    Private Pensions: Information on Cash Balance Pension Plans
    (03-NOV-05, GAO-06-42).

    The nation's private defined benefit (DB) pension system, a key
    contributor to the financial security of millions of Americans,
    is in long-term decline. Since 1980, the number of active
    participants in Pension Benefit Guaranty Corporation (PBGC)
    insured single employer DB plans has dropped from 27.3 percent of
    all national private wage and salary workers in 1980, to about 15
    percent in 2002, and more recently the PBGC has assumed billions
    of dollars in unfunded benefit obligations from bankrupt plan
    sponsors. Some analysts have identified hybrid DB plans like cash
    balance (CB) plans as a possible means to revitalize this
    declining system. However, conversions from traditional DB plans
    to CB plans have sometimes been controversial because of the
    effect conversions may have on the benefits of workers of
    different ages. As House and Senate committees consider
    comprehensive pension reform legislation that includes efforts to
    resolve uncertainties about CB plans, GAO was asked to (1) review
    current research about the implications of CB conversions for
    employee benefits, (2) describe the prevalence and type of
    transition provisions used to protect workers' benefits in past
    CB conversions, and (3) estimate the effects of CB conversions on
    the benefits of individual participants under a hypothetical
    conversion to a typical CB plan from a typical traditional DB
    plan.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-06-42
        ACCNO:   A40459
      TITLE:     Private Pensions: Information on Cash Balance Pension
    Plans
         DATE:   11/03/2005
      SUBJECT:   Employee retirement plans
    	     Fringe benefits
    	     Older workers
    	     Pensions
    	     Retirement benefits
    	     Retirement income
    	     Comparative analysis
    	     Cash balance plans
    	     Defined benefit plans

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    GAO-06-42

         * Appendix I: Information on Cash Balance Pension Plans
         * Appendix II: Review of Literature on Cash Balance Plans
         * Appendix III: Analysis of Form 5500 Data on Cash Balance Plans
         * Appendix IV: Analysis of Simulated Cash Balance Plans and Traditional
           Final Average Pay Plans
         * Appendix V: GAO Contacts and Staff Acknowledgments

                     United States Government Accountability Office

    GAO

                                      October 2005

    PRIVATE PENSIONS

                       Information on Cash Balance Pension Plans

    GAO-06-42

    PRIVATE PENSIONS

    Information on Cash Balance Pension Plans

      What GAO Found

    Current pension and economic literature provides little conclusive
    evidence about the effects of CB plan conversions on benefits. In many
    cases, data and other methodological issues (e.g., sampling methods) limit
    the generalization of results. Nonetheless, cash balance research
    indicates that the effects of a conversion depend on many factors,
    including the generosity of the CB plan, transition provisions that might
    limit any adverse effects on current employees, and firm-specific employee
    demographics. CB plan conversions are posited to have distributional
    effects on expected pension wealth: younger, more mobile workers usually
    benefit while older workers with long job tenure are likelier to
    experience a loss, particularly if they are nearly eligible for early
    retirement.

    GAO's analysis of a representative sample of plan conversions determined
    that most conversions occurred between 1990 and 1999 and primarily in the
    manufacturing, health care, finance and insurance industries. Most
    conversions set participants' opening account balances equal to the
    present value of benefits accrued under the previous plan, although the
    interest rate used to calculate the balance varied around the 30-year
    Treasury bond rate. Most plans provided some form of transition provisions
    to mitigate the potential adverse effects of a conversion on workers'
    expected benefits for at least some employees. About 47 percent of all
    conversions grandfathered at least some of the employees into the former
    traditional DB plan. In most cases, grandfathering eligibility was limited
    to employees meeting a specified minimum age and/or years of service.

    GAO's simulations of the effects of conversions on pension benefits show
    the following:

         o In conversions from a traditional DB plan to a typical CB plan, most
           workers, regardless of age, would have received greater benefits under
           the DB plan. Unless grandfathered into the former plan, older workers
           experience a greater loss of expected benefits than younger workers.
         o In comparing a typical CB plan to a terminated FAP plan, all vested
           workers would do better under the CB plan.
         o In conversions from a traditional DB plan to a CB plan of equal cost
           to the sponsor and more generous than the typical CB plan, while more
           workers at age 30 have benefit increases under the CB plan, this was
           not true for those at age 40 and 50.
         o In comparing a equal cost CB plan to a terminated FAP plan, again all
           vested workers would do better under the CB plan.
         o GAO's comparisons focusing on the lifetime present value of benefits
           did not change the basic findings of GAO's analysis of monthly
           benefits.

                     United States Government Accountability Office

    Contents

      Letter 1

    Concluding Observations 8 Agency Comments 9

    Appendix I Information on Cash Balance Pension Plans

    Appendix II Review of Literature on Cash Balance Plans

      Appendix III Analysis of Form 5500 Data on Cash Balance Plans

    Appendix IV Analysis of Simulated Cash Balance Plans and Traditional Final
    Average Pay Plans

    Appendix V GAO Contacts and Staff Acknowledgments

      Tables

    T able 1: Cash Balance Plan Sample Disposition 57 Table 2: Conversions
    Costs of Typical Cash Balance Plan by

    Conversion Age 66

    Abbreviations

    APS            age plus service
    BLS            Bureau of Labor Statistics
    CB             cash balance
    CBOLT             Congressional Budget Office's long-term social security
                      model
    DB             defined benefit
    DC             defined contribution
    LABOR          Department of Labor
    GAM            Group Annuitant Mortality
    FAP            final average pay
    PBGC           Pension Benefit Guaranty Corporation
    PENSIM         pension policy microsimulation model
    PSG            Policy Simulation Group
    PSID           Panel Study of Income Dynamics
    SIPP           Survey of Income and Program Participation
    SPD            summary plan description

    This is a work of the U.S. government and is not subject to copyright
    protection in the United States. It may be reproduced and distributed in
    its entirety without further permission from GAO. However, because this
    work may contain copyrighted images or other material, permission from the
    copyright holder may be necessary if you wish to reproduce this material
    separately.

    United States Government Accountability Office Washington, DC 20548

    November 3, 2005

    The Honorable George Miller Ranking Minority Member Committee on Education
    and the Workforce United States House of Representatives

    The Honorable Bernard Sanders Ranking Minority Member Subcommittee on
    Financial Institutions

    and Consumer Credit Committee on Financial Services United States House of
    Representatives

    The Honorable Tom Harkin United States Senate

    The nation's private defined benefit (DB) pension system, 1 a key
    contributor to the financial security of millions of American workers and
    their families, is in long-term decline. The number of single employer DB
    plans has declined dramatically over the past several decades, 2 from over
    95,000 in 1980 to less than 35,000 in 2002, with the number of active
    participants in such plans dropping from 27.3 percent of all national
    private wage and salary workers in 1980, to about 15 percent in 2002. 3
    Structural problems in industries like airlines, steel, and auto parts
    have led to large bankrupt firms terminating their DB plans, with
    thousands of workers losing some of their benefits and saddling the
    Pension Benefit

    1

    In DB plans, formulas set by the employer determine employee benefits. DB
    plan formulas vary widely, but benefits are frequently based on
    participant pay and years of service.

    2

    Single employer plans provide benefits to employees of one employer or, if
    under common control, employees of several related employers.
    Multiemployer plans are DB plans created by collective bargaining
    agreements covering more than one employer and generally operate under the
    joint trusteeship of labor and management. These plans cover over 9.7
    million participants or about 22 percent of all workers and retirees
    insured by the Pension Benefit Guaranty Corporation (PBGC). See GAO,
    Private Pensions: Multiemployer Plans Face Short and Long-Term Challenges,
    GAO 04-423 ( Washington, D.C.: Mar. 26, 2004).

    3

    Pension Benefit Guaranty Corporation, Pension Insurance Data Book,
    (Washington, D.C., 2004).

    Guaranty Corporation (PBGC) with billions of dollars in unfunded benefit
    guarantees. 4 In response, several congressional committees have proposed
    comprehensive pension reform legislation that, among other issues, would
    address the underfunding of single employer defined benefit plans. 5

    Some analysts have identified hybrid DB plans like cash balance (CB) plans
    as a possible means to revitalize this declining system. CB plans are
    referred to as hybrid plans because legally they are DB plans but contain
    certain features that resemble defined contribution plans. Similar to
    traditional DB plans, CB plans use a formula to determine pension
    benefits. However, unlike traditional final average pay (FAP) plans that
    pay retirement benefits on the basis of an annuity amount calculated using
    years of service and earnings, CB plans express benefits as a hypothetical
    individual account balance that is based on pay credits (percentage of
    salary or compensation) and interest credits, rather than an annuity.

    In the late 1990s, many pension plan sponsors converted their traditional
    final average pay plans to CB plans. Conversions to CB plans have been
    controversial because of the effect they may have on pension benefits of
    workers of different ages and years of service. 6 In particular, CB plan
    conversions can sometimes result in so-called "wearaway" situations where
    some workers do not earn additional pension benefits while other workers
    continue to do so. 7 The legality of CB plans has recently been questioned
    in a court ruling regarding whether a CB plan is age

    4

    The PBGC is the federal corporation that insures certain benefits of
    vested participants in DB plans. PBGC insures both single employer and
    multiemployer defined benefit plans. As of the end of fiscal year 2004,
    PBGC reported an accumulated deficit in its single employer program of
    $23.3 billion. See GAO, Private Pensions: Recent Experiences of Large
    Defined Benefit Plans Illustrate Weaknesses in Funding Rules , GAO-05-294
    (Washington, D.C.: May 31, 2005).

    5

    For example, see H.R. 2830 and S. 1783.

    6

    As we noted in past GAO work, plan participants could benefit from
    receiving clearer information regarding the conversions they face. See
    GAO, Private Pensions: Implications of Conversions to Cash Balance Plans,
    GAO/HEHS-00-185 (Washington, D.C.: Sept. 29, 2000) and Cash Balance Plans:
    Implications for Retirement Income, GAO/HEHS-00-207 (Washington, D.C.:
    Sept. 29, 2000).

