Private Pensions: Implications of Conversions to Cash Balance Plans
(Letter Report, 09/29/2000, GAO/HEHS-00-185).

Pursuant to a congressional request, GAO provided information on private
pensions, focusing on: (1) the prevalence and major features of cash
balance plans, and reasons why firms adopt them; (2) how the use of cash
balance plans affect the pension benefits for workers of different ages
and tenure, particularly after conversion; and (3) what information
employers converting to cash balance plans typically provide to plan
participants and how disclosure might be improved.

GAO noted that: (1) GAO's survey of 1999 Fortune 1000 firms indicates
that the number of firms sponsoring cash balance plans has increased
within the last few years, with few firms sponsoring such plans prior to
the early 1990s, but increasing to about 19 percent of all Fortune 1000
firms this year; (2) these plans cover an estimated 2.1 million workers;
(3) firms in many sectors of the economy sponsor these plans but greater
concentrations are found in the financial services, health care, and
manufacturing industries; (4) about 90 percent of the firms GAO surveyed
that sponsor such plans previously covered their workers under a
traditional defined benefit plan; (5) most of the conversions occurred
within the past 5 years; (6) key reasons firms gave for converting
include lowering total pension costs, adding a lump sum feature to
increase the portability of pension benefits, thereby improving the
firm's ability to recruit more mobile workers, and facilitating
communication of the value of plan benefits; (7) as with traditional
pension plans, cash balance plan designs vary significantly; (8)
conversions to cash balance plans can be advantageous to certain groups
of workers, for example, to those who switch jobs frequently, but can
lower pension benefits for others; (9) cash balance plans provide a
larger share of a participant's accumulated benefit earlier in a career,
compared with a traditional defined benefit plan that is based on final
average pay; (10) as a result, conversions can increase the value of
some workers' benefits, especially younger or short-tenured workers who
leave firms before retirement; (11) unlike traditional defined benefit
plans, cash balance plans can result in a declining rate of normal
retirement benefit accrual over time; (12) this declining accrual rate
can result in older workers receiving lower benefits at retirement from
a cash balance plan than they would have from a traditional final
average pay plan if it had not been converted; (13) current disclosure
requirements provide minimum standards for the information plan sponsors
must give participants about plan changes; (14) GAO found wide variation
in the type and amounts of information workers receive; (15) the
communications provided to employees vary from general statements about
plan changes to specific examples of how a conversion to a cash plan
might affect workers of different ages and tenure; and (16) often,
sponsors did not ensure that participants received sufficient
information about plan changes that can reduce future benefit accruals.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  HEHS-00-185
     TITLE:  Private Pensions: Implications of Conversions to Cash
	     Balance Plans
      DATE:  09/29/2000
   SUBJECT:  Retirement pensions
	     Employee retirement plans
	     Information disclosure
	     Pension plan cost control
IDENTIFIER:  Social Security Program

******************************************************************
** This file contains an ASCII representation of the text of a  **
** GAO Testimony.                                               **
**                                                              **
** No attempt has been made to display graphic images, although **
** figure captions are reproduced.  Tables are included, but    **
** may not resemble those in the printed version.               **
**                                                              **
** Please see the PDF (Portable Document Format) file, when     **
** available, for a complete electronic file of the printed     **
** document's contents.                                         **
**                                                              **
******************************************************************
GAO/HEHS-00-185

Appendix I: Scope and Methodology

42

Appendix II: Pension Benefits Simulation Model

45

Appendix III: Cash Balance Plans and Minimum Lump Sum
Distributions

58

Appendix IV: Comments From the Department of the Treasury

64

Table 1: Lump Sum Distributions From a Traditional Final Average
Pay Formula and a Cash Balance Formula After
Conversion 22

Table 2: Lump Sum Wearaway Created at Conversion for a
45-Year-Old Worker 29

Table 3: The Creation of Wearaway Periods After Conversion by Fluctuation in
the Mandatory Discount Rate for Defined
Benefit Plans 31

Table 4: Early Retirement Benefit Wearaway Payable at Age 60 32

Table 5: Assumptions for the Baseline Simulations We Report 50

Figure 1: Participant Coverage in Fortune 1000 Cash Balance
Plans 11

Figure 2: Annual Annuity Benefits Under a Cash Balance Formula
and a Final Average Pay Formula 17

Figure 3: Rate of Accrual for a Cash Balance Formula and
a Traditional Final Average Pay Formula 20

Figure 4: How Conversion to a Cash Balance Plan Potentially
Lowers Annuities 26

Figure 5: Incremental Benefit Accruals for Workers of Different
Ages Under Different Formulas 27

Figure 6: Comparison of Benefits From Weighted Pay Credit
Formulas, Basic Cash Balance Formula, and Final
Average Pay Formula 35

Figure 7: The Whipsaw Effect: Hypothetical Balance Is Less
Than Lump Sum Benefit 60

Figure 8: Hypothetical Balance Is Greater Than Lump Sum Benefit 61

BLS Bureau of Labor Statistics

EEOC Equal Employment Opportunity Commission

ERISA Employee Retirement Income Security Act of 1974

IRA individual retirement account

IRC Internal Revenue Code

IRS Internal Revenue Service

PBGC Pension Benefit Guaranty Corporation

PWBA Pension and Welfare Benefits Administration

SPD summary plan description

Health, Education, and
Human Services Division

B-283648

September 29, 2000

The Honorable William J. Coyne
Ranking Minority Member
Subcommittee on Oversight
Committee on Ways and Means
House of Representatives

The Honorable Robert Andrews
Ranking Minority Member
Subcommittee on Employer-Employee Relations
Committee on Education and the Workforce
House of Representatives

The Honorable Major R. Owens
Ranking Minority Member
Subcommittee on Workforce Protections
Committee on Education and the Workforce
House of Representatives

Employer-provided pensions are an important source of income for many
retired persons. To encourage employers to establish and maintain pension
plans for their employees, the federal government provides preferential tax
treatment under the Internal Revenue Code (IRC) for plans that meet certain
requirements. The Joint Committee on Taxation estimates that in fiscal year
2000 the tax expenditure for qualified employer-sponsored pension plans will
be about $76 billion.1 In exchange for preferential tax treatment, an
employer is required to design the pension plan within legal limits that are
intended to improve the equitable distribution and security of pension
benefits. There has been recent controversy concerning how conversions of
traditional defined benefit pension plans to cash balance

plans can affect workers, especially those nearing retirement.2 Questions
have also been raised about the application of current tax qualification
requirements to this new type of pension plan.

You asked us to (1) describe the prevalence and major features of cash
balance plans and reasons why firms adopt them; (2) discuss how the use of
cash balance plans can affect the pension benefits for workers of different
ages and tenure, particularly after conversion; and (3) determine what
information employers converting to cash balance plans typically provide to
plan participants and how disclosure might be improved.

To address your questions, we conducted a random sample survey of 420 firms
on the 1999 Fortune 1000 list and reviewed pension plan documents to examine
the features of cash balance plans.3 In addition, we conducted in-depth
interviews with officials from 14 firms with cash balance or similar plans
to discuss why they adopted such plans and to obtain information about how
firms disclosed changes to their pension programs. We modeled pension plan
design features to compare pension benefits provided by a "basic" cash
balance plan and a defined benefit plan with a final average pay formula,
common to large defined benefit plans.4 Also, we interviewed various federal
agency officials, pension consultants, and actuaries. We conducted our work
between September 1999 and August 2000 in accordance with generally accepted
government auditing standards. (See app. I for details on our scope and
methodology.)

Our survey of 1999 Fortune 1000 firms indicates that the number of firms
sponsoring cash balance plans has increased within the past few years, with
few firms sponsoring such plans before the early 1990s but increasing to
about 19 percent of all Fortune 1000 firms this year. These plans cover an
estimated 2.1 million workers. Firms in many sectors of the economy sponsor
these plans but greater concentrations are found in the financial services,
health care, and manufacturing industries. About 90 percent of the firms we
surveyed that sponsor such plans previously covered their workers under a
traditional defined benefit plan. Most of the conversions occurred within
the past 5 years. Key reasons firms gave for converting include lowering
total pension costs; adding a lump sum feature to increase the portability
of pension benefits, thereby improving the firm's ability to recruit more
mobile workers; and facilitating communication of the value of plan
benefits. As with traditional pension plans, cash balance plan designs vary
significantly.

