement inflation risk

– Design more in line with pay-for-performance philosophy Two employees who contribute equally to the business are rewarded

equally – eliminates age-based component of benefit value in today’s dollars

– Depending on design, plan could be less expensive. Improves balance sheet and income statement items.


Why the Negative Press?

Negative press has come about for two primary reasons

– Transition approaches

– Different accrual pattern of benefits

Transition approach that draws fire

– Example: Plan will switch to cash balance at January 1, 2008. Benefit is larger of:

A) Final average pay benefit as of December 31, 2007, or B) Monthly benefit equivalent from a cash balance account, assuming

the person had been in the new cash balance plan since inception

– Individual may go years without accruing an additional benefit

Older workers can be harmed significantly


How are Employees Impacted?

The next few slides assume the following:

– Final average pay plan (2% per year of service) is changed to a cash balance plan

– Annual allocation is 10% of pay

– Interest crediting rate is 5%

Note: The following examples are for illustration purposes only. These two plans may or may not be similar in cost.


How are Employees Impacted?Harm to older workers has created negative press

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65

Age

Interest credit rate for cash balance plan: 5%Salary increase rate: 6%; 5%; 4.5%; 3.5%; 3%

Final Average Pay

FAP changed to CB

Older EE Data at 2007: Age = 50, Service = 15, Salary = $60,000

Life Annuity, Retire at Age 65 (or Now if Over Age 65)


How are Employees Impacted?Harm to older workers has created negative press

$0

$100,000

$200,000

$300,000

$400,000

$500,000

$600,000

35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65

Age


Final Average Pay

FAP changed to CB

Older EE Data at 2007: Age = 50, Service = 15, Salary = $60,000

Present Value of Benefit Payable as a Lump Sum

Value of early retirement subsidies is reduced significantly


How are Employees Impacted?Picture becomes less clear with mid-career employees

$0

$10,000

$20,000

$30,000

$40,000

$50,000

$60,000

$70,000

$80,000

$90,000

30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65

Age


Final Average Pay

FAP changed to CB

Mid Career EE Data at 2007: Age = 40, Service = 10, Salary = $50,000



How are Employees Impacted?Some Employees are benefited

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42 43 44 45 46 47 48 49 50 51 52 53 54 55 56 57 58 59 60 61 62 63 64 65

Age


Final Average Pay

FAP changed to CB

Young, Recently hired EE Data at 2007: Age = 30, Service = 3, Salary = $40,000



How are Employees Impacted?It Depends!

Annuity Benefit: Ratio of New Plan to Old PlanOld Plan: Final Average PayNew Plan: FAP changed to CB

After a Number of Years, Retire at Age 65 At Retirement AgeAge Service Salary Count 5 10 15 20 25 30 35 55 60 62 6525 0 $30,000 610% 419% 292% 208% 149% 110% 83% 46% 54% 57% 64%25 0 $60,000 610% 419% 292% 208% 149% 110% 83% 46% 54% 57% 64%25 0 $90,000 610% 419% 292% 208% 149% 110% 83% 46% 54% 57% 64%35 0 $30,000 293% 208% 148% 109% 82% 63% · 92% 53% 56% 63%35 0 $60,000 293% 208% 148% 109% 82% 63% · 92% 53% 56% 63%35 0 $90,000 293% 208% 148% 109% 82% 63% · 92% 53% 56% 63%35 10 $30,000 150% 135% 109% 87% 68% 54% · 44% 48% 50% 54%35 10 $60,000 150% 135% 109% 87% 68% 54% · 44% 48% 50% 54%35 10 $90,000 150% 135% 109% 87% 68% 54% · 44% 48% 50% 54%45 0 $30,000 145% 106% 79% 60% · · · 89% 68% 64% 60%45 0 $60,000 145% 106% 79% 60% · · · 89% 68% 64% 60%45 0 $90,000 145% 106% 79% 60% · · · 89% 68% 64% 60%45 10 $30,000 102% 86% 70% 56% · · · 78% 53% 53% 56%45 10 $60,000 102% 86% 70% 56% · · · 78% 53% 53% 56%45 10 $90,000 102% 86% 70% 56% · · · 78% 53% 53% 56%45 20 $30,000 93% 80% 66% 54% · · · 59% 54% 53% 54%45 20 $60,000 93% 80% 66% 54% · · · 59% 54% 53% 54%45 20 $90,000 93% 80% 66% 54% · · · 59% 54% 53% 54%55 0 $30,000 74% 56% · · · · · · · · 56%55 0 $60,000 74% 56% · · · · · · · · 56%55 0 $90,000 74% 56% · · · · · · · · 56%55 10 $30,000 81% 64% · · · · · 100% 77% 71% 64%55 10 $60,000 81% 64% · · · · · 100% 77% 71% 64%55 10 $90,000 81% 64% · · · · · 100% 77% 71% 64%55 20 $30,000 82% 67% · · · · · 100% 77% 71% 67%55 20 $60,000 82% 67% · · · · · 100% 77% 71% 67%55 20 $90,000 82% 67% · · · · · 100% 77% 71% 67%55 30 $30,000 83% 68% · · · · · 100% 79% 73% 68%55 30 $60,000 83% 68% · · · · · 100% 79% 73% 68%55 30 $90,000 83% 68% · · · · · 100% 79% 73% 68%