    7

    See GAO, Private Pensions: Implications of Conversions to Cash Balance
    Plans, GAO/HEHS-00-185 (Washington, D.C.: Sept. 29, 2000).

    discriminatory. 8 Employers report this legal uncertainty has made CB plan
    conversions less popular than in the past. In 2000, we reported on the
    implications of conversions to CB plans and recommended legislative and
    executive agency actions to address the regulatory uncertainty concerning
    CB plans and to improve disclosure to affected participants. 9

    In response to the problems facing the DB system, committees in both the
    House and the Senate have recently proposed legislation that would address
    many issues facing defined benefit plans, including the legal uncertainty
    regarding the formation of new CB plans or the conversion of traditional
    DB plans to CB plans. 10 To help in your deliberations, you asked us to
    provide information on the incidence, features, and effects of CB plan
    conversions. More specifically, you asked: (1) What does the current
    research say about the implications of CB plan conversions for workers'
    benefits? (2) What is the prevalence and types of transition provisions
    provided to protect workers' benefits in past conversions to CB plans? (3)
    How do individual participants fare under a hypothetical conversion to a
    typical CB plan compared to the typical FAP plan? On September 1, 2005,
    and again on October 12, 2005, we briefed your staff on the results of our
    analysis. This report formally conveys the information provided during
    those briefings. (See app. I).

    To determine the results of current research, we conducted a review of
    academic and business literature regarding CB plans and the conversion of
    traditional DB plans to CB plans. To identify the prevalence and types of
    transition provisions in CB plans, we worked with the 2001 Form 5500 to

    8 See Cooper v. IBM Pers. Pension Plan, 274 F.Supp.2d 1010 (S.D. Ill.
    2003). Compounding this uncertainty, in September 1999, the Internal
    Revenue Service announced that it would begin requiring that applications
    for the approval of cash balance formula designs be forwarded to its
    headquarters for technical review, resulting in an effective moratorium on
    approving conversions to cash balance plans.

    9

    For more information, see GAO/HEHS-00-185 and GAO, Cash Balance Plans:
    Implications for Retirement Income , GAO/HEHS-00-207 (Washington, D.C.:
    Sept. 29, 2000).

    10

    See for example, H.R. 2830 and S.1783.

    identify and examine CB plan conversions for their design features. 11 We
    first identified all 843 plans with 100 or more participants that
    indicated a CB or hybrid plan component on Form 5500. We then selected a
    random sample of 205 of these plans. Our sample was comprised of the 45
    largest plans (the smallest of which has about 17,500 participants) and a
    random sample of 160 other plans. 12 Of these 205 plans, we identified 31
    large plans and 102 smaller plans as conversions from traditional DB plans
    to CB plans. (For our methodology, see apps. II, III and IV.)

    To analyze the effects of a CB plan conversion on individual workers, we
    used a pension policy microsimulation model (PENSIM). PENSIM simulates
    lifetime retirement benefits for over 100,000 participants in the 1955
    birth cohort. We calculated and compared monthly retirement income for
    workers from the 1955 birth cohort who are projected to be alive at age
    68, and vested in a job covered by a typical FAP plan that is converted to
    a CB plan. The model allows comparison of benefits received from CB plans
    and ongoing traditional FAP plans, as well as terminated FAP plans.

    We conducted four simulations:

         o typical CB plan versus typical FAP plan,
         o typical CB plan versus terminated FAP plan,
         o equal cost CB plan versus typical FAP plan, and
         o equal cost CB plan versus terminated FAP plan.

    Plan characteristics for the traditional FAP plan and typical CB plan were
    based on Bureau of Labor Statistics' (BLS) employee compensation and
    benefit data, our analysis of CB conversions as designated in the 2001

    11

    The Form 5500 contains considerable information on plan assets,
    liabilities, contributions, design features, including whether a plan is a
    cash balance plan. Although the Form 5500 provides the most comprehensive
    data, its problems are well documented. Our analysis focused on the
    features of the CB plan at the time of conversion and thus would not
    include information on how these plans might have been amended since that
    date. It is possible that some sponsors have amended their plans since the
    initial conversion, in light of employee reactions and recent court
    decisions. Also, it is possible that some sponsors have changed other
    employee benefit plans to help mitigate the potential reduction in some
    workers' future benefits resulting from a CB plan conversion, but
    determining the nature and extent of such changes was outside the scope of
    our work.

    12

    Estimates based on our random sample of plans are subject to sampling
    error. We are 95 percent confident that the true population values are
    within +/- 9 percentage points of the estimated percentages.

    Form 5500 data base and discussions with industry actuaries and
    consultants knowledgeable about CB plans and DB plans generally. We
    developed the features of our equal cost CB plan by starting with the
    design features of the typical CB plan and then increasing both the base
    pay credit and the weighted pay credits (a percentage of pay that
    increases as an employee's age and/or years of service increase) until the
    cost was equivalent with a traditional FAP plan with a workforce of
    identical actuarial, demographic, and labor market characteristics. (See
    slides 19 to 25 in app. I.) We conducted our work between September 2004
    and September 2005 in accordance with generally accepted government
    auditing standards.

    In summary, we found the following:

         o The pension and economic literature provides little conclusive
           evidence about the effects on benefits and other aspects of CB plan
           conversions, particularly with regard to why sponsors convert to CB
           plans in the first place. (See slides 9 and 10.) In many cases, data
           and other methodological issues (e.g., sampling methods) limit the
           generalization of results. The effects of a conversion depend on a
           variety of factors including the generosity of the CB plan itself,
           transition provisions that might limit any adverse effects on current
           employees, 13 and firm-specific employee demographics. CB plan
           conversions are posited to have distributional effects on expected
           pension wealth: younger, more mobile workers usually benefit while
           older workers with long job tenure are more likely to experience a
           loss, particularly if they are near the age and service requirements
           for early retirement. Less research is available on the actual benefit
           distributional effects of such conversions, e.g., how participants are
           likely to fare under a CB plan compared to the traditional DB plan
           that is being replaced.
         o Our analysis of plan conversions determined that most conversions
           occurred between 1990 and 1999, and primarily in the manufacturing,
           health care, finance and insurance industries. Most conversions set
           participants' opening account balances equal to the present value of
           their accrued benefits under the previous plan, although the interest

    Some firms protected workers against a potential reduction in future
    benefits by grandfathering, at the time of conversion, all or some plan
    participants. Grandfathering allows eligible participants to continue to
    accrue benefits under the prior formula or entails operating both formulas
    and providing eligible participants with the greater benefit.
    Grandfathering can be implemented in various ways, affecting different
    groups of workers.

    Page 5 GAO-06-42 Pension Plans

    rate used to calculate the balance varied plus or minus 1 percent of the
    30-year Treasury bond rate. (See slides 11 to 18.) 14 The use of interest
    rates above the 30-year Treasury rate is more likely to result in a
    wearaway situation, unless otherwise mitigated. Most plans provided some
    form of transition provisions to mitigate the potential adverse effects of
    a conversion on workers' expected benefits for at least some employees.
    About 47 percent of all conversions used some form of grandfathering that
    was applied to at least some of the employees in the former traditional DB
    plan. 15 In most cases, grandfathering eligibility was limited to
    employees meeting a specified minimum age or years of service or both.
    Most conversions also used some form of ongoing weighted pay credit.

    o  Our comparison of a typical FAP plan that is converted to a typical CB
    plan finds that, regardless of a worker's age, more workers would have
    received greater benefits under the FAP than under the typical CB plan. 16
    (See slides 26 to 28.) For workers who receive less under the CB
    conversion, median benefit decreases range from $59 per month at age 30 to
    $238 per month at age 50. For the workers who receive more under the
    conversion, median benefit increases range from $15 per month at age 30 to
    $27 per month at age 50. 17 Those who experience either benefit increases
    or decreases are more likely to be men, except for those at the age 50
    conversion, where they are more likely to be women.

    14

    IRC section 417(e)(3) stipulates that DB sponsors that permit lump sum
    distributions must, among other conditions, calculate distributions to
    departing participants using an interest rate no greater than 30-year
    Treasury rate. Using a higher interest rate would result in a lower lump
    sum distribution.

    15

    There is a range of types of grandfathering that can be used by plan
    sponsors. They can include provisions such as giving employees a choice of
    whether to stay in the old FAP plan or join the new CB plan, providing a
    minimum benefit where the employee is guaranteed to at least earn the
    benefit of their former plan until a future specified date, or making
    grandfathering available to only some or all employees in the former plan.

    16

    These comparisons are based on amounts of annuity benefits and do not take
    into account death benefit coverage before an annuity begins. For the
    purpose of this report, it is recognized that participants do not have an
    entitlement to future or expected benefits.

    17

    We also conducted a comparison of lifetime benefits for workers under a
    traditional FAP and those converted to a typical CB plan as well as to an
    equal cost CB plan. In these cases, while the number of workers faring
    better under the CB plans is greater at each age compared to the numbers
    in the monthly benefits calculation, the basic results found under the
    monthly benefit comparison are not changed in either case. (See slides
    31-32, 38-39.)

         o In comparing a conversion to a typical CB plan with a terminated FAP,
           all vested workers would do better under the CB plan. Median monthly
           benefits increase at conversion ages 30, 40, and 50, with increases
           ranging from $150 per month for conversions at age 30 to $305 per
           month for conversions at age 50. (See slides 29 to 30.) The increase
           in benefits for older workers is because grandfathered benefits are
           included in these results. Although the analysis focuses on vested
           workers at the time of conversion, under a terminated FAP plan, by law
           all previously unvested workers (those with less than 5 years service)
           are immediately vested. 18
         o Under a traditional FAP plan conversion to an equal cost CB plan,
           larger numbers of workers at all ages have benefit increases than
           under the typical CB plan/FAP plan scenario. 19 (See slides 33 to 35.)
           Grandfathering again protects the benefits of those older workers who
           were covered. However, while more workers who are converted at age 30
           fare better under the CB plan, this was not true at other ages. A key
           factor is the greater generosity of the equal cost CB plan compared to
           the typical CB plan we also simulated. 20 Under the equal cost
           scenario, median reductions range from $75 per month for conversions
           at age 30 to $128 per month for conversions at age 50, while median
           increases range from $90 per month for conversions at age 30 to $29
           per month for conversions at age 50. For all conversion ages, those
           with longer job tenure and who are not covered by grandfathering
           protections are more likely to lose than those workers with shorter
           tenure. At each conversion age, a greater percentage of those who are
           more likely to experience benefit increases are men rather than women.
         o In comparing a conversion to an equal cost CB plan with a terminated
           FAP plan, again all vested workers do better under the CB plan. Median
           increases range from $283 per month for conversions at age 30 to $396
           per month for conversions at age 50. (See slides 36 to 37.) The
           increase in benefits for older workers comes about because
           grandfathered benefits are included in these results.