Conversions to cash balance plans can be advantageous to certain groups of
workers--for example, to those who switch jobs frequently--but can lower
pension benefits for others. Cash balance plans provide a larger share of a
participant's accumulated benefit earlier in a career, compared with a
traditional defined benefit plan that is based on final average pay. As a
result, conversions can increase the value of some workers' benefits,
especially younger or short-tenured workers who leave firms before
retirement. For example, a 30-year-old worker at the time of a conversion,
who leaves a firm 10 years later, would receive a lump sum distribution from
a cash balance plan about 1.5 times larger than that from a traditional plan
based on final average pay, all other factors being equal. Other workers,
however, can be disadvantaged after conversion to a cash balance plan.

Unlike traditional defined benefit plans, cash balance plans can result in a
declining rate of normal retirement benefit accrual over time. This
declining accrual rate can result in older workers' receiving lower benefits
at retirement from a cash balance plan than they would have received from a
traditional final average pay plan if it had not been converted. However,
workers could also receive lower retirement benefits under a traditional
plan if an employer reduces future accruals or terminates the plan. Under
some circumstances, conversions to cash balance plans can also result in
periods during which some workers do not earn additional pension benefits
while other workers continue to accrue benefits. These situations, known as
"wearaway," tend to last longer for older or long-tenured workers and occur
because a participant's initial cash balance benefit is less than the value
of the benefit accrued under the prior plan. While most of the firms in our
survey that adopted cash balance plans included transition provisions to
help protect the future benefits of workers, these provisions can vary in
the extent to which they accomplish this objective.

Current disclosure requirements provide minimum standards for the
information sponsors must give participants about plan changes. We found
wide variation in the type and amounts of information workers receive. The
communications provided to employees vary from general statements about plan
changes to specific examples of how a conversion to a cash plan might affect
workers of different ages and tenure. For example, some firms provided
employees with a short written notice while others gave them a copy of the
actual plan amendment to inform them about the conversion to a cash balance
plan. This type of information was often difficult to understand and
provided employees little or no information on how the change could affect
their future pension benefits. In other instances, firms provided employees
with extensive educational materials and automated benefit calculators to
help them understand how conversion to a cash balance plan could affect
their individual benefits. Often, however, sponsors did not ensure that
participants received sufficient information about plan changes that could
reduce future benefit accruals.

This report includes matters for consideration by the Congress related to
improving disclosure to participants about plan changes and preventing
situations in which some participants do not accrue new pension benefits for
a period of time after conversion to a cash balance plan. We also recommend
actions to the Department of Labor concerning improvements to current
disclosure requirements and to the Department of the Treasury and the
Internal Revenue Service (IRS) concerning administrative actions they can
take to clarify the regulatory treatment of cash balance plans. Today we are
issuing another report on cash balance plans, particularly on the effects of
such plans on the adequacy of retirement income.5

IRC defines pension plans as either defined benefit or defined contribution
plans and includes separate requirements for each type of plan. According to
Bureau of Labor Statistics (BLS) survey data, most participants in large and
medium-sized firms' defined benefit plans are covered by plans that use a
final average pay formula that is based on years of service, average
earnings over a specific number of years, and a multiplier. For example, a
final average pay formula might determine benefits on the basis of 1.25
percent multiplied by years of service completed multiplied by the

employee's average salary over the past 5 years of service.6 Defined benefit
plans typically express an accrued pension benefit as an annuity beginning
at the plan-specified normal retirement age.7 The firm, as the plan sponsor,
is responsible for funding the promised benefit, investing and managing the
plan assets, and bearing the investment risk.

Under defined contribution plans such as 401(k) plans, workers have
individual accounts to which employers, employees, or both make periodic
contributions. Defined contribution plan benefits are based on the
contributions to and investment returns on these accounts. Employees bear
the risk of poor investment performance and often control, at least in part,
how the funds are invested.

Cash balance plans are referred to as hybrid plans because legally they are
defined benefit plans but contain features that resemble defined
contribution plans. Similar to traditional defined benefit plans, cash
balance plans use a formula to determine pension benefits. However, cash
balance plans express benefits as an "account balance." An employee account
balance is based on hypothetical pay credits (percentage of salary or
compensation) and hypothetical interest credits to employee accounts rather
than an annuity. As with other defined benefit plans, under cash balance
plans, employee pension benefits are paid from commingled funds invested in
a pension trust on behalf of all participants, and plan trustees have a
fiduciary responsibility for all assets in the pension trust. Hypothetical
account balances need not be related to investment returns on assets in the
plan's pension trust, and hypothetical accounts are not credited with the
plan's actual investment gains or losses. Employees neither own these
"accounts" nor generally make investment decisions. Cash balance plans are
defined benefit plans because federal pension law defines any pension plan
that does not provide individual accounts with benefits based solely on
those accounts as a defined benefit plan.8

Federal law provides specific rules on how pension benefits must be accrued
in order for plans to receive favorable tax treatment as well as safeguards
to preserve benefits that participants have already earned. The law
prohibits firms from amending a plan's benefit formula to reduce benefits
that have already accrued. Firms can, however, change a pension plan's
benefit formula to prospectively reduce or eliminate future benefit
accruals. For example, defined benefit plan formulas can be amended to
reduce the percentage of final pay used in the future to determine the
annual benefit or limit the number of years over which benefits accrue.
Firms can also terminate their pension plans. Defined benefit plan sponsors
that terminate their plans are subject to an excise tax of up to 50 percent
on any surplus assets in their pension trusts if they do not share excess
pension assets with participants.

The Employee Retirement Income Security Act of 1974 (ERISA) mandates the
types of information that must be disclosed to plan participants. The law
requires firms to provide all plan participants with a summary plan
description that describes the terms of the plan. Furthermore, whenever
there is a significant change to the plan (called a plan amendment), firms
must provide participants with a summary of the changes no later than 210
days after the end of the plan year in which the changes are adopted, known
as a summary of material modification. Firms must notify participants of
amendments that will result in a significant reduction in the rate of future
benefit accrual at least 15 days before the effective date. This
notification can entail providing either a copy of the amendment to the plan
or a written summary of the change.

IRS, the Pension Benefit Guaranty Corporation (PBGC), and the Department of
Labor's Pension and Welfare Benefits Administration (PWBA) are primarily
responsible for enforcing laws related to private pensions. IRS enforces
participation, vesting, and funding standards that concern how participants
become eligible to participate in benefit plans and earn rights to benefits
and that ensure that plans have sufficient assets to pay promised benefits.
PWBA enforces ERISA's reporting and disclosure provisions and fiduciary
standards, which concern how plans should operate in the best interest of
participants. PBGC insures the benefits of participants in most private
defined benefit pension plans. Employers can voluntarily submit an
application to IRS, seeking approval of their plan when it is started, when
the plan is amended to comply with law changes or plan design changes, or
when the plan is terminated.

Under the Age Discrimination in Employment Act, it is unlawful for employers
to sponsor a defined benefit plan that stops a benefit accrual or reduces
the rate of an employee's benefit accrual because of age.9 The Equal
Employment Opportunity Commission (EEOC) enforces federal law prohibiting
employment discrimination, including discrimination based on age (aged 40
and older). IRC and ERISA have similar provisions prohibiting a defined
benefit plan from ceasing accruals or reducing the rate of accrual because
of the attainment of any age.10

Prompted by concern from members of the Congress and charges by participants
in plans that were converted, federal agencies are now reviewing age
discrimination and other issues raised by cash balance plans. In September
1999, EEOC began a review of potential age discrimination issues in cash
balance conversions and is coordinating with agencies that are responsible
for administering federal pension laws. Within the past year, more than 800
workers and retirees have filed age discrimination charges with EEOC
concerning cash balance plans. EEOC has opened 34 cases to investigate these
charges. The Department of the Treasury and IRS are currently reviewing tax
qualification issues raised by cash balance plans. For example, in September
1999, IRS 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. In addition, in October 1999 IRS
announced that it was soliciting public comments on issues related to the
conversion of traditional defined benefit formulas to cash balance formulas.
Further, in July 2000, the Office of Management and Budget issued a
Statement of Administration Policy proposing legislative action to address
certain issues raised by conversions to cash balance plans.