IBMJust the basics

July 31, 2003 – Federal District Court ruled that IBM’s cash balance plan violated age discrimination requirements (Cooper v. The IBM Personal Pension Plan)

The participants’ argument with respect to the cash balance formula was as follows:

– Cash balance credits provided under the formula produce higher rates of accrual for a younger employee than for an older employee with the same service and salary, if the rate of accrual is defined in terms of the amount of annual benefit payable at normal retirement age


IBMAge Discrimination Illustration

50 year-old 35 year-old Current Year Pay $ 50,000 $ 50,000

Cash Balance Credit (5% of pay) 2,500 2,500 Interest to age 65 2,450 7,790

Cash Balance Account at age 65 4,950 10,290 Equivalent Life Annuity (annual) $ 412.49 $ 857.53

Court ruled that the larger annuity benefit provided at age 65 to the younger employee makes the cash balance plan age discriminatory


IBMUpdate

August 7, 2006: US Court of Appeals for the Seventh Circuit ruled that IBM’s cash balance plan does not discriminate on the basis of age (Cooper v. IBM Personal Pension Plan)

Appeals court found that the plaintiffs (and the lower court) should not have focused on the plan’s “outputs” (the amount of the age-65 benefit), but should have focused on its “inputs” (the amount of the pay credits). The court saw no reason to treat cash balance plans differently from economically equivalent defined contribution plans.

The court said that it is possible “for litigation about pension plans to make everyone worse off,” noting that since the litigation began IBM had eliminated its cash balance plan for new workers and “confined them to pure defined-contribution plans.”

August 17, 2006: Pension Protection Act signed into law for plans governed by ERISA. Act specifically states that cash balance plans are not age-discriminatory as long as certain minimal requirements are met. Prospective application only.

Supreme Court has refused to hear the case


Application to Public Sector Employers

Many public sector pension plans already have a cash-balance-like feature

– Employee contributions with interest

Going to full cash balance

– Employer contribution also used to provide an account-based benefit

– Allocation rate my be higher than contribution rate Example:

Plan requires 5% contribution from both the employer and employee

Plan could provide an annual cash balance credit of 12% (instead of 10%) with the extra 2% being covered by expected plan earnings above the interest crediting rate


Application to Public Sector Employers

There are many different options for employers to achieve desired goals for their retirement programs:

– Allocation Rates: can be based on service, age, or both (points)

– Interest Crediting Rate

– Vesting schedule

– Payout options: lump sum, annuity, or choice

– Commencement: at termination or retirement only

– Transition benefits, if any

Cash balance plans may make sense for employers who like the benefit growth pattern of a DC plan, but want other features of a DB plan (early retirement subsidies, windows, annuity payouts, etc.)

Documents

Lee D. Gold Denver Cash Balance Plans State Association of County Retirement Systems – Educational Symposium 2007 February 6, 2007