    18

    In our simulations, about 36 percent of our sampled individuals (57,049)
    who participated in at least one private sector FAP or CB plan never
    vested in such plans.

    19

    Again, these comparisons are based on amounts of annuity benefits and do
    not take into account death benefit coverage before an annuity begins.

    20

    This plan's pay credits were more generous than virtually all of the 136
    plan conversions we analyzed.

    Page 7 GAO-06-42 Pension Plans

    Concluding Observations

    Our analysis illustrates one of the difficult choices facing the Congress
    in crafting comprehensive DB pension reform legislation, including the
    controversial issues surrounding the legal status of CB plans, and
    particularly CB conversions. The current confusion concerning CB plans is
    largely a consequence of the present mismatch between the ongoing
    developments in pension plan design and a regulatory framework that has
    failed to adapt to these designs. Although CB plans legally are DB plans,
    they do not fit neatly within the existing regulatory structure governing
    DB plans. This mismatch has resulted in considerable regulatory
    uncertainty for employers as well as litigation with potentially
    significant financial liabilities. For many workers, this mismatch has
    raised questions about the confidence they may have in the level of income
    they expect at retirement, confidence that has already been shaken by the
    termination of large pension plans by some bankrupt employers. 21

    CB plans may provide more understandable benefits and larger accruals to
    workers earlier in their careers, advantages that may be appealing to a
    mobile workforce. However, conversions of traditional FAP plans to CB
    plans redistribute benefits among groups of workers and can result in
    benefits for workers, particularly those who are longer tenured, that fall
    short of those anticipated under the prior FAP plan. Our simulations
    suggest that grandfathering plan participants who are being converted can
    protect those workers' expected benefits, and, in fact, such protections,
    in some form, are fairly common in conversions. Our simulations also show
    that without such mitigation, many workers can receive less than their
    expected benefits when converted from a traditional FAP plan, even in
    cases where the CB plan is of equal cost to the FAP plan it is replacing.
    As a result, as we noted in our 2000 report, 22 additional protections are
    needed to address the potential adverse outcomes stemming from the
    conversion to CB plans. For example, requirements for setting opening
    account balances could protect plan participants, especially older
    workers, from experiencing periods of no new pension accruals after
    conversion while other workers continue to earn benefits.

    Our simulated comparison of CB plans with the termination of a FAP plan
    leads to several important observations. First, the immediate vesting of
    all unvested workers requirement in a plan termination actually leads to a
    greater number of workers getting some retirement benefits and highlights

    21 See GAO-05-294. 22 See GAO/HEHS-00-185.

    Page 8 GAO-06-42 Pension Plans

                                    Agency Comments

    the portability limitation of DB plans. Workers in an ongoing DB plan only
    receive benefits if they are vested. Appealing to a mobile workforce would
    seem to place an even greater significance on pension portability. Yet
    even CB plans, which often feature lump sum provisions in their design, do
    not address this issue because they typically have similar vesting
    requirements as traditional FAPs.

    In our simulations, vested workers under either a typical or equal cost CB
    plan still fare better than if the FAP plan is terminated. We note further
    that some sponsors of CB plans have already exited the DB system, a system
    that has been declining in sponsorship and participation for several
    decades now. There is a crucial balance between protecting workers'
    benefit expectations with unduly burdensome requirements that could
    exacerbate the exodus of plan sponsors from the DB system. Congress, as it
    grapples with the broader components of pension reform, has the
    opportunity not only to protect the benefits promised to millions of
    workers and eliminate the legal uncertainty surrounding CB plans that
    employers face, but also to craft balanced reforms that could stabilize
    and possibly permit the long-term revival of the DB system.

    We provided a draft of this report to the departments of Labor, Treasury,
    and the PBGC. No written comments were provided by these agencies. They
    did, however, provide technical comments, which we incorporated as
    appropriate.

    We plan to provide copies of this report to the Secretaries of the
    Department of Labor and the Department of Treasury and to the Pension
    Benefit Guaranty Corporation and interested congressional offices. We will
    make copies available to others upon request. In addition, the report will
    be available at no charge on the GAO Web site at http://www.gao.gov.

    If you have any questions concerning this request please contact me at
    (202) 512-5932. Other major contributors to the report are listed in
    appendix VI.

    Barbara D. Bovbjerg

    Director, Education, Workforce and Income Security Issues

    Appendix I: Information on Cash Balance Pension Plans

                                       Objectives

    I. Literature Review: Evaluate current research on the implications of
    cash balance (CB) plan conversions

    II. Plan Analysis: Review CB plans for the prevalence and types of
    transition provisions provided to protect workers' benefits when
    converting to CB plans

    III. Simulations: Analyze how participants may fare under hypothetical CB
    plan conversions compared to the typical final average pay (FAP) plan and
    to a terminated FAP plan.

                                       Background

            * CB pension plans:
                 o Are a type of hybrid defined benefit (DB) plan that expresses
                   benefits as a hypothetical account balance based on pay,
                   service, and interest credits.
                 o Are classified as DB plans because participants' benefits are
                   determined by a benefit formula.
         o FAP plans are a type of DB plan where participants' benefits are
           derived from a formula that is based, in part, on the employee's final
           average pay.

                                   Background, cont.

         o Some conversions to CB plans have been controversial because of the
           effect they may have on pension benefits of workers with different
           ages and years of service. At the same time, CB plans have been noted
           for providing lump sum benefits that can be rolled over upon
           separation and providing benefit accruals based on pay and length of
           service.
         o Wearaway periods: CB plan conversions can sometimes result in
           situations where some workers do not earn additional pension benefits
           while other workers continue to do so.
              * Wearaway can occur for a variety of reasons. Examples of when
                wearaway can occur are:
                   o At conversion when a participant's hypothetical opening
                     account balance is set at less than the present value of the
                     prior accrued benefits (the level of benefits received if
                     paid out as a lump sum).
                   o After conversion because of a fall in the federally mandated
                     discount rate used to determine a lump sum amount.
                   o In relation to annuity benefits earned as of conversion. It
                     is dependent on the the form of annuity selected by the
                     participant and the design of early retirement benefits in
                     the prior plan's formula.

                                   Background, cont.

         o During wearaway, pay and interest credits do not represent new benefit
           accruals until the CB account exceeds the value of benefits that could
           be paid under the old plan.
         o Wear-away periods tend to be longer for older workers.
         o Status of CB plans has been questioned after a court's ruling that at
           least one CB plan is age discriminatory. In late 1999, the Treasury
           Department stopped issuing IRS determination letters approving CB plan
           conversions.
         o Proposed pension reform legislation includes provisions that could
           clarify some legal issues concerning CB plans.
         o Some analysts believe that CB plans represent a potential opportunity
           to stem the decline or even revitalize the declining DB system.

                                      Methodology

    I. Conducted review of academic and business literature.

    II. Analyzed Form 55001 information and attachments from 2003 and earlier
    years capturing design features of CB plan conversions at the point of the
    initial conversion. Initial conversions from a traditional DB plan to a CB
    plan with most covering the period from early 1990s to 2003 with a few
    plan conversions in the mid 1980s. Subsequent changes to CB plans' design
    were not part of the analysis nor were changes made to other plan
    benefits.

         o Identified 843 plans with 100+ participants that indicated CB on Form
           5500
         o Selected the 45 largest plans (1.8 million participants) and a random
           sample of 160 other plans
         o Of these 205 plans, 31 large plans and 102 smaller plans met criteria
           as conversions

    1The Form 5500 Report, which is completed and filed by the Plan sponsor,
    is the primary source of information for both the federal government and
    the private sector regarding the operation, funding, assets, and
    investments of private pension plans and other employee benefit plans. The
    Form 5500 does not provide enough detail to determine the number of
    participants affected by a conversion.

                                   Methodology, cont.

    o  Estimates are based on a random sample of plans, so slightly different
    estimates could result from a different random sample. We are 95%
    confident that the true population values are within +/-9 percentage
    points of the estimate percentages based on our sample.

    III. Simulate effects of a conversion to a CB plan and other scenarios -
    Used a pension policy micro-simulation model (PENSIM).

            * Model simulates lifetime retirement benefits for over 100,000
              participants in the 1955 birth cohort. Lifetime and monthly
              retirement income is analyzed for those who are:
                 o projected to be alive at age 68, and
                 o vested in a job covered by a typical FAP plan that is
                   converted to a CB plan (typical or equal cost).
         o Model allows comparison of benefits received from CB plans, ongoing
           traditional final average pay plans, and terminated FAPs.
         o See appendixes II, III, and IV for a discussion of our methodology.

                                  Summary of Findings

    I. Literature provides few generalizable conclusions, particularly with
    regard to:

         o why sponsors convert to CB plans
         o the benefit distributional effects of such conversions.

    II. Analyzed plan conversions show most, but not all:

         o converted accrued benefits into an opening account balance and offered
           some form of transition provisions.
         o had age and service eligibility restrictions on transition provisions.

                               Summary of Findings, cont.

    III. Regardless of age, workers who were converted from an FAP plan to a
    typical CB plan generally had reductions from expected FAP benefits. A
    majority of younger workers received larger benefits under a conversion to
    an equal cost CB plan.

         o Analysis of lifetime benefits under a conversion to an equal cost CB
           plan does not change basic findings.
         o Vested workers receive larger benefits under a CB conversion of either
           type compared to benefits received under termination of an FAP.

    I. Literature Review

          Research Provides Limited Evidence to Generalize About CB
          Conversions

    ta and othe thodolog issues

    o   o DDaata and othethodolog issues (e.g., sampling methods) limit
    generaizaon of results.

    limit genera iza on of results.

         o Conversion impact depends on a variety of factors including plan
           generosity, transition provisions, and firm specific employee
           demographics.
         o Also, because of the different accrual patterns in a CB plan compared
           to a FAP plan, for a variety of workers, the impact of a conversion
           varies.