Few firms that we surveyed on the 1999 Fortune 1000 list that sponsor cash
balance plans adopted such plans before the early 1990s. Our analysis
indicates that as of July 2000, about 19 percent of these firms sponsor cash
balance plans. Firms adopted cash balance formulas for a variety of reasons,
including reducing total pension costs, increasing portability to enhance
the recruitment of younger or more mobile workers, and adding a

lump sum benefit feature that can be used to better explain pension benefits
to workers. As with traditional defined benefit plans, cash balance plans
exhibit a considerable variety of designs, particularly in the amount of pay
credited to participants' hypothetical accounts.

About 19 percent of Fortune 1000 firms sponsor cash balance plans that cover
an estimated 2.1 million active participants.11 Similar to traditional
pension plans, many cash balance plans that we identified generally do not
cover all workers at a firm. Instead, these plans cover particular segments
of a firm's workforce such as managers or salaried employees or certain
workers in a firm's subsidiary. Most cash balance plans we identified in our
survey (an estimated 69 percent) have fewer than 10,000 active participants
(see fig. 1), including 8 percent with no active participants because
benefit accruals are frozen.12 The most common reason sponsors froze a cash
balance plan was that the plan was acquired as part of a merger or
acquisition and the firm did not want to continue the cash balance plan.

The earliest known cash balance plan has been in use since 1925, but such
plans have become prominent since the 1980s. The earliest a firm in our
survey had adopted a cash balance plan was 1985; more than 60 percent of the
cash balance plans we identified have been adopted in the past 5 years.13
Firms sponsoring these plans exist in many sectors of the economy, but the
greater concentrations are found in the financial services, health care, and
manufacturing industries. Some of these firms have undergone mergers or
acquisitions and have adopted cash balance plans to "harmonize"
benefits--that is, to provide the same pension plan for employees who had
been covered by different plans. Most firms in our survey that sponsor cash
balance plans previously covered their workers under another defined benefit
plan. Other firms started cash balance plans as their first pension plan or
to supplement existing defined contribution plans.

While we were told by pension practitioners, employer associations, and
agency officials of firms' continuing interest in cash balance or similar
hybrid plan designs, few of the firms we surveyed expected to adopt a cash
balance plan in the future. About 3 percent of the firms we surveyed told us
that they were considering whether to adopt a cash balance plan within the
next 5 years, and about a third of these, or 1 percent of Fortune 1000
firms, told us that they plan to adopt a cash balance plan next year. All
the firms considering adopting a cash balance plan told us that the
continuing uncertainty as to whether such plans violate pension and age
discrimination laws might discourage them from converting their plans.

Firms sponsoring cash balance plans told us that their decision to adopt
these plans was based on a combination of factors such as the desire to
become more competitive within their specific industry and to address
changing workforce demographics. For example, some firms decided to adopt
cash balance plans in order to improve their ability to recruit new workers
by providing them with higher pension benefits earlier in their careers and
allowing lump sum distributions so that pension benefits are more portable.
Other firms told us, however, that they decided not to use cash balance
plans because they had older or long-tenured workforces that could be
adversely affected by a change to a cash balance plan.

Some firms we surveyed that chose to convert their plans cited the financial
implications of changing to a cash balance plan as a key reason in their
decision. Reducing the overall cost of the defined benefit plan was a
primary reason some firms converted to a cash balance formula. For example,
some firms have reduced costs by eliminating early retirement subsidies on
future accruals. A PricewaterhouseCoopers survey of 100 cash balance plan
sponsors found that 56 percent of firms expected the long-term cost of their
defined benefit plans to decrease after conversion. Even when enhancements
to other retirement programs were considered in conjunction with a
conversion, 33 percent of the firms expected a decrease in the costs of
their total retirement benefits package.14 However, a few firms we surveyed
reported that converting to a cash balance plan increased the cost of their
defined benefit plan because their plan provided a higher level of benefit
for all workers.

Converting to cash balance plans is also an alternative to terminating a
pension plan. Firms can terminate their defined benefit plans, but doing so
imposes various economic costs. When plan sponsors terminate defined benefit
plans, the sponsors must pay income and excise taxes on any surplus assets,
immediately vest participants in their accrued benefits, and provide
participants with annuities or lump sum payments. These costs may prevent
some firms from terminating their plans.15 Instead, firms can convert to
cash balance plans and achieve economic benefits from the surplus pension
funds without incurring the costs related to plan termination. For example,
converting to a cash balance plan can extend the period of time a firm would
not have to make a contribution to the pension plan while still having the
plan considered to be fully funded or overfunded--that is, the value of plan
assets meet or exceed the value of currently accrued pension benefits. Also,
after a conversion, if the pension plan's assets earn a higher rate of
return than the interest rate credited to hypothetical employee accounts,
this can lower the overall cost of maintaining the cash balance plan.

Firms deciding not to adopt a cash balance formula cited increased costs as
influencing their decision. These costs included increased administrative
costs such as consultants' fees to design the plan formula and the costs of
developing individualized participant statements. In addition, cash balance
plans can have ongoing administrative costs that are higher than those
typically incurred by traditional defined benefit or defined contribution
plans. Firms also cited the potential cost of special plan provisions to
protect the benefits of workers nearing retirement as another reason not to
convert.

Firms that adopted cash balance plans reported that the opportunity for the
increased portability of benefits influenced their decision to adopt such
plans. The lump sum benefit distribution feature common to most cash balance
plans allows eligible workers, upon separation, to gain access to

their pension benefit.16 These firms believed that offering a pension plan
with such a benefit feature would enhance their recruitment of younger,
relatively mobile workers. While traditional defined benefit plans can
provide lump sum payments, historically many of these plans have not done
so. Most of the plans in our survey did not allow lump sum distributions
above $5,000 before converting to a cash balance plan. Instead, participants
generally received their benefits as an annuity at retirement. The
percentage of plans in our survey offering lump sum distributions at both
separation and retirement increased from 15 percent before conversion to 83
percent after conversion. Most of the firms we conducted in-depth interviews
with stated that after conversion the majority of vested participants who
have separated from the firm or retired opted for a lump sum payment,
indicating its popularity.

Most firms that expressed a desire to attract and hire more mobile workers
as a reason for converting did not, however, change their vesting
requirement when converting from a traditional defined benefit plan to a
cash balance plan. As under traditional defined benefit plans, workers under
a cash balance plan must remain with a firm long enough to earn a right to
such benefits. Large defined benefit plans typically have a "cliff" vesting
requirement--that is, participants are 100 percent vested in their benefits
after a certain number of years, with no rights to a pension benefit if they
leave the firm before then. Most of these large plans have 100 percent
vesting after 5 years. Seventy-two percent of the firms we surveyed with
cash balance plans had a 5-year cliff vesting requirement, while the
remaining firms sponsoring cash balance plans had various vesting
requirements, including graded vesting.17

Finally, firms deciding to convert told us that employees better understand
benefits under cash balance plans than under traditional defined benefit
plans. Because benefits under cash balance plans are expressed as lump sum
values rather than retirement-age annuities, some employees may better
understand and value such plans. Furthermore, according to company
officials, given that many of these employees also have a 401(k) plan, the
cash balance plan is more "visible" and comparable to benefits under the
401(k) plans.18 This is in contrast to the view many employees have of their
benefits under traditional defined benefit plans. Human resource and
benefits officials at several firms we visited said that defined benefit
plans have been one of the least understood and least appreciated benefits
in a worker's compensation package. Employees rarely focused on the benefits
from a defined benefit plan until they neared retirement age.

