MONEY SAVVY WEEKEND : How Cash-Balance Pensions Work, and Why a Controversy : A rush of firms converting traditional pensions is worrying older workers. But most workers may benefit.

By PAUL J. LIM

Sept. 3, 1999 12 AM PT

TIMES STAFF WRITER

Despite growing government scrutiny of a new type of company pension program--the cash-balance plan--the wave of companies converting to these plans from traditional pensions is expected to continue, many experts say.

The controversy surrounding cash- balance plans was rekindled this week when The Times reported that the Internal Revenue Service is concerned that some of the plans may discriminate against older workers--even though the majority of workers may benefit.

That may lead to changes in how such pensions are implemented, analysts say. But the momentum for these plans--already offered by 12% of the nation’s largest companies, up from 6% in 1995, according to benefits-consulting firm Hewitt Associates--is strong. Hundreds of companies are thinking about making the switch.

Just what are cash-balance pensions, and why are they so controversial? Here are answers to some common questions:

Question: What is a cash-balance plan?

Answer: Cash-balance plans are hybrid pensions that blend certain features of traditional pensions, known as defined- benefit plans, and 401(k)s, or defined-contribution plans.

As with traditional pensions, cash-balance plans promise workers a certain retirement payout, or benefit. At the same time, as with 401(k)s, cash-balance plans allow workers to see what their pensions are worth at any moment--something that can’t be easily done with a traditional pension.

Also, when workers leave a company with a cash-balance plan, they can generally roll their account balances into an individual retirement account. This is a common feature in 401(k) plans but not in traditional pensions.

But as with traditional pensions, the employer, not the employee, makes all the contributions to a cash-balance plan. Also, the employer, not the employee, is responsible for managing money in the account--and therefore assumes all of the “investment risk.”

Cash-balance plans typically promise employees a set annual rate of return, sometimes pegged to the yield on 30-year U.S. Treasury bonds. Should the investments within the plan fall short of returning what Treasuries are yielding--or whatever the promised rate of return is--the company is responsible for making up the difference.

Q: What are the major differences between cash-balance plans and traditional pensions?

A: The payout a retiree receives from a traditional pension is often based on how many years he or she worked for that company, as well as the individual’s salary in the final years of employment--when workers tend to earn the most.

A typical plan might set the base annual payout on a formula such as 1% of the worker’s average pay in the final five years of service multiplied by the number of years of employment with the firm.

So a 65-year-old worker with 45 years of service with a company stands to receive a considerably larger pension than a 35-year-old worker who quits after 10 years.

Sums accrued in cash-balance plans, by contrast, typically are based on a worker’s average salary over his or her total years of service. This means employees tend to accrue benefits gradually and evenly over the course of their careers under cash-balance plans--rather than mostly toward the end of their careers, as they do in traditional pension plans.

Q: What is it about cash-balance plans that has so many people up in arms? Don’t many workers benefit?

A: Even some critics of such plans concede that cash-balance plans are good for certain workers. For instance, “a cash-balance plan is good for new employees” in that they see benefits accrue earlier, noted John Guarrera, a professor at Cal State Northridge and vice chairman of the Coalition for Retirement Security, a pension-rights group.

Carol Quick, research analyst at the Employee Benefit Research Institute in Washington, added: “There’s nothing inherently bad or discriminatory about cash-balance plans,” despite the recent publicity about potential discrimination.

“The problems are in the implementation,” Quick said.

When a firm converts a traditional pension to a cash-balance plan, older workers, especially those in their late 40s or 50s who have stuck with a company expecting a traditional pension, often lose out. How? True, it’s illegal for companies to take away pension benefits already accrued. But because most of the benefits in a traditional pension accrue between 55 and 65, a 54-year old caught in a switch may lose the opportunity to earn that final windfall.

Said Rick Rocco, consulting manager and an actuary at Knobel & Associates in Seattle: “Anyone over 50 should beware.”

Q: Are there things that companies can do to ease the transition for older workers?

A: Yes. Guarrera said that when Eastman Kodak switched to a cash-balance plan, the company offered older workers a choice of sticking with the old system or going to a cash-balance plan. “That’s what we recommend,” he said.

About a third of companies that converted to cash-balance plans have allowed workers to do just that, benefits consultants say.

Other companies have gone a different route. The World Bank Group opted not to convert its existing traditional pension, but rather created a separate plan for new workers that was part cash-balance plan and part traditional pension.

Other plans have offered to make additional contributions to the accounts of older workers to ease the transition--or to improve other benefits.

Still, “many of these efforts will fall short of making the older worker whole,” said William Arnone, director of Ernst & Young’s employee financial education and counseling services unit.

Q: What’s in it for a company that converts a traditional pension to a cash-balance plan?

A: Companies can save money. Remember, under traditional back-loaded pensions, each additional year that an employee stays with the firm forces the company to fund a much larger pension benefit.

But the changing nature of the work force also is driving the change to cash-balance plans, consultants say. It is becoming increasingly rare, for instance, for workers to stay with one firm for their entire careers. Indeed, workers on average change jobs seven times in their lives. In this environment, talented young workers often prefer pension plans that are portable, said Arnone.

Q: Why wouldn’t a company move entirely to a 401(k) plan?

A: Some companies simply prefer defined-benefit pensions over 401(k)s. Also, companies that shift from a traditional pension to a 401(k) are subject to a big tax hit.

What’s more, by switching to a cash-balance plan, companies are still guaranteeing workers a set pension benefit. With a 401(k) alone, by contrast, workers are on their own--and at the markets’ mercy.

Q: In the final result, do most workers win or lose with cash-balance plans?

A: A study last year sponsored by the Society of Actuaries looked at the actual retirement and termination patterns of employees at 35 of the nation’s largest companies between 1989 and 1995.

Based on hypothetical traditional pensions and cash-balance plans of equal total asset value, the study found “that about two-thirds of the employees would have received more valuable benefits under the cash-balance plan,” said Larry Sher, a principal at PricewaterhouseCoopers and a co-author of the report.

Furthermore, about three-quarters of women in the study benefited more from a cash-balance plan than a traditional pension. This seems to reflect that women are disproportionately penalized under traditional pensions if they leave the work force sporadically to have and rear children.

In effect, cash-balance plans redistribute pension benefits.

Q: But with some older workers upset, could the IRS and Congress clamp down on cash-balance plans?

A: The Cincinnati office of the IRS recently sent a memo to the national office seeking guidance on whether a particular firm’s planned conversion to a cash-balance plan was age discriminatory. The national office has yet to rule but could do so soon.

However, the memo addresses a single company’s transition plan--not all cash-balance plans.

Meanwhile, some experts believe Congress could penalize firms that don’t offer older workers a choice of joining a cash-balance plan or staying in a traditional pension.

But most experts believe the government’s issues are with implementation of cash-balance plans--and not the plans themselves. Thus, the trend toward conversion isn’t likely to stop.

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Who’s Using Cash-Balance Plans

In recent months and years, hundreds of the nation’s largest corporations have adopted a controversial type of pension plan known as a cash-balance plan. Among leading companies with such plans:

Aetna

Allied Signal

American Express

Ameritech

AT&T;

Avon Products

Bell Atlantic

Browning-Ferris

Cigna

Citigroup

Colgate-Palmolive

Crown Cork & Seal