    I. Literature Review

        Research Provides Limited Evidence to Generalize About CB Conversions,
        cont.

    ent search prov ed evidence as t

    o   o CCuurrrrentsearch proved evidence as t

    y sponso to plans.

            * WWhhy sponso to plans.
            * par pant kel fa under
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    re tive to the tra ona DB that is ing repl

    retive to the traona DB that ising repl

    o  CB plan conversions have distributional effects on pension wealth:

         o Younger, more mobile workers who vest usually benefit.
         o Older workers with long job tenure likely to experience a loss,
           particularly if they are near age and service requirements for early
           retirement.

    Note: About 36 percent of our sampled individuals (57,049) who
    participated in at least one private sector FAP or CB plan never vested in
    such plans.

             Methods for Determining Opening Account Balances at Conversion

            * There were 2 primary methods for setting the opening account
              balance:
                formula that may include factors
           such as interest rates, employer-added incentives, early retirement
           benefits, & other assumptions.

    Conversion Interest Rates and Transition Provisions Are Key Factors in Wearaway

         o 23 of 39 plans with data available used conversion interest rates
           within 1% of the prior month's 30-year Treasury rate
         o Wearaway may occur when a participant's hypothetical opening account
           balance is set at less than the present value of its accrued benefits
           using 30-year Treasury rate, as specified under the Internal Revenue
           Code.
         o Transition provisions (e.g., grandfathering, transition pay credits)
           are important factors in mitigating wearaway.

    o  Grandfathering prevents wearaway for participants who continue to
    accrue benefits under the prior plan formula.

                About Half of Plans Offered Some Form of Grandfathering

    o  Grandfathering was offered in 47% of all conversions and in 55% of the
    largest converted plans, although most of these provisions had some form
    of age or service restrictions.

            * Eligibility requirements in plans offering grandfathering included:
                 o age plus service
                 o all employees
                 o age or service
         o Age plus service was the method most often used.

    II. Plan Analysis

                   Most Conversions Used Weighted Ongoing Pay Credits

         o 62% of all conversions used some form of weighted pay credits (those
           that increase based on the participant's age and/or service).
         o 36% of all conversions used level pay credits (those that are a level
           function of salary).
         o About 42% of large conversions used an age plus service method for
           providing ongoing pay credits.
         o Weighted pay credits tend to benefit older and longertenured workers
           relatively more than level pay credits.

                                    III. Simulations

                            Simulations of Plan Conversions

            * Compare monthly and lifetime retirement income for workers from the
              1955 birth cohort who were converted at different ages to a CB plan
              and were either:
                 o Not vested in a typical, traditional FAP plan at the time of
                   conversion but stay on the job and later vest; or
                 o vested at the time of conversion in a typical, traditional FAP
                   plan;
            * 4 Simulations:
                 o Typical CB plan vs. typical FAP plan
                 o Typical CB plan vs. terminated FAP plan
                 o Equal cost CB plan vs. typical FAP plan
                 o Equal cost CB plan vs. terminated FAP plan

                                           19

                                    III. Simulations

                  Plan Characteristics: Typical Final Average Pay Plan

         o Immediate eligibility and 5-year cliff vesting and normal retirement
           age 65, early retirement age 55 with 10 years of service with early
           retirement benefit reduction of 5 percent per year.
         o Immediate disability retirement benefits for those vested, no
           survivors benefits or joint-and-survivor annuities.
         o Benefits paid as a nominal annuity (i.e., no benefit COLA).
         o Terminal earnings (final pay) is final five-year average.
         o Benefits formula is excess integrated with base rate of 1.5 percent of
           final pay per year of service and has a rate of 0.45 percent of final
           pay per year of service for those amounts in excess of the social
           security maximum.
         o Typical FAP plan design based on prior GAO reports, literature
           reviews, and discussions with pension actuaries, consultants
           knowledgeable about DB plans.

                                    III. Simulations

                    Plan Characteristics: Typical Cash- Balance Plan

         o Immediate eligibility and five-year cliff vesting; base pay credit of
           3.0 percent of salary for employee with age-plus-service (APS) =< 35.
         o Pay credit rises gradually until it is 6.0 percentage points above the
           base pay credit for employee with APS >= 70.
         o Cash-balance account crediting rate is the Treasury rate.
         o Employee rolls over account balance at separation and earns Treasury
           rate. Balances converted to nominal single-life annuity at retirement
           using the Treasury rate and the GAM 83 mortality table adjusted to the
           pertinent year.
         o Typical CB plan design is based on plans analyzed in GAO's Form 5500
           data, and confirmed by pension actuaries, consultants knowledgeable
           about CB plans.
         o Some typical CB plan design features may have changed in light of
           recent court decisions and congressional interest

    III. Simulations

                   Plan Characteristics: Equal Cost Cash Balance Plan

            * Same assumptions as the typical CB plan except:
                 o Base pay credit of 7.35 percent of salary for employee with
                   age-plus-service (APS) =< 35.
                 o Pay credit rises gradually until it is 6.0 percentage points
                   above the base pay credit for employee with APS >= 70.
            * Equal cost CB plan used for our simulations is:
                 o More generous pay credits than virtually all plans in our Form
                   5500 analysis
                 o More generous than those specified in pension research
                 o Though not explicitly modeled, to some extent, our equal cost
                   cash balance plan could be considered to implicitly include
                   other enhancements made by employers to other benefits, such
                   as those provided by a DC plan, for example.

                                    III. Simulations

                  Plan Characteristics: Cash-Balance Plan Conversions

         o Opening cash balance equal to the present value of accrued finalpay
           benefit at plan conversion date. Discount rate is the 30-year Treasury
           rate. Mortality table is GAM 83 projected for mortality improvements
           to the pertinent year.
         o Employees who meet an age-plus-service (APS) >= 60 eligibility
           requirement at plan conversion date are grandfathered under the FAP
           plan and receive benefits according to that plan's provisions.
              * Treatment of early retirement benefits:
                   o The FAP plan considered in this report has a modest
                     earlyretirement subsidy: benefits are reduced by 5 percent
                     for each year benefits are claimed before age 65.
                   o Federal anti-cutback rules are simulated correctly in that
                     when a FAP plan is converted or terminated, employees who
                     remain with the firm until early retirement age are eligible
                     for early retirement benefits under the old plan.

                                    III. Simulations

                       Plan Characteristics: Terminated FAP Plan

            * Same assumptions as the typical FAP plan and:
                 o Terminated FAP plan has immediate cessation of additional
                   benefit accrual.
                 o Current law on plan terminations requires "immediate vesting"
                   for "non-vested" workers regardless of years of service. This
                   results in previously ineligible workers now receiving a small
                   benefit.
         o Analysis focuses on "vested" workers only --those with at least five
           years service.
         o FAP plan and termination scenarios provide benchmark range of possible
           comparisons, including plan freezes

                                    III. Simulations

            Monthly Retirement Income Results vs. Lifetime Benefits Results

         o Results are shown in terms of present value of lifetime benefits for
           those alive at age 68 and monthly retirement income for those alive at
           age 68. Age 68 is the age when the largest number of individuals are
           retired and alive in our sample.
              * Monthly benefit and lifetime benefit comparisons for those alive
                at age 68 will have slightly different results:
                   o For example, vested workers under CB plans who typically
                     separate earlier in their careers may start benefits at a
                     different age compared to similar workers who separate from
                     an FAP plan.
                   o Thus, the present value of lifetime benefits paid to these
                     workers under CB plans may be distributed over a different
                     time period than for similar workers under FAP plans. So
                     monthlybenefits may be slightly different.

                                    III. Simulations

    Comparisons of Median Monthly Retirement Income: Typical CB Plan vs. Typical FAP
                                          Plan

    o  Regardless of age at conversion, more workers who are converted from a
    FAP plan to the typical CB plan experience benefit reductions. (See figure
    5).

         o Key factor is lack of generosity of the typical CB plan.
         o Grandfathering protects those workers who meet eligibility

    requirements.

    o  For those not grandfathered, at conversion ages 30, 40, and 50: (See

    figure 6)

            * Reductions in median monthly income range from $59 for conversions
            * at age 30 to $238 for conversions at age 50.
         o Increases range from $15 per month for conversions at age 30 to $27

    per month for conversions at age 50.

         o Those who benefit as well as those who lose from conversion at ages 30
           and 40 are more likely to be men and at age 50 are more likely to be
           women.
         o At all conversion ages, those experiencing greater benefits from
           conversion are generally more highly educated and have higher incomes.

                                    III. Simulations

    Comparisons of Median Monthly Retirement Income: Typical CB Plan Conversion vs.
                              Terminated Typical FAP Plan

         o Regardless of age, all vested workers who converted to a typical CB
           plan experienced monthly benefit increases compared to a terminated
           FAP plan.
         o At conversion ages 30, 40, and 50, increases range from $150 per month
           for conversions at age 30 to $305 per month at age 50. Grandfathered
           benefits for those eligible under the CB plan greatly impact results
           shown for older workers.(See figure 7.)

    o  Terminated plan benefits are shown for only those participants who were
    vested in the typical CB plan.

                                    III. Simulations

    Workers Converted to Typical CB Plan from Typical FAP at Earlier Ages Generally
                           Receive Reduced Lifetime Benefits

    o  Comparison of lifetime benefits for typical CB plan and typical FAP
    plan does not change basic findings from monthly benefit comparisons.

         o Regardless of age at conversion, more workers who are converted from a
           FAP plan to the typical CB plan have lower present value of lifetime
           benefits. (See figure 8.)
         o Nearly half of workers experiencing a conversion at age 50 are
           grandfathered in their FAP benefit.