As with traditional pension plans, significant variation exists in cash
balance plan designs, particularly the benefit formulas. Thirty-five percent
of cash balance plans in our survey provide level pay credits for all
participants, regardless of age or years of service. Most plans, however,
provide pay credits that increase, based on participant age or service. For
example, one plan provides an annual pay credit of 3 percent of salary for
participants younger than 30 that increases in increments up to 11 percent
for participants aged 50 and older. Another plan provides annual pay credits
of 3 percent for participants with 4 or fewer years of service with
incremental increases up to 9 percent for participants with 25 or more years
of service. About 30 percent of the cash balance plans in our survey,
because they were integrated with Social Security, provided participants
with higher pay credits on pay above the Social Security wage base.19 For
example, two plans provided 4 percent of pay for earnings that were subject
to Social Security taxes ($76,200 in 2000) and 8 percent for earnings that
were not subject to Social Security taxes.

Cash balance plans generally credit interest to participant hypothetical
accounts using an index tied to a Treasury security. About 80 percent of the
cash balance plans in our survey tied interest credit rates in their plan
formulas to the rate of return on a Treasury security. For example, we found
that many cash balance plans credit interest on the basis of the yield to
maturity for 30-year Treasury bonds, but some cash balance plans credit
interest on the basis of the yield to maturity for 1-year Treasury bonds or
another Treasury index.

Lower Benefits at Retirement for Others

Conversions to cash balance plans can result in higher pension benefits
accruing earlier in a worker's career and increased portability of benefits,
which can be advantageous to younger or more mobile workers. However, the
declining rate at which normal retirement benefits accrue in "basic" cash
balance plan formulas (providing a level pay credit for all workers) can
result in older workers receiving smaller annuities after conversion from a
plan with a final average pay formula, assuming that the traditional plan
remained unchanged. Conversions can also result in periods during which
older workers accrue no new pension benefits while others do. While most
Fortune 1000 firms in our survey that adopted cash balance plans have
included transition provisions to mitigate the effects of plan formula
changes on some participants, these provisions can vary in the extent to
which they accomplish this objective.

Benefits Differently Than Cash Balance Plans

Cash balance plans provide a larger share of a participant's accrued benefit
earlier in the worker's career than a traditional defined benefit plan based
on a final average pay formula. Traditional defined benefit plans express
benefits as the normal retirement age annuity the participant has accrued to
date. Typically, participants under a defined benefit plan with a final
average pay formula accrue the greatest share of their benefits in the final
years of their careers because benefits are based on completed years of
service and final average salary, both of which usually increase as workers
age. Generally, under a cash balance plan, the basis for determining
benefits payable at normal retirement age includes both the hypothetical
account balance (annual pay and interest credits) accrued to date plus the
value of future hypothetical interest credits each pay credit would earn up
to the plan's normal retirement age. As shown in figure 2, workers under a
cash balance plan who have many years before reaching normal retirement age
earn a greater proportion of their benefits early in their careers.

Average Pay Formula

Note: Figures based on participation in a traditional final average pay
formula or cash balance formula. Results are based on the assumption of a
$31,000 salary at age 25 (see app. I for details). Our assumption of equal
benefits at the normal retirement age for purposes of illustration does not
mean that the two formulas in this example would provide equivalent benefits
at times other than normal retirement age or would result in equivalent
costs to the sponsor.

Cash balance plans can result in a decreasing rate at which normal
retirement benefits accrue over time. The rate at which normal retirement
benefits accrue in both defined benefit final average pay plans and cash
balance plans depends on the number of years participants have remaining
until they reach the plan-specified normal retirement age. However, in a
defined benefit plan with a final average pay formula, the rate of normal
retirement benefit accrual increases as participants age, being driven by
growth in service and wages. As with defined benefit plans, under the law,
the accrued benefit in cash balance plans must be expressed as an annual
benefit beginning at normal retirement age. Cash balance plans must

express benefits in this manner to comply with defined benefit plan rules.20
For the purposes of satisfying these rules, employee hypothetical accounts
are not equal to the accrued benefits participants are entitled to receive.
As a result, cash balance plans cannot simply provide participants
hypothetical account balances as their benefit. Instead, the hypothetical
balance must be calculated to comply with defined benefit plan accrual and
other requirements.21

When a worker's hypothetical account balance in a given year is projected
forward with hypothetical interest to normal retirement age, the rate of
normal retirement benefit accrual declines as the employee ages, because
each additional year's pay credit will have one less year in which future
interest will compound. This declining rate of accrual results from plans
providing for future interest credits in accordance with IRS Notice 96-8.
The notice discusses the applicability of defined benefit plan rules to cash
balance plans and provides that the accrual of future interest credits
attributable to hypothetical pay credits may be required in the year in
which the pay credit is allocated to a worker's account.

To demonstrate how a worker earns pension benefits under a traditional final
average pay plan and a basic cash balance plan, we calculated several
scenarios for workers of different ages. These hypothetical scenarios assume
that a worker participates under either a basic cash balance plan or
traditional final average pay formula (no conversion) until retirement and
that the formulas result in equivalent benefits at retirement. In reality,
workers may have very discontinuous work histories, work at many different
places under various pension plans, or retire early.

Our comparative design scenarios illustrate the declining rate of normal
retirement benefit accrual inherent in cash balance plans.22 The basic cash
balance plans we simulated add annuity benefits to a participant's total
pension benefit at smaller dollar increments each year that the participant
ages.23 For example, a 25-year-old worker who is assumed to participate in a
cash balance plan until retirement at age 65 accrues an incremental annuity
benefit of approximately $1,660 at age 26 but earns a smaller incremental
benefit of about $630 at age 65. In contrast, the traditional final average
pay plan provided normal retirement benefits at an increasing rate as
workers age. The same 25-year-old worker earns an incremental annuity
benefit of $310 at age 26 but earns a higher incremental benefit of about
$2,440 at age 65. The basic cash balance plan produced a declining rate of
normal retirement benefit accrual for all hypothetical workers we modeled.
(See fig. 3.)

Average Pay Formula

Note: Results are based on the assumption of a $31,000 salary at age 25 and
an entire career under a cash balance formula or a traditional final average
pay formula.

A cash balance plan's declining rate of normal retirement benefit accrual as
workers age is the reason some have charged that these plans are age
discriminatory. Cash balance proponents define the accrued benefit as the
employee's hypothetical account balance. Under this definition, cash balance
plans generate a level rate of accrual for all employees regardless of age
and therefore do not appear to raise issues of disparate treatment of
employees based on age. Critics state that cash balance plans, as defined
benefit plans under the law, must express an employee's accrued benefit as
an annual benefit beginning at normal retirement age or the actuarial

equivalent to a deferred annuity.24 When cash balance plans are viewed in
this way, the amount of the actuarially determined benefit is a function of
the participant's age and decreases as the participant ages. Therefore,
critics argue, cash balance plans violate the prohibition on age
discrimination. Federal agencies are considering the issue of whether cash
balance plans violate age discrimination statutes. Participants have filed a
number of court cases alleging that cash balance plans are age
discriminatory but no definitive decision has been reached.

There is uncertainty concerning whether plan sponsors must adhere to IRS'
guidance on calculating cash balance benefits. The methodology described in
Notice 96-8 has been subject to legal challenge in federal court. Two recent
U.S. Court of Appeals decisions have approved the methodology.25 When Notice
96-8 was issued, IRS characterized it as including proposed interest rate
equivalencies that were to be incorporated in a subsequent regulation, but
nothing more has been promulgated on this subject. However, IRS has
determined whether cash balance plans comply with current defined benefit
plan requirements on the basis of its position that Notice 96-8 represents
current law.

It should be noted that a cash balance plan can result in a declining rate
of normal retirement benefit accrual over a worker's career but not
necessarily a lower benefit than a defined benefit plan with a final average
pay formula would provide. The actual benefit that any individual worker
would receive under either plan would depend on a variety of factors,
particularly the actual design of the specific pension plan. Workers under a
cash balance plan who leave a firm before retiring could ultimately achieve
either a higher or a lower pension benefit at retirement. For example, a
worker who elected a lump sum payment option could receive a higher or lower
retirement benefit, depending on the rate of return of the investments and
whether the money were preserved until retirement. We discuss these issues
in more detail in another report we issued

concurrently on the potential implications of cash balance plans on
retirement income.26

Some Workers

Conversions to cash balance plans can have distributional effects in terms
of the lump sum benefits that favor vested younger workers and short-tenure
workers. This group can be a significant percentage of a firm's workforce,
depending on the specific firm and industry. Plan sponsors told us that the
vast majority of participants under cash balance plans elect a lump sum
distribution rather than an annuity when they are given a choice. For many
workers, these distributions can be greater than those provided by a plan
with a final average pay formula.

We compared lump sum benefits that basic cash balance plans can provide with
lump sum benefits from the traditional final average pay formula after
conversion for the workers we modeled. 27 Compared with the final average
pay formula, the basic cash balance plan formula can provide larger lump sum
distributions for the younger workers we modeled for a period of time after
conversion. For example, anytime within the next 14 years, a 35-year-old
worker at conversion would receive higher lump sum benefits from the cash
balance plan upon leaving the firm. As shown in table 1, a 30-year-old at
conversion would when leaving a firm receive a larger lump sum distribution
from the cash balance plan at any given age until reaching 53.

 Age at separation Final average paya  Cash balanceb
 30                $2,476              $2,476
 35                7,849               13,699
 40                18,684              30,358
 45                39,618              54,510
 50                79,096              88,926
 53                117,686             116,000
 55                152,611             137,322
 60                288,878             204,673
 65                544,153             297,625

Note: Results are based on baseline scenario assumptions for a 30-year-old
worker at conversion and show several possible ages when the worker might
leave the firm. The 30-year-old worker was assigned a tenure and income
value at conversion that correspond to the worker's age. Lump sum
distributions paid from the traditional formula are calculated on the basis
of annuity values that the formula would have produced had no conversion
occurred and in accordance with IRC 417(e) regulations. Lump sum values are
comparable at given ages but are not comparable across years.

aBased on normal retirement age annuity.

bNominal account balance.

As with traditional defined benefit plans, workers must meet a plan's
vesting requirement before they have a right to their accrued pension
benefit. BLS reported that median tenure among all workers aged 25 and older
was 4.7 years in 1998, indicating that some workers change jobs before
vesting. As we discussed earlier, most cash balance plans, like many
traditional defined benefit plans, have a 5-year vesting requirement. Plan
sponsors we interviewed told us that the 5-year vesting requirement of many
cash balance plans results in some short-term, mobile workers' not
benefiting from the higher benefits provided by cash balance plans because
they leave before vesting and forfeit their accrued benefits.

In addition to increasing the value of preretirement lump sum distributions
for many workers, conversions to cash balance plans can benefit workers in
other ways. For example, because cash balance plans spread benefit accruals
more evenly over a worker's career than a traditional defined benefit plan
with a final average pay formula does, workers can accrue higher benefits
sooner. This is especially important for workers who change jobs frequently
or move in and out of the workforce. According to a Society of Actuaries
study of vested workers with 5 or more years of service, 45 percent of
workers terminate employment before completing 10

years of service.28 This length of service allows workers to earn a right to
their pension benefits. Generally, cash balance plans allow vested
participants to receive preretirement lump sum distributions when they leave
a firm. Many traditional defined benefit plans, however, do not offer such
an option. When participants leave firms that sponsor final average pay or
other traditional defined benefit plans, their normal retirement-age annuity
benefits are frozen when they separate. Because many cash balance plan
participants can receive preretirement lump sum distributions, they can
invest these funds for retirement or transfer the distribution to their new
employer's pension plan. Finally, as with other defined benefit plans, PBGC
insures cash balance plan participants' benefits against the risk of benefit
loss when a plan terminates with insufficient assets to pay promised
benefits.

Benefits

Depending on the age of a participant at conversion and a plan's design
features, conversions of defined benefit plans with final average pay
formulas to cash balance plans can result in lower annuities for some
participants than they would receive if no conversion occurs.29 We used our
model to compare the annuity benefit provided by a basic cash balance plan
at normal retirement age with the annuity that a traditional final average
pay formula would have generated at retirement had no conversion occurred
and the traditional plan continued unchanged. After conversion, the
decreasing rate of normal retirement benefit accrual in the basic cash
balance plan we modeled produces a lower annuity at retirement compared with
the annuity benefit that traditional final average pay formula would
generate.30 For example, a 45-year-old worker at the time of conversion
receives an annual annuity of about $18,500 at retirement from the cash
balance plan instead of the $39,800 annuity the worker could have received

from the defined benefit plan with a final average pay formula.31 Likewise,
a worker 50 years old at conversion receives an annual annuity of about
$17,800 from the cash balance plan rather than the $35,100 annuity the final
average pay formula could have provided. For all workers we modeled,
conversions to the basic cash balance plan resulted in lower annuities at
the plan's normal retirement age than resulting from the final average pay
formula.

For workers with equal salary and tenure at conversion, the basic cash
balance plan we modeled produces the lowest annuity at retirement for the
worker who was oldest at conversion. This results from older workers having
fewer years after conversion to earn benefits from the cash balance formula
and a lower rate of normal retirement benefit accrual compared with the
prior final average pay formula. For example, we modeled benefits from a
basic cash balance formula for a 35-, 45-, and 55-year-old worker with equal
salary and tenure at conversion.32 At retirement, the worker who was 55
years old at conversion receives an annual annuity of $6,900 from the cash
balance plan, while the 35-year-old and 45-year-old workers receive
annuities of approximately $24,300 and $12,600 per year, respectively, at
retirement (see fig. 4). Conversion to the cash balance plan resulted in
lower annuities for each of these workers compared with the annuities they
would have received had no conversion occurred. The rate of normal
retirement benefit accrual generated by the cash balance plan is lowest for
the 55-year-old worker (see fig. 5.)

Note: Model results are based on the assumption of $40,000 salary and
10-year tenure at conversion for both the 35-year-old and the 55-year-old
worker at conversion. See additional assumptions in app. II.

Different Formulas

Note: Model results are based on the assumption of $40,000 salary and
10-year tenure at conversion for both the 35-year-old and the 55-year-old
worker at conversion. See additional assumptions in app. II.

Participants Accrue No New Pension Benefits

Conversions to cash balance plans sometimes result in "wearaway" situations
in which some workers do not earn additional pension benefits after
conversion while other workers continue to accrue benefits.33 A wearaway
period is created at conversion when a participant's opening hypothetical
account balance is set at less than the present value of his or her prior
accrued benefits--that is, the amount benefits would currently equal if paid
out as a lump sum. During wearaway, hypothetical pay and interest credit
contributions do not represent new pension accruals until the cash balance
account exceeds the value of benefits accrued under the prior formula. This
is because workers who leave a firm during a wearaway period are entitled to
receive the higher benefit they had accrued under the old formula before
conversion.

Wearaway established at conversion tends to be longer for older workers. For
example, the basic cash balance plan we modeled as establishing opening
account balances at less than the present value of prior accrued benefits
generated a 2-year lump sum wearaway for a 35-year-old worker, a 4-year
wearaway for a 45-year-old worker, and an 11-year wearaway for a 55-year-old
worker at conversion (see table 2).34 This is because older workers
generally accrue larger benefits before conversion. Thus, older workers must
wait longer before their hypothetical balances catch up to the value of
prior accrued benefits and new benefits begin to accrue. Wearaway created at
conversion is also problematic for older workers because these periods often
occur during the years when the traditional formula would have provided the
most favorable rate of pension benefit accrual for them had no conversion
occurred.

 January 1 Value of prior accrued        Hypothetical cash balance account
           benefit
 1998      $30,849a                      $23,709b
 1999      32,749                        27,294
 2000      34,774                        31,157
 2001      36,931                        35,317
 2002      39,231                        39,792

Note: The 30-year Treasury rate represents the monthly rate for December of
the previous year. Results are baseline scenario assumptions. The opening
account balance was established as the present value of prior accrued
benefits at the date of conversion, using an interest rate of 6.99 percent
or the December 1997 30-year Treasury rate plus 1 percent. This example
assumes no change in the mandatory discount rate (5.99 percent) used to
calculate the lump sum value of prior accrued benefits. Lump sum values are
comparable at given ages but are not adjusted to be comparable across years.
App. II describes the model's operation and the assumptions used in
calculating pension benefits.

aMinimum lump sum at conversion.

bValued at 6.99 percent.