                                    III. Simulations

    Grandfathering Protects Eligible Older Workers' Monthly Benefits When Converted
                    to an Equal Cost CB Plan from a Typical FAP Plan

         o Grandfathering protects eligible older workers' benefits converted to
           an equal cost CB Plan from a FAP Plan (See figure 9.)
              * More workers who converted from a FAP plan to an equal cost CB at
                age 30 generally experience monthly benefit increases
                      * Increases range from $90 per month for conversions at age
                        30
                      * to $29 per month for conversions at age 50. (See figure
                        10.)
                   o Reductions range from $75 per month for conversions at age

    30 to $128 per month for conversions at age 50.

    o  For all conversion ages, those with a longer job tenure and who are

    not covered by grandfathering protections are more likely to

    experience lower benefits than those with shorter tenure

                                    III. Simulations

        Comparisons of Median Monthly Retirement Income: Equal Cost CB Plan vs.
                              Terminated Typical FAP Plan

         o Regardless of age, all vested workers who converted to an equal cost
           CB plan experience benefit gains compared to a terminated FAP.
         o Median increases range from $283 per month for conversions at age 30
           to $396 per month for conversions at age 50. Grandfathered benefits
           for older workers under the CB greatly impact results.(See figure 11.)

    o  Terminated plan benefits are shown for only those participants who were
    vested in the equal cost CB plan.

                                    III. Simulations

    Workers Converted to Equal Cost CB Plan from Typical FAP at Age 30 Receive
                               Greater Lifetime Benefits

    o  Comparison of lifetime benefits for equal cost CB plan and typical FAP
    plan consistent with basic findings from monthly benefit comparisons (See
    figure 12).

         o More workers converted to an equal cost CB plan from a typical FAP at
           age 30 receive greater present value of lifetime benefits through
           conversion than would at later conversion ages.
         o Nearly half of workers experiencing a conversion at age 50 are
           grandfathered in their FAP benefit, while a significant number (41%)
           of unprotected workers converted at age 50 experience a lower present
           value of lifetime benefits.
         o Outside of grandfather protections, results show a redistribution of
           benefits from older workers to younger workers.

    Appendix II: Review of Literature on Cash Balance Plans

    GAO compiled a comprehensive list of the academic literature on CB pension
    plans since our last reports on the subject issued in 2000, 1 focusing on
    those studies that contained original and material empirical work on the
    issue. After constructing a list of the relevant literature, we eliminated
    partial or incomplete studies, those that did not contain material
    empirical work and those that exhibited serious methodological concerns.
    We then conducted a more detailed review of the remaining studies,
    including several surveys of CB plans. The review concentrated on the
    studies' findings and on the methodological issues that may limit
    conclusions that can be reached. There is a list of the studies and
    surveys reviewed for this report at the end of this appendix. 2

    Although there are academic studies that attempt to go beyond anecdotal
    information, the literature remains in its infancy. Data and other
    methodological issues often limit the conclusions that the empirical
    studies examining the impact of plan conversions can reach and, the
    ability to generalize their results. In general, the results of all
    studies are sensitive to assumptions regarding earnings growth, interest
    rates, investment returns, and turnover rates. Because some specifics of
    the simulations presented in some studies do not include sufficient
    detail, it is difficult to evaluate the quality of the estimates in some
    cases. 3

    1

    See GAO, Cash Balance Plans: Implications for Retirement Income,
    GAO/HEHS-00-207 (Washington, D.C.: Sept. 29, 2000) and GAO, Private
    Pensions: Implications of Conversions to Cash Balance Plans,
    GAO-HEHS-00-185 (Washington, D.C.: Sept. 29, 2000).

    2

    Since we focused on empirical literature produced since 2000, we did not
    include one older study that is cited in the literature in our detailed
    review (Kopp and Sher, "A Benefit Value Comparison of a Cash Balance Plan
    with a Traditional Average Pay Defined Benefit Plan," The Pension Forum
    [Society of Actuaries, October 1998]). The study contains data and other
    methodological limitations, as well as making similar conclusions. For
    example, because the study examines hypothetical rather than actual plan
    conversions, it is not clear that the results extend to the broader
    workforce. Additional limitations include that fact that the authors had
    limited wage information and therefore relied on simple wage assumptions
    rather than actual wage histories and did not test the sensitivity of the
    results to the assumptions made regarding key variables.

    3

    See for example, Watson Wyatt Worldwide, The Unfolding of a Predictable
    Surprise: A Comprehensive Analysis of the Shift from Traditional to Hybrid
    Plans (2000) and Robert Clark, and Sylvester Schieber, "The Transition to
    Hybrid Pension Plans in the United States: An Empirical Analysis," Private
    Pensions and Public Policies, eds. W. Gale et al. (Washington, D.C.:
    Brookings Institution, 2004).

    Lack of Available Data Limits Empirical Studies

    Because of the limited availability of data on actual conversions and on
    the workforce associated with a particular conversion, few empirical
    studies have the ability to examine actual conversions. 4 Because a range
    of factors that are unique to each conversion influence the final impact
    on workers-including demographic characteristics, the transition benefits
    offered during the conversion and the generosity of the new CB plan
    relative to the old plan it is replacing-it is difficult to extend the
    results of the literature to the actual experience of workers. For
    example, in the conversion to a new plan, a sponsor may eliminate early
    retirement subsidies-a significant reason why older workers may receive
    lower benefits. Similarly, some employers may offer transition benefits
    that can help to ameliorate the adverse effects of plan changes on the
    more senior segment of the workforce, while others do not. Other studies
    focus on "hypothetical" or "prototypical" workers instead of actual
    employees and therefore cannot make definitive statements about many
    segments of the population or actual workers in the plans analyzed. 5

    In addition, the majority of the research simulates the effects of plan
    conversions on the workforce assuming that the conversion is cost neutral
    (the cost of the new CB plan is equal to the cost of the old DB plan so
    that overall pension benefits remain constant). However, some research
    suggests that the retirement benefit implications due to a shift to a less
    generous CB plan differ materially from the effects of a cost-neutral
    conversion. 6 Moreover, several studies were limited to plans that include
    transition benefits that often ensure that existing workers do not suffer
    significant losses in pension wealth during plan conversions and exclude

    4

    Virtually all researchers studying this issue, including GAO, have
    suffered these data limitations.

    5

    The use of hypothetical workers is also a limitation of prior GAO reports
    on cash balance plans. See GAO-02-207 and GAO-00-185.

    6

    See, for example, Watson Wyatt Worldwide (2000). In simulating the effects
    of one conversion to a cost-reducing cash balance plan, the authors find
    that the majority of workers receive lower benefits. However, another
    simulation of a shift to a cost neutral plan finds that the majority of
    the workers receive higher benefits and, although the losses are
    disproportionately borne by the older workers, they are lower than the
    losses experienced in the cost-reducing case.

    Small Sample Size Limits Survey Reports

    pension wealth on previous jobs. 7 Thus, their inclusion/omission may lead
    to a bias in the empirical findings either in favor or against CB plan
    designs.

    Some studies examine only a few plan conversions or rely on assumptions
    based upon information extracted from the limited surveys discussed below.
    Since the plans analyzed may not be representative, the outcomes may not
    generalize to the typical CB conversion or related to the broader
    workforce. 8

    A few widely cited studies which use survey data in an attempt to
    determine the reasons why employers initiate CB plan conversions contain
    methodological limitations and base their conclusions on employers' self
    perceptions along with additional biases, and cannot be extended beyond
    the small samples of firms studied. 9 For example, one study is limited by
    a low response rate (20 percent) and insufficient information about the
    population and sampling method, survey instrument and its development,
    while the others raise concerns over the potential for sample bias and/or
    the additional bias due to the fact that over half of the plans evaluated
    were those for which the researchers were the primary design

    7

    This pertains to the majority of the literature we reviewed. Although
    Johnson and Uccello

    (R.W. Johnson, and C. Uccello, "Cash Balance Plans and the Distribution of
    Pension Wealth," Industrial Relations, 42(4) [2003], 745-773) include
    pension wealth on previous jobs, analyze actual workers and capture a
    greater diversity of outcomes, the results do not generalize to
    cost-reducing plan conversions or conversions where the defined benefit
    plan incorporated early retirement incentives (see below for more on the
    cost neutral assumption). Moreover, the pension wealth in cash balance
    plans may be exaggerated because of issues with the data and the
    assumptions regarding turnover rates.

    8

    For example, see several studies conducted by Schieber (including Clark
    and Schieber [2004]) which are derived from data on 77 plans collected and
    analyzed initially by Watson Wyatt Worldwide in their 2000 study. Given
    estimates of the number of actual cash balance conversions and their
    growth since 2000, it is not clear that this work can be used as a
    reliable guide to gauging the impact of a typical cash balance conversion
    on workers. Moreover, GAO found other research studies that were based on
    significantly fewer cash balance conversions, e.g., Clark and F.W.
    Munzenmaier (R. Clark, and F.W. Munzenmaier. "Impact of Replacing a
    Defined Benefit Pension with a Defined Contribution Plan or a Cash Balance
    Plan." North American Actuarial Journal, 5 (1). (2003-4): 32-56. (2001).

    9

    See, for example, Watson Wyatt Worldwide (2000); PriceWaterhouseCoopers,
    Survey of Conversions from Traditional Pension Plans to Cash Balance Plans
    (2000); and Mellon Financial Corporation, 2004 Survey of Cash Balance
    Plans (Secaucus, N.J.: 2004).

    Studies and Surveys Reviewed

    consultants. 10 In general, we determined that the results from these
    surveys may not be representative of the population of CB plan conversions
    and methodological limitations suggest that the results should be
    interpreted with caution.

    Clark, Robert. "Pension Plan Options: Preferences, Choices and the
    Distribution of Benefits." Pension Research Council Working Paper, PRC WP.
    2003-24.

    Clark, Robert, and Fred W. Munzenmaier. "Impact of Replacing a Defined
    Benefit Pension with a Defined Contribution Plan or a Cash Balance Plan."
    North American Actuarial Journal, 5 (1). (2003-4): 32-56.

    Clark, Robert, and Sylvester Schieber. "The Transition to Hybrid Pension
    Plans in the United States: An Empirical Analysis." Private Pensions and
    Public Policies, eds. W. Gale et al. Washington, D.C.: Brookings
    Institution. 2004.

    Coronado, Julia, and Philip Copeland. "Cash Balance Pension Plan
    Conversions and the New Economy." Federal Reserve Board Working Paper.
    November 2003.

    D'Souza, Julia, John Jacob, and Barbara Lougee. Why Do Firms Convert to
    Cash Balance Pension Plans? An Empirical Investigation. Cornell
    University, December 2004.

    Johnson, R.W., and C. Uccello. "Cash Balance Plans and the Distribution of
    Pension Wealth." Industrial Relations, 42(4) (2003): 745-773.