We also simulated several examples in which workers' salary and tenure were
equal at conversion in order to determine whether the length of a wearaway
created at conversion can differ for workers of different ages.35 In most of
these simulations, the length of a lump sum wearaway created at conversion
was extended 1 to 2 years for workers with equal salary and tenure but
different ages. For example, we found that a 45-year-old faces a 4-year
wearaway at conversion, while a 55-year-old with the same salary and tenure
at conversion faces a 6-year wearaway. Another simulation we modeled
indicates that a 40-year-old worker faces a 3-year wearaway at conversion
while a 50-year-old worker with the same salary and tenure faces a 4-year
wearaway. Although our simulations show that differences in wearaway periods
based on age can be small, the older worker faces the longer wearaway at
conversion in every instance in which a difference in wearaway periods
emerged.

Plan sponsors determine whether to create wearaway at conversion. When
defined benefit plan sponsors provide accrued benefits as preretirement lump
sum distributions, they must follow federally mandated assumptions. However,
current federal law does not govern how plan sponsors set opening
hypothetical account balances for cash balance plans, provided that a plan
ensures that participants do not receive less than the present value of
prior accrued benefits if they separate from the employer. Plan sponsors can
set the opening balances with any discount rate and set of mortality
assumptions they choose. Thus, at conversion, cash balance plan sponsors can
select assumptions that establish opening account balances at amounts lower
than those they would be required to pay as lump sum distributions of
benefits accrued under the prior formula. Many firms, however, choose not to
create a wearaway at conversion. According to a recent survey by
PricewaterhouseCoopers, 60 percent of cash balance plan conversions that
established opening account balances at the value of prior accrued benefits
used a discount rate equal to or lower than the mandatory discount rate at
conversion, thereby avoiding wearaway at conversion.36

Wearaway can also occur outside the control of plan sponsors after a
conversion. In this instance, wearaway occurs because of fluctuations in the
federally mandated discount rate for determining lump sum distributions from
defined benefit plans. The value of the distributions rises when the
mandatory discount rate falls, and the value falls when the mandatory
discount rate rises. Therefore, a falling mandatory discount rate can
generate wearaway while participants remain with the sponsor, even when no
wearaway was created at conversion. For example, we modeled a scenario in
which no wearaway was created at conversion and the mandatory discount rate
changes after conversion. Table 3 shows that the fall in the discount rate 1
year after conversion causes the value of the annuity benefit accrued under
the prior formula to exceed the value of the 35-year-old worker's
hypothetical account balance, resulting in a wearaway period. Two years
after conversion, the mandatory discount rate rises, and the lump sum value
of the participant's prior accrued benefit falls below the participant's
hypothetical account balance.

 January 1 30-year        Value of prior         Hypothetical cash balance
           Treasury rate  accrued benefit        account
 1998      5.99%          $7,590                 $7,590
 1999      5.06           11,196                 10,017
 2000      6.35           7,553                  12,649

Note: The 30-year Treasury rate represents the monthly rate for December of
the previous year. Results are for a 35-year-old worker at conversion and
are based on baseline scenario assumptions. The lump sum values are
comparable at given ages but are not adjusted to be comparable across years.
App. II describes the model's operation and the assumptions used in
calculating pension benefits.

In addition to arising from conversion of a final average pay formula to a
cash balance formula, wearaway can arise in relation to annuity benefits
that participants have earned as of conversion. For purposes of this report,
annuity wearaway refers to a period of time after conversion when the
annuity benefit produced by the cash balance formula is less than the
annuity benefit earned under the prior formula up to the date of conversion.
Whether annuity wearaway results from conversion to a cash balance formula
depends on several factors, including how the plan sponsor determines
opening balances, the cash balance formula design, and whether the prior
formula has an early retirement benefit.

Annuity wearaways can arise as a result of conversion to a cash balance
formula, depending on the form of annuity benefit that the worker selects
and the design of early retirement benefits in the prior formula. Even when
no lump sum wearaway is established at conversion, annuity wearaway can
arise on the worker's accrued normal or early retirement benefits. For
example, as indicated above, the 45-year-old worker described in table 2 has
a 4-year lump sum wearaway, assuming the account balance is established with
a 6.99 percent interest rate (the rate of return on 30-year Treasuries plus
1 percent), but there would be no lump sum wearaway if the opening account
balance was established with a 5.99 percent interest rate. Table 4 is based
on an example in which the participant's opening account balance was
established as the minimum lump sum distribution of prior accrued benefits
from conversion of a final average pay formula with an early retirement
subsidy. In this example, there is a wearaway on both the accrued normal
retirement benefit and the early retirement benefit

earned as of the date of conversion.37 Specifically, if the prior formula
had included a subsidized early benefit, the 45-year-old worker who elects
to receive early retirement benefits at age 60 has a 9-year wearaway of the
early retirement annuity benefit even if the opening balance is established
with the mandatory 417(e) discount rate.38

 January 1 Final average paya  Cash balancea
 1998      $9,373              $6,196
 1999      9,373               6,622
 2000      9,373               7,038
 2001      9,373               7,444
 2002      9,373               7,840
 2003      9,373               8,226
 2004      9,373               8,603
 2005      9,373               8,971
 2006      9,373               9,379
 2007      9,373               9,679

Note: Results are for a 45-year-old worker with a $45,000 salary and 20
years of tenure at conversion. At conversion, the participant's prior
accrued normal retirement age annuity benefit is $10,188. The opening
account balance was established as the present value of prior accrued
benefits at the date of conversion, using an interest rate of 5.99 percent
or the December 1997 30-year Treasury rate. The cash balance formula credits
interest at 5.99 percent and credits pay at 5 percent. The prior formula's
early retirement subsidy is based on eligibility at age 55 with 30 years of
service, where the normal retirement benefit is reduced by 4 percent
annually for benefits received before age 62.

aNinety-two percent of the normal retirement age benefit of $10,188.

of Plan Changes on Older Workers

Most of the Fortune 1000 firms we surveyed that adopted cash balance plans
included various provisions to mitigate the potential reductions in some
workers' benefits, but these provisions can vary in the extent to which they
mitigate potential reductions in expected benefits.39 While 84 percent of
the firms in our survey that adopted cash balance plans included one or more
features to mitigate potential reductions in future benefits for some or all
participants, our analysis indicates that these provisions can provide
varying levels of protection. Some firms protected against a potential
reduction in future benefits by grandfathering plan participants at the time
of conversion. Grandfathering allows eligible participants to continue
accruing 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, each affecting different groups of
workers. For example, in one firm in our survey eligible participants who
had a minimum of 60 points based on age and service at the date of
conversion receive benefits from the formula that provides the greater
benefit. Another firm in our survey allowed all participants aged 45 and
older with a minimum of 60 points, based on age and service, to continue
accruing benefits under the prior formula.

To mitigate the potentially adverse effects of adopting a cash balance
formula on older participants, some firms incorporated features such as
formulas that provide additional pay credits on the basis of a participant's
age or years of service or they increased opening account balances. For
example, one plan in our survey provides additional pay credits that range
from 5 to 10 percent (above the ongoing pay credit in the plan formula) for
eligible participants 40 years old or older at conversion that increase with
age. Another plan in our survey enhanced opening account balances by
increasing initial balances on the basis of a specific percentage related to
a participant's age and service.

Including age-weighted pay credits in the cash balance formulas that we
modeled usually produced a larger annuity for the participant at retirement
than the basic cash balance formula. We modeled conversions to several
variations of cash balance formulas with weighted pay credits for
hypothetical participants ranging from age 30 through age 55 at conversion,
and they produced similar results. For example, a 45-year-old participant
would receive an annuity of approximately $29,200 per year from a cash
balance plan with weighted pay credits compared with $18,500 from the basic
cash balance plan (see fig. 6). However, under another, less generous
formula with age-weighted credits that we modeled, the same participant
would receive an annuity of only $21,200.40

Balance Formula, and Final Average Pay Formula

Note: Results are for a 45-year-old worker with 20 years of service. The pay
credits in the more generous weighted formula ranged from 3 to 11 percent.
The pay credits in the less generous formula ranged from 3 to 8 percent. We
also modeled formulas with pay credits that ranged from 4 to 7 percent and 3
to 10 percent.

Current disclosure requirements provide only minimum guidelines that firms
must follow on the type of information they provide participants about plan
changes. We found wide variation in the type and amounts of information
workers receive about plan changes. In many instances of conversions to cash
balance plans, sponsors did not ensure that participants received sufficient
information about plan changes that can reduce future benefit accruals.

Under current disclosure requirements, firms may have broad flexibility in
the type of information they provide participants about plan changes. ERISA
specifically requires that plan sponsors notify plan participants about any
plan amendment that may significantly reduce the rate of future benefit
accruals for some or all employees. Employers must provide the notice no
later than 15 days before the implementation of an amendment.41 Notification
must be in writing and must state that the plan formula has been amended as
well as give the effective date of the amendment. However, the law does not
specifically require that plan sponsors articulate the nature of the formula
amendment or identify groups of participants who may be adversely affected.
Also, no notice is specifically required for reductions to early retirement
benefits. Consequently, the communications provided to employees typically
vary from general statements about plan changes to specific examples of how
conversions to cash balance plans might affect workers of different ages and
tenure.

We found significant variation in the information provided to participants
about conversions to cash balance plans. Some firms went beyond the minimum
disclosure requirements and provided extensive information to participants
about how the conversion to a cash balance plan could affect their benefits.
Firms that provided extensive communications to plan participants often
engaged in a communications process with them, sometimes a year or longer,
before conversion. Disclosure included briefing participants and issuing
them brochures or newsletters, benefit calculators to compare benefits under
the traditional and cash balance formulas, and individualized benefit
statements. Several plan sponsors we spoke with indicated that the firms
designed a communications process to provide information to and give
opportunity for dialogue with plan participants at regular intervals before
conversion. The communications began with very basic information about a
firm's decision to convert to a cash balance plan and culminated with
information about how the conversion might affect various groups of
employees. One firm provided its employees the following notice about
reductions in future accruals:

"Generally, the change we are making results in a reduction in the rate of
future pension accruals. There will be no change in the basic pension
formula for employees who are `grandfathered.' Reductions for those who are
well into their working careers but do not meet the grandfathering criteria
will be lessened to some extent through special transition provisions. There
may be large reductions in the rate of future pension accruals compared to
the current pension plan for those who are furthest from retirement today."

Other firms, however, satisfied the notice requirement concerning reductions
in future accruals by providing participants with the minimum amount of
information necessary to satisfy the specific ERISA requirement--namely, a
summary of the plan amendment detailing the cash balance formula or a copy
of the actual plan amendment. It is likely that the technical language
contained in the plan amendment is difficult to understand and does not
adequately convey changes made to the plan or identify types of employees
who might be adversely affected.

Summary plan descriptions (SPD) are another means of providing information
to employees about how conversions to cash balance plans can affect their
pension benefits. New employees must receive a copy of the plan sponsor's
latest SPD 90 days after becoming covered by the plan. These descriptions
are used to convey basic information about company pension benefits in
clear, nontechnical language.

We reviewed many of the SPDs of cash balance plans identified in our survey
and found a range in the quality of information they contained. Some SPDs
provided a clear statement regarding the nature of the cash balance plan,
indicating that the accounts were hypothetical and that employees did not
own the assets in the accounts. For example, one SPD we reviewed included
the following description:

"Because your pension benefit grows as an account balance, it is referred to
as a cash balance type plan. Although your benefit is referred to as an
`account,' no assets or funds are set aside to fund an individual account in
your name. Rather plan assets are held and managed in a single retirement
trust."

However, many of the SPDs we reviewed did not clearly explain that the cash
balance accounts were hypothetical and that participants did not actually
own individual accounts as in a 401(k) plan. About half of the cash balance
plan SPDs we analyzed did not make any reference to the hypothetical nature
of cash balance plan accounts. Not stating that the accounts are
hypothetical or making claims that the cash balance accounts are similar to
401(k) plan accounts can prevent plan participants from understanding how
cash balance plans work and the benefits they are entitled to receive. For
example, without making reference to the hypothetical nature of cash balance
accounts, one firm described its cash balance plan as a "personal retirement
account" that grows on the basis of compensation credits and interest
credits. Other summary plan descriptions or related plan information
described cash balance plans in a similar manner, including providing
illustrations of the growth in cash balance accounts alongside of examples
of how 401(k) plan accounts can increase over time without explicitly
explaining that participants did not "own" the cash balance accounts and did
not control how the assets are invested.

Cash balance and similar hybrid plans have become more common among large
firms than they were in the 1980s and point to a desire firms have to offer
pension benefits that more closely complement their business strategies. In
particular, conversions to cash balance plans allow firms to redistribute
pension benefits among different groups of employees. This redistribution
can be advantageous for young or mobile workers but can have adverse effects
for older workers. Recognizing that some workers face reductions in future
benefits or periods of no new benefit accruals, many firms have adopted
transition provisions to mitigate the loss of expected benefits for some of
their workers. The trend toward cash balance plans and other hybrid plan
designs underscores the challenge of developing a pension system that
provides retirement income for a broad complement of workers while ensuring
benefit equity among various groups of workers.

The increased use of cash balance plans highlights the growing mismatch
between the continuing innovation in pension plan design and a regulatory
framework that is much slower to adapt to new designs. Although cash balance
plans legally are defined benefit plans, they do not fit neatly within the
current defined benefit plan regulatory structure. Consequently, this
mismatch has now resulted in considerable regulatory uncertainty for
employers, as well as litigation with potentially significant financial
liabilities and contradictory court decisions. For many workers, this
mismatch has also raised questions about the security of their retirement
income and the rights they have to their pension benefits. As a result,
additional protections are needed to address issues raised by the emergence
of cash balance and similar hybrid plan designs. 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.

Another major issue in the debate over cash balance plan conversions has
been the clarity and usefulness of information provided to employees about
changes in their retirement benefits. We found considerable variation in the
clarity and comprehensiveness of the information disclosed to employees
affected by past plan conversions. At a minimum, employees should have
clear, understandable information about pension plan modifications that will
help them make intelligent employment and retirement savings decisions. Such
information is especially important when workers must choose whether to
remain under a traditional formula or participate in a cash balance plan.
Participants could benefit from more timely notice of plan changes that can
reduce future benefit accruals. Such an extended notification period would
be comparable to the advance notice provided in the event of a proposed
pension plan termination and would provide participants more time to
evaluate plan changes and the potential effects on their benefits. The
notice could also provide employees a clear, written description about
changes to the plan and which groups of participants might have lower future
benefit accruals under the amended plan.

To improve disclosure related to pension plans, the Congress should consider
amending ERISA so that it specifically requires firms to provide
participants with more timely information, in plain language, about plan
changes that can reduce future pension benefits. Such notice could be
provided to employees no less than 90 days before the effective date of the
plan amendment rather than the current 15 days. This notice requirement
could also be expanded to include instances in which a plan amendment will
significantly reduce or eliminate early retirement benefits.

To better ensure continuity of pension accruals for workers affected by
conversions to cash balance formulas, the Congress should consider amending
the Internal Revenue Code and ERISA to establish requirements to prevent
firms that convert to cash balance plans from creating a wearaway period at
conversion on the value of prior accrued benefits on an annuity and lump sum
basis.

To address the continuing regulatory uncertainty concerning cash balance and
other hybrid plan designs, the relevant federal agencies should take steps
to clarify how these plan designs will be treated under current pension law.
Specifically, we recommend that the Secretary of the Treasury direct the
Commissioner of Internal Revenue to continue the effective moratorium on
determination letters approving conversions to cash balance or similar
hybrid plan designs until IRS acts on our recommendations by promulgating
regulations addressing key issues concerning these plans.

We also recommend that in clarifying the regulatory treatment of cash
balance and similar hybrid plans, the Secretary direct the Commissioner of
Internal Revenue to

ï¿½ develop a regulatory framework that--where appropriate on issues under its
authority, including coordination with other appropriate agencies such as
EEOC--provides requirements on key issues for cash balance and similar
formulas, recognizing the hybrid nature of these new plan designs, and

ï¿½ define the accrued benefit provided by cash balance plans under the
framework for hybrid pension plans.