    Mellon Financial Corporation. 2004 Survey of Cash Balance Plans. Secaucus,
    N.J.: 2004.

    Niehaus, Greg, and Tong Yu. "Cash-Balance Plan Conversions: Evidence on
    Excise Taxes and Implicit Contracts." The Journal of Risk and Insurance,
    72(2). 2005.

    PriceWaterhouseCoopers. Survey of Conversions from Traditional Pension
    Plans to Cash Balance Plans. July 2000.

    10

    PriceWaterhouseCoopers (2000).

    Purcell, Patrick. Pension Issues: Cash Balance Plans. Washington, D.C.:
    Congressional Research Service, August 2003.

    Rao, A., L. Higgins, and S. Taylor. "Cash Balance Pension Plans: Good News
    or Bad News." Journal of Applied Business Research, 18 (3). 2002.

    Samwick, Andrew, and Jonathan Skinner. "How will 401(k) Plans Affect
    Retirement Income?." American Economic Review, Vol. 94, No.1. March 2004.
    11

    Schieber, Sylvester. "The Shift to Hybrid Pensions by U.S. Employers: An
    Empirical Analysis of Actual Plan Conversions." Pension Research Council
    Working Paper, PRC WP. 2003-23.

    Watson Wyatt Worldwide. The Unfolding of a Predictable Surprise: A
    Comprehensive Analysis of the Shift from Traditional to Hybrid Plans.
    2000. 12

    11

    Findings of this paper are not directly discussed in this appendix as it
    involves an assessment of plan conversions from traditional defined
    benefit plans to defined contribution plans.

    12

    Looking at 78 plan conversions, Watson Wyatt Worldwide (2000) found that
    56.4 percent of the plans were cost-reducing, 20.5 percent were
    cost-neutral and 23.1 were costincreasing. However, when the authors
    assumed workers took full advantage of the enhancements to the defined
    contribution plan that occurred contemporaneously with the transition,
    44.9 percent of the plans were cost reducing, 17.9 percent were cost
    neutral and

    37.2 percent were cost increasing. This work has led some researchers to
    deduce that the average cash balance conversion is cost neutral, since the
    majority of the plans (55.1 percent) were cost-neutral or increasing.
    However, as we indicated earlier, it is not clear that this small sample
    of conversions is representative. Also, some recent statistics do not
    support the assumption of full participation used by Watson Wyatt to
    incorporate these enhancements. For example, some estimates suggest that a
    significant percentage of employees do not participate in their 401(k)
    program at all, and the majority of those that do participate do not
    maximize the value of the plan. See Congressional Research Service,
    Automatic Enrollment in Section 401(k) Plans (Washington, D.C., Oct. 14,
    2004). The CRS found that because enrollment in most S:401(k) plans is
    voluntary, not all workers whose employers offer a plan choose to
    participate. `The Bureau of Labor Statistics reports that in 2003, 51
    percent of workers in the private sector were employed at establishments
    that offered a defined contribution plan, but just 40 percent of employees
    at private establishments participated in a plan. Consequently, the
    participation rate among employees whose employer offered a DC plan was 78
    percent." Also see Alicia H. Munnell and Annika Sunden, Coming Up Short:
    The Challenge of 401(k) Plans (Washington, D.C.: Brookings Institution
    Press, 2004).

    The authors conclude that one in four employees do not participate in a
    401(k) plan, and less than 10 percent contribute the maximum.

    Appendix III: Analysis of Form 5500 Data on Cash Balance Plans

                              Sample of Cash Balance Plans

    To obtain information about CB plan conversions, we reviewed 2001 Form
    5500 data for a random sample of CB plans. We drew this sample from the
    population of plan sponsors that indicated on their Form 5500 that they
    sponsored a CB plan. 1 The study population consisted of all CB plans as
    of 2001 having at least 100 active participants, supplemented with an
    additional 96 CB plans that were identified by PBGC based on 2002 and 2003
    data not yet available to the GAO. For the purpose of this report, we
    excluded plans having fewer than 100 participants in order to focus on the
    plans with the greatest number of participants. 2 This resulted in a total
    of 843 plans in our study population.

    We used the Form 5500 as our primary source of information for analyzing
    the prevalence of transition provisions used by plan sponsors when they
    converted to a CB plan because it was a cost effective way of obtaining
    conversion information for a large number of plans. It would have been
    optimal to obtain summary plan descriptions (SPD) from plan sponsors.
    However, since plan sponsors are no longer required to file SPDs, direct
    contact with such a large number of plan sponsors would have been cost
    prohibitive. 3

    Although it is the most comprehensive pension data available, using Form
    5500 data also presented limitations and weaknesses. We had limited
    ability to determine the full scope of conversions beyond tax year 2001
    since this was the most current and complete 5500 data publicly available
    from the Department of Labor (Labor) when we began our analysis. In
    addition, we also had difficulty obtaining Form 5500 filings for some
    years, particularly from the early 1990s and before. As previously
    reported by GAO, 4 statutory reporting requirements, processing issues,
    and current

    1

    The Form 5500 is a disclosure form that private sector employers with
    qualified pension plans are required to file with the Internal Revenue
    Service (IRS), Labor's Employee Benefit Security Administration (EBSA),
    and Pension Benefit Guaranty Corporation (PBGC). This dataset contains all
    private sector single employer DB plans that are insured by the PBGC.

    2

    There were 1590 plans of any participant size that indicated they were
    cash balance plans in the Form 5500.

    3

    Effective August 5, 1997, with the passage of the Taxpayer Relief Act of
    1997, plan sponsors were no longer required to file summary plan
    descriptions or related documents with the Department of Labor. Instead,
    plans are required to furnish this information only upon request.

    4

    See GAO, Private Pensions: Government Actions Could Improve the Timeliness
    and Content of Form 5500 Pension Information , GAO-05-491 (Washington,
    D.C.: June 2005).

                                     Sample Design

    Labor practices affect the timeliness of the release of available Form
    5500 information, in some cases, resulting in a 3-year lag between data
    reporting and its release. In addition, information provided on the form
    and attachments proved, in some instances, to be inconsistent from one
    plan sponsor to another. This inconsistency hampered our data collection
    efforts, and subsequently, we were unable to provide meaningful results on
    all of the information our data collection instrument was designed to
    capture. For example, we found that not all plans reported having a lump
    sum feature for those who separate before retirement although we believed
    some of those plans did so. In addition, some plans provided extensive
    details on discount rates and formulas used in their opening account
    balance calculations while others provided no information. In situations
    where we could not find information on the form or its attachments, we
    recorded this as "information not found." Finally, although the Form 5500
    provides information on the number of active participants in the entire
    plan, it was often impossible to determine how many of those participants
    were converted to the CB plan in instances where only certain employee
    groups were converted. Nevertheless, our estimates are based on plan-level
    data.

    The sample design for this study was a stratified random sample of CB
    plans, with the 45 largest plans comprising the first stratum, and an
    additional 160 plans selected from the remaining plans, producing a total
    sample of 205 plans. Of these sampled plans, we obtained sufficient plan
    information for 165, we found 21 plans to be out-of-scope for our study
    (not CB plans), and for 19 plans we could not obtain sufficient
    information on the plans. Also, of these 205 sampled plans, 7 plans
    started a new CB plan only for the new employees, while keeping their
    existing employees in the traditional DB plan. We did not include these
    plans in our analysis since they were start-up CB plans and not converted
    CB plans.

    This sample disposition information is summarized in table 1.

     Table 1: Cash Balance Plan Sample Disposition
                              Not CB  Sufficient           Insufficient Completion
     Stratum Population Sample plana information Converted information        rate
                                                 plan
     1.
     Largest         45     45   2            40        31            3        93%
     45
     plans
     2. Rest of         798 160  19          125       102           16        90%
     plans
     Total              843 205  21          165       133           19

    Description of the Review

    Source: GAO analysis of sampled Form 5500 data.

    a

    Sampled plans that were determined to be hybrid plans other than CB plans
    were outside the scope of this study.

    After obtaining Form 5500s, attachments, and summary plan descriptions
    where available 5 for sampled plans, we recorded plan features on a
    standardized instrument containing 51 questions designed to capture
    information about

         o characteristics of the traditional DB plan, such as the conversion
           date and the type of DB plan in place before the conversion;
         o the conversion such as when it took place, which employees were
           affected, and the type of transition provisions used; and
         o the ongoing features of the CB plan, such as pay credits and interest
           credits provided at the time of conversion.

    Estimates Estimates of converted CB plans were based on our sample of CB
    plans. Estimates for this target population were formed by weighting the
    survey data to account for both the sample design and the completion rate.

    Sampling Error Because we surveyed a sample of CB plans, our estimates are
    subject to sampling errors that are associated with samples of this size
    and type. A

    5

    We had some summary plan descriptions available to us as a result of past
    GAO work on cash balance issues. See GAO, Private Pensions: Implications
    of Conversions to Cash Balance Plans , GAO/HEHS-00-185 (Washington D.C.:
    September 2000) and GAO, Cash Balance Plans: Implications for Retirement
    Income, GAO/HEHS-00-207 (Washington D.C.: September 2000). We determined
    that some plans that had supplied summary plan descriptions reviewed in
    those studies were also included in the sample of this study. In addition,
    for this study a few plan sponsors provided plan documents upon our
    request for additional information and information on a few other plans
    was available via the Internet.

                                   Nonsampling Error

    different random sample could produce slightly different estimates. Our
    confidence in the precision of the results from this sample is expressed
    in 95 percent confidence intervals. The 95 percent confidence intervals
    are expected to include the actual results for 95 percent of the samples
    of this type. We calculated confidence intervals for our study results
    using methods that are appropriate for a stratified, probability sample.
    For the percentages presented in this report, we are 95 percent confident
    that the results we would have obtained if we had studied the entire study
    population are within +- 9 or fewer percentage points of our results. For
    example, we estimate that 47 percent of the CB plan conversions offered
    some form of grandfathering. The 95 percent confidence interval for this
    estimate would be no wider than +- 9 percent, or from 38 percent to 56
    percent.

    In addition to sampling error, the practical difficulties in conducting
    sample file reviews of this type may introduce other types of errors,
    commonly referred to as nonsampling errors. For example, questions may be
    misinterpreted, or errors could be made in keying questionnaire data. We
    took several steps to reduce these errors.

    To minimize some of these errors, each completed data collection
    instrument was verified for accuracy, and a process of content analysis
    was undertaken to resolve interpretation differences. We performed 100
    percent verification of all keypunched questionnaire data. We also traced
    and verified the data collection instrument to descriptive statistics and
    output generated by GAO data analyst staff. In the event of changes, the
    entire verification process was again performed which included 100 percent
    verification of the new keypunched data, additional content analysis to
    verify the change being made, and reverifying the output generated by the
    data analyst staff.

    In addition, we were only to record a plan as having a characteristic if
    evidence of that characteristic was found in the file review. For example,
    it is possible that some CB plans had transition provisions at conversion
    that were not clearly indicated in the 5500 files and attachments. We can
    only conclude that evidence of transition provisions being offered was not
    found in the 5500 data for this plan.

    Appendix IV: Analysis of Simulated Cash Balance Plans and Traditional
    Final Average Pay Plans

    To analyze the effects of a CB plan conversion on individual workers, we
    used a pension policy simulation model PENSIM. 1 PENSIM is a dynamic
    microsimulation model for analysis of the retirement income implication of
    government policies affecting employer-sponsored pensions. The model has
    been developed by the Policy Simulation Group (PSG) since 1997 with
    funding by the Office of Policy and Research at the EBSA of the U.S.
    Department of Labor. To meet GAO's needs for this project the model
    includes several enhancements that permit the analysis of CB plan
    conversions.

    PENSIM uses discrete event simulation methods to generate a sample of life
    histories that reflect the effects of individual risks (mortality,
    disability, earnings, etc.). The likelihood and timing of simulated life
    events are represented by a variety of probability models, including
    hazard functions and multinomial logit models that have been estimated
    using various survey data sets. The timing of job history events and
    employer pension sponsorship are estimated using longitudinal SIPP data
    and longer-term longitudinal PSID data. Simulated life histories contain
    information on educational attainment, disability, mortality, and a
    complete job history that includes details on earnings and pension
    accumulation for each job. Details of pension plan(s) covering a worker on
    a job are assigned using a pension characteristics imputation model, which
    has been estimated with late-1990s BLS Employee Benefit Survey data. 2
    Life histories simulated by PENSIM generate social security benefit and
    payroll tax results similar to those generated by the Congressional Budget
    Office's long-term social security model (CBOLT).

    PENSIM simulates the pension accruals of employees as they move from job
    to job over their lifetime and estimates their retirement income from a
    lifetime of pension coverage. With its CB plan analysis capability, PENSIM
    can also simulate changes in retirement income caused by conversions from
    traditional defined benefit pension plans to CB pension plans. PENSIM
    produces a large random sample of simulated life histories for people born
    in a given year and for their spouses who may have been born in a
    different year. For our report, we do not include spousal benefits in the
    analysis. The members of the birth cohort sample experience demographic
    and economic events, the incidence and timing of which vary

    1

    For more information on PENSIM, go to http://www.polsim.com/PENSIM.html.

    2

    For more information on the pension characteristics imputation model, go
    to http://www.polsim.com/penchar.pdf.

    Page 59 GAO-06-42 Pension Plans Appendix IV: Analysis of Simulated Cash
    Balance Plans and Traditional Final Average Pay Plans 06-42templated.doc

    Simulated Pension Plans

    by age, gender, education, disability, and employment status. The types of
    life events that are simulated in PENSIM include

         o demographic events (birth, death);
         o schooling events (leaving school at a certain age, receiving a certain
           educational credential);
         o family events (marriage, divorce, childbirth);
         o disability events;
         o initial job placement;
         o job mobility events (earnings increases while on a job, duration of a
           job, movement to a new job, or out of the labor force);
         o pension events (becoming eligible for plan participation, choosing to
           participate, becoming vested, etc.); and
         o retirement events.

    This broad scope of simulated life events is necessary in order to
    simulate lifetime pension accruals with any realism.

    Three pension plans are used in this study to simulate several kinds of
    private-sector plan conversions and terminations. The baseline from which
    the conversion/termination analysis starts is a typical final-pay defined
    benefit pension plan ("typical FAP"). This typical FAP plan has common
    private-sector characteristics and a benefit formula that produce an
    employer cost of providing the pension equal to the average cost of the
    full variety of final-pay plans observed in BLS Employee Benefit Survey
    data. 3 The second plan considered in the analysis is a typical CB pension
    plan ("typical CB") that has been specified to have characteristics found
    to be typical of the plans we analyzed in the GAO Form 5500 data
    collection

    3

    We chose to evaluate the effects of converting or terminating a typical
    FAP to determine the changes in benefits that would be experienced by
    those currently participating in a FAP plan. An alternate approach would
    be to base the typical plan on characteristics of FAP plans that elected
    to convert or terminate. However, this would have required additional
    information and analysis related to the individual circumstances of such
    FAP plans that were outside of the scope of our study. While such an
    alternative could be used to evaluate the effect of past conversions and
    terminations on affected participants, the results would be limited in
    predicting the effect of future conversions or terminations on those
    currently covered by a FAP pension plan.

    Appendix IV: Analysis of Simulated Cash Balance Plans and Traditional
    Final Average Pay Plans 06-42templated.doc

    conducted as part of this study. 4 The third plan is a more generous
    version of the typical CB pension plan ("equal-cost CB") that has been
    constructed to have the same employer cost as the typical FP plan.

    The typical FAP plan has the following characteristics

         o immediate eligibility;
         o 5-year cliff vesting;
         o normal retirement age of 65;
         o early retirement age of 55 with 10 years of service with benefits
           reduced by five percent for each year of early retirement (i.e., fifty
           percent reduction at age 55);
         o immediate unreduced disability retirement benefit for those who are
           vested;
         o no survivors' benefit for those who die on the job;
         o selection of single-life annuity at retirement (no selection of joint
           and survivor annuity because study ignores survivors' benefits);
         o benefit paid as a nominal annuity (i.e., no benefit COLA);
         o FAP is the highest consecutive five-year average; and
              * benefit formula is excess integrated with a base rate of 1.5
                percent of final pay per year of service and has a rate of 0.45
                percent of final pay per year of service for those amounts over
                the social security maximum.
              * The typical CB plan has the following characteristics
         o immediate eligibility;
         o 5-year cliff vesting;
         o base pay credit of 3.0 percent of salary for employee with age plus
           service of less than or equal to 35;
         o pay credit rises gradually until it is 6.0 percentage points above the
           base pay credit for employee with age plus service greater than or
           equal to 70 (this results in a maximum pay credit of 9.0 percent of
           salary);
         o interest credit is calculated using current 30-year Treasury rate;

    The typical CB plan features derived from GAO's Form 5500 data were, in
    part, established by employee and sample selection weighting. As stated
    previously in this report, it is not known how many participants of the
    plan were actually affected by the conversion to a CB plan. However, for
    the purposes of construction, we applied the employee weights assuming 100
    percent of participants were affected. Results for how participants will
    fare under our typical CB plan, when taken in conjunction with our equal
    cost CB plan, provide two polar views of how a distribution of individuals
    may be affected when converted.

      Appendix IV: Analysis of Simulated Cash Balance Plans and Traditional Final
                          Average Pay Plans 06-42templated.doc

         o employee always rolls over full account balance into an IRA at job
           termination; 5
         o rollover account earns current 30 year Treasury rate each year;
         o account balances are converted to a nominal single-life annuity at
           retirement using the treasury rate, current projected mortality rates,
           and projections of future reductions in mortality. An annuity loading
           fee was used such that it ensures the provider is solvent (i.e., 1.5
           percent for women and 3.0 percent for men);
         o at conversion, opening account balance is equal to the statutory
           present value of accrued benefit under old plan;
              * at conversion, employee with age plus service greater than or
                equal to 60 is grandfathered in old plan so that benefit at job
                end can never be lower than it would have been if the old plan
                had continued operating
              * The equal-cost CB plan has the following characteristics
         o same characteristics as the typical CB plan except the base pay credit
           is 7.35 percent of salary for employee with age-plus-service (APS) =<
           35, rather than the 3.0 percent of salary in the typical CB plan, and
              * pay credit rises gradually until it reaches a maximum of 6
                percentage points above the base pay credit for employee with age
                plus service greater than or equal to 70.
              * These three plans are used to simulate the following conversion
                and termination situations
         o typical CB plan versus typical FAP plan;
         o typical CB plan versus FAP plan that is terminated with no replacement
           of any kind;
         o equal cost CB plan versus typical FAP plan; and
         o equal cost CB plan versus FAP plan that is terminated with no
           replacement of any kind.

    All PENSIM runs conducted for this study simulate a 3 percent sample of

    Simulation

    the 1955 birth cohort using historical information through the present and
    Assumptions 2004 OASDI Trustees Report intermediate-cost assumptions for
    the future

    5

    One claimed benefit for CB plans is the ability to rollover account
    balances upon separation. Our simulation model fully captures this
    feature. This contrasts with a traditional FAP plan where a participant
    who leaves before early retirement loses both future final pay increases
    and the early retirement subsidy.

    Page 62 GAO-06-42 Pension Plans Appendix IV: Analysis of Simulated Cash
    Balance Plans and Traditional Final Average Pay Plans 06-42templated.doc

    projection. The resulting cohort sample consists of 151,263 individuals
    born in 1955 either in the U.S. or elsewhere (and immigrated to the U.S.
    in a subsequent year).

    The PENSIM runs differ only in their assumptions concerning privatesector
    sponsorship of the typical FAP plan (which is assumed to be offered by all
    private-sector employers who are simulated to offer a FAP DB plan) and the
    typical or equal-cost CB plan (which is assumed to be offered by all
    private-sector employers who are simulated to offer a CB DB plan). The
    employment history of each individual and coverage/participation in
    employer-sponsored DB and DC plans are a key component to determining the
    lifetime benefits for each individual. Pension benefits accumulated as a
    result of movement to different employers during a person's entire work
    history is included in reported results. Pension coverage across a
    lifetime may include participation in a variety of DB and DC plans or no
    coverage at all. Workers who are not covered under either a private sector
    FAP or a CB pension plan are excluded from the study analysis. Most of the
    study analysis focuses on those who have vested in at least one
    private-sector FAP or CB plan. Public-sector FAP plans are assumed to be
    unchanged across all runs, and all other types of DB plans (i.e., other
    than FAP or CB) and all types of DC pension plans in all sectors are
    assumed to be unchanged across all the runs. Additionally, all the PENSIM
    runs used in this study contain the exact same life histories and job
    careers for the cohort sample. That is, the only change that takes place
    in all PENSIM runs is whether the private sector DB plan is a FAP or a CB
    plan. 6 The simulation analysis provides the following general results
    about the cohort sample

         o sample individuals who had at least one private-sector FAP or CB
           pension plan: 57,049 (100.0 percent);
         o sample individuals who never vest in such a plan: 20,274 (35.5
           percent);
              * sample individuals who vest in such a plan but die before age 68:
                6882
              * (12.1 percent);
         o sample individuals who vest in such a plan and live to age 68: 29,893

    (52.4 percent);

    o  of the 29,893, 87.0 percent vest in just one FAP or CB pension plan
    over their lifetime, while 12.3 percent vest in two plans, and all but
    three of the rest vest in three such plans; and

    We did not attempt to model any changes in employee behavior that may
    affect job tenure as a result of a conversion to a CB plan.

    Page 63 GAO-06-42 Pension Plans Appendix IV: Analysis of Simulated Cash
    Balance Plans and Traditional Final Average Pay Plans 06-42templated.doc

    o  of the 26,018 who vest in just one FAP or CB pension plan, only 10.2
    percent accumulate thirty years or more of service on that job.

    The study makes four pair-wise comparisons between PENSIM runs: (1)
    typical CB plan versus ongoing typical FAP plan, (2) equal-cost CB plan
    versus ongoing typical FAP plan, (3) typical CB plan versus terminated
    typical FAP plan, and (4) equal-cost CB plan versus terminated typical FAP
    plan. In each comparison, the difference in lifetime pension income
    between the two runs is calculated for each sample individual. Lifetime
    pension income includes all pension benefits earned during a person's
    career even if they are unaffected by the assumed change in employer
    pension sponsorship between the two runs. Lifetime pension income is
    expressed in one of two ways: the present value of all pension income
    received over the individual's lifetime or the monthly pension income
    received at age 68. In both cases, the monetary amounts are expressed in
    2004 dollars.

    The conversion/termination of the typical FAP plan is assumed to occur at
    one of eight ages: 25, 30, 35, 40, 45, 50, 55, and 60. The entire cohort
    sample was put through eight separate simulation runs --one simulation run
    for each age. Results are shown for those who were vested in a job that
    was caught in a conversion. The conversion provisions (opening balance and
    grandfathering) described above for the typical and equal-cost CB plans
    were found to be typical in our analysis of the Form 5500 sample drawn for
    this study. Based on our Form 5500 sample plan analysis and meetings with
    consultants who are experts on CB plans, there was concurrence that the
    opening CB would be equal to the present value of accrued benefit under
    the old plan at the conversion date. The expected present value of the
    accrued benefit is calculated using a GAM83 mortality table adjusted to
    the proper year and the current Treasury rate as the discount rate. 7 If
    eligible for grandfathering, an individual receives the higher of two
    amounts at job termination: the accumulated CB under the new plan and the
    expected present value of the benefit the individual would have received
    if the typical FAP plan had not been converted. The expected present value
    is calculated using the same mortality and discount assumptions as used in
    the opening balance calculation. All individuals affected by a conversion
    or termination are covered under the federal

    We have no wearaway-neither initial nor inadvertent wearaway, or any other
    form-in our modeling.

    Page 64 GAO-06-42 Pension Plans Appendix IV: Analysis of Simulated Cash
    Balance Plans and Traditional Final Average Pay Plans 06-42templated.doc

    anticutback rules. The PENSIM runs use these same mortality and discount
    assumptions for the anticutback calculations.

    The employer cost of sponsoring a pension plan is defined as the
    percentage ratio of the present value of benefits paid to all individuals
    who Estimates worked on a job where that pension plan was sponsored and
    the present

    value of earnings paid to all individuals who worked on a job where that

    pension plan was sponsored. The present value calculations use Treasury

    rates to discount both the benefit and earnings cash flows. For a FAP
    plan,

    the benefit cash flow is the annuity payment stream. For a CB plan, the

    benefit cash flow is the CB amount paid at job termination.

    All employer cost estimates are for the 1955 birth cohort. Using a younger
    birth cohort would produce a higher employer cost rate for the typical FAP
    plan because of rising life expectancy and about the same employer cost
    rate for the typical CB plan because of its earnings-based benefit
    formula. The estimated employer cost rates are as follows

         o full variety of private-sector final-pay plans in BLS data: 7.547
           percent;
         o typical FAP plan: 7.545 percent (by construction equal to cost of full
           variety) Note: the employer cost of providing disability retirement
           benefits in the typical FAP plan to the 1955 birth cohort is 0.487
           percent out of 7.545 percent. Note: in order to simplify the study
           presentation, the typical FAP plan is assumed to have no survivor
           benefits, which are actually a typical benefit under FAP plans, and
           thus the 7.545 percent is an underestimate of a typical FAP plan's
           cost;
         o typical CB plan with no conversion costs: 5.006 percent (i.e.,
           conversion age 15); 8
         o typical CB plan with conversion costs by conversion age (see table 2);
           and
         o equal-cost CB plan with averaged conversion costs: 7.547 percent. 9

    8

    This is an estimate of the ongoing cost of the typical CB plan after all
    conversion costs have been paid.

    9

    The base pay credit rate of the equal-cost CB plan has been adjusted so
    that the plan's employer cost equals that of the typical FAP plan.

    Page 65 GAO-06-42 Pension Plans Appendix IV: Analysis of Simulated Cash
    Balance Plans and Traditional Final Average Pay Plans 06-42templated.doc

    Comparison of Estimated Employer Cost of the Typical CB Plan Immediately
    After the Conversion with the Estimated Employer Cost of the Typical FAP
    Plan

    Table 2: Conversions Costs of Typical Cash Balance Plan by Conversion Age

                                 Conversion age Percent

                                        25 4.843

                                        30 4.645

                                        35 4.464

                                        40 4.680

                                        45 5.602

                                        50 6.937

                                        55 7.925

                                        60 7.866

    Cost averaged over 8 conversions agesa,b

    Source: GAO analysis using the PENSIM Model.

    aNote that calculating a simple average of the eight cost rates assumes a
    uniform conversion-age distribution, which is analogous to assuming a
    uniform employee age distribution at the plan conversion date. While this
    assumption may not be exactly true for individual plans, there is no
    publicly available data that provide information that would support an
    assumption of a nonuniform employee age distribution for all plan
    conversions.

    b

    This 5.870 percent is an estimate of employer cost immediately after the
    conversion from the typical FAP plan to the typical CB plan when
    conversion costs are being paid. Given the widespread belief that typical
    cash balance conversions have not produced substantial immediate pension
    cost savings for employers, the reasons for the difference between the
    7.545 percent and 5.870 percent are discussed below.

    There are several reasons why the estimated employer cost of the typical
    CB plan immediately after the conversion of 5.870 percent is below the
    estimated employer cost of the typical FAP plan of 7.545 percent by about
    22 percent. First, the typical FAP plan has been constructed to reflect
    the full variety of private-sector FAP plans contained in the BLS Employee
    Benefits Survey data used to impute plan characteristics in PENSIM. The
    characteristics of the typical CB plan are drawn from the Form 5500 sample
    used for this study and from discussions with pension experts and
    actuaries who confirmed that the characteristics were in the range of what
    they believe was typical for CB plans. This sample of CB plans is the
    largest available sample, and the only sample to be drawn using
    statistical sampling methods.

    The difference in the estimated employer cost rates for these two plans is
    consistent with prior research. Specifically, the cost difference reported
    here is somewhat smaller than the cost difference for typical plan

    Appendix IV: Analysis of Simulated Cash Balance Plans and Traditional
    Final Average Pay Plans 06-42templated.doc

    conversions reported in a widely cited study by Watson Wyatt Worldwide. 10
    In the Watson Wyatt study, the employers who convert typical (i.e., middle
    of the cost distribution) FAP plans to CB plans-the 20 percent in deciles
    5 and 6 in table 9-experience an immediate definedbenefit pension employer
    cost reduction of about 19 percent (18.72 percent in fifth decile and
    19.76 percent in sixth decile). However, the 22 percent cost reduction
    estimated in this study and the 19 percent cost reduction estimated in the
    Watson Wyatt study are not comparable because of differences in the Watson
    Wyatt life history simulations, which ignore disability events, and
    therefore, underestimate the cost of the FAP plans. To make our estimates
    comparable to the Watson Wyatt estimates, we subtracted the 0.487 percent
    disability costs from 7.545 percent yielding a without-disability employer
    cost estimate for the typical FAP plan of 7.058 percent. Our estimate of
    the immediate cost of the typical CB plan is 5.870 percent, which is about
    17 percent below the 7.058 percent without-disability estimate. This 17
    percent immediate employer definedbenefit cost reduction is about the same
    as the 19 percent reduction found in the Watson Wyatt study.

    See Watson Wyatt Worldwide, The Unfolding of a Predictable Surprise: A
    Comprehensive Analysis of the Shift from Traditional Pensions to Hybrid
    Plans (2000), 18-19.

    Appendix V: GAO Contacts and Staff Acknowledgments

    Barbara D. Bovbjerg, Director (202) 512-7215

    GAO Contacts

    Staff Acknowledgments

    The following staff members made major contributions to this report:
    Charles A. Jeszeck, Assistant Director, Kimberley M. Granger,
    Analyst-in-Charge, Joseph Applebaum, Kevin Averyt, Richard Burkard,
    Virginia Chanley, Tamara Cross, David Eisenstadt, Lawrence Evans Jr.,
    Benjamin Federlein, Nila Garces-Osorio, Sharon Hermes, Jason Holsclaw,
    Gene Kuehneman Jr., Michael Maslowski, Amanda Miller, Michael Morris,
    Luann Moy, Macdonald Phillips, Mark Ramage, Tovah Rom, Nyree Ryder, George
    Scott, and Roger Thomas.

    (130410)

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