We also recommend that the Secretary of Labor direct the Assistant Secretary
of the Pension and Welfare Benefits Administration, under authority as
provided by ERISA, to amend the disclosure requirements for summary plan
descriptions and summaries of material modifications to plans to

ï¿½ include a clear statement regarding the hypothetical nature of cash
balance accounts, including that employees do not own the accounts, and how
such accounts differ from any defined contribution accounts an employer may
also provide and

ï¿½ clearly identify the potential of the conversion to reduce future pension
accruals and early retirement benefits and under what circumstances such
reductions are likely to occur.

The Secretary of Labor should also direct the Assistant Secretary of the
Pension and Welfare Benefits Administration to develop standardized language
that firms may use to meet the amended disclosure requirements.

We provided EEOC, IRS, Labor, and Treasury the opportunity to comment on a
draft of this report. Treasury generally agreed with our findings,
conclusions, and recommendations and agreed that legislation like that
proposed in our matters for congressional consideration is needed.
Treasury's comments are included in appendix IV. In its comments, IRS
concurred with Treasury. In their comments, EEOC and Labor also generally
agreed with the report's findings, conclusions, and recommendations.
Treasury and Labor said that they are currently considering the appropriate
course of action to take in response to our recommendations.

Treasury and Labor also provided technical comments, which we incorporated
where appropriate, including clarification of our recommendations.

We are sending copies of this report to the Honorable Charles E. Grassley,
Chairman, Senate Special Committee on Aging; the Honorable Lawrence H.
Summers, Secretary of the Treasury; the Honorable Alexis M. Herman,
Secretary of Labor; the Honorable Ida L. Castro, Chairwoman of the Equal
Employment Opportunity Commission; the Honorable Charles O. Rossotti,
Commissioner of Internal Revenue; and others who are interested. We will
also make copies available to others on request.

If you or your staffs have any questions concerning this report, please call
me on (202) 512-7215. Major contributors to this report are Charles A.
Jeszeck, George A. Scott, Daniel F. Alspaugh, Jeremy F. Citro, Andrew M.
Davenport, Lise L. Levie, and Roger J. Thomas.

Barbara D. Bovbjerg
Associate Director, Education, Workforce,
and Income Security Issues

Scope and Methodology

To determine the prevalence of cash balance plans among large employers and
to describe the major features of cash balance plans adopted by large
employers, we conducted a telephone survey of 420 employers listed among the
1999 Fortune 1000. We selected the firms randomly. We obtained responses
from 409 firms, or about 97 percent of the companies we sampled.

Of the 409 firms that responded to our survey, 19 percent reported
sponsoring a cash balance plan. Because the survey was based on random
sampling with equal probabilities of selection, the sample proportion is a
reasonable estimate of the total population of 1999 Fortune 1000 companies
sponsoring a cash balance plan. Applying the sample proportion (19.3
percent) to the 1999 Fortune 1000 list provides an estimate of 193 1999
Fortune 1000 firms with cash balance plans as of July 2000.42

We obtained plan documents, including summary plan descriptions (SPD) from
the cash balance plan sponsors we identified in the sample survey. We
summarized the major features of cash balance plans sponsored by the 1999
Fortune 1000 firms we surveyed. Information extracted from plan documents
provided by the cash balance plans we identified includes data on whether
the plan is a new or converted plan, participation and vesting requirements,
how opening balances were established, cash balance plan features, and
whether transition provisions were provided.

For each variable in the data collection instrument as well as for
information on plan features that we obtained from plan documents, we
developed a database to compile and analyze plan data. Counts were performed
to generate the frequency of occurrence for each variable in the database
and particular plan features. The percentage and number of 1999 Fortune 1000
firms that sponsor cash balance plans as well as the number of participants
in those plans were calculated at the 95 percent confidence level. The other
statistics we report from our survey on cash balance plans represent sample
statistics.

We conducted in-depth interviews with officials from 14 firms that sponsor
cash balance or similar hybrid plans; 13 of these firms converted
traditional pension plans to cash balance or pension equity plan formulas.
These interviews allowed us to examine in-depth the reasons why employers
converted and how plan sponsors implemented conversions to cash balance
plans. We selected firms judgmentally on the basis of several criteria.
Selection criteria included company industry, geographic region, and whether
the company had received favorable or unfavorable press regarding its
conversion. Two of the 14 companies are nonprofit organizations. Information
from these interviews is included in the body of the report to provide
relevant examples and context. We do not mention firm names in order to
preserve confidentiality. We provided a pledge of confidentiality to firms
that provided us proprietary information.

To analyze how traditional final average pay formulas and cash balance
formulas determine the amount of pension benefits, we calculated comparative
design scenarios that show how benefits accrue over a worker's career. For
these scenarios, we assume that a hypothetical worker spends an entire
career with a sponsor of a traditional final average pay plan or cash
balance plan to illustrate how traditional final average pay formulas and
basic cash balance plans provide pension benefits.43 Because these scenarios
are not intended to compare pension benefits received at any age or to
illustrate the potential effects of conversion, we equalized annuity and
lump sum benefits provided by the two formulas at age 65 the assumed normal
retirement age. Our assumption of equal benefits at the normal retirement
age for purposes of illustration does not mean that the two formulas in this
example would provide equivalent benefits at times other than normal
retirement age or would result in equivalent costs to the sponsor. The
traditional final average pay formula provides an annuity commencing at age
65 based on years of service, a multiplier of 1.0 percent of pay, and the
worker's average final (previous) 5 years of salary. An early retirement
subsidy was not incorporated into the traditional formula for these
examples. We assume that cash balance plan benefits are based on 5.99
percent interest credits (rate of interest on the 30-year Treasury note in
December 1997) to employee "accounts." To equalize pension benefits at age
65, we held the traditional formula accrual factor and the cash balance
formula interest credit rate constant and solved for the cash balance plan
formula's pay credit. For example, the 25-year-old worker we modeled
participates in a cash balance plan that credits 5.9 percent of pay for each
year of participation.

We converted cash balance nominal account balances to annuity equivalents by
projecting account balances forward to age 65 (the assumed normal retirement
age) with the interest credit rate and applying an annuity conversion
factor, which converts the projected balance to an annuity equivalent
commencing at age 65. The annuity conversion factor consists of a discount
rate (5.99 percent, or the rate on 30-year Treasuries as of December 1997)
and unisex mortality assumptions from the 1983 Group Annuity Mortality
table.

Pension Benefits Simulation Model

We used a computer simulation model to examine the potential effects of
converting to a traditional defined benefit plan with a final average pay
formula to a cash balance formula on the pension benefits for individual
workers of different ages and tenure. We designed this actuarial model as an
Excel file in consultation with actuaries from pension-related government
agencies. To conduct simulations, users must input various parameter values
to specify the design of the traditional and cash balance formulas, worker
characteristics at conversion, and key interest rates. The model permits
considerable flexibility in plan design, particularly for cash balance
formulas. This flexibility includes varying the assumptions used to
determine opening account balances and the level and structure of pay and
interest credits. We conducted nearly 100 simulations reflecting various
features of employer-sponsored traditional and cash balance pension plans.
We specified parameter values for the scenarios discussed in the report that
we based on our comprehensive review of actual cash balance plan
conversions. This review included industry-specific data, our survey of
Fortune 1000 firms, in-depth interviews with firms that converted to cash
balance plans, and interviews with knowledgeable actuaries, consultants, and
government officials.

To analyze the potential effects of conversion from a traditional final
average pay formula to a cash balance formula, the model computes benefit
streams in dollars for annuity and lump sum benefits provided by both
formulas. The model computes these streams provided by both formulas
annually up to the plan's normal retirement age of 65. This allows us to
compare annuity and lump sum benefits after conversion for individual
workers for any age at the time of conversion until age 65. To understand
the potential effects on workers' pension benefits that result from
conversion to a cash balance formula, both annuity and lump sum benefit
streams must be calculated. By computing benefit streams, we are able to
compare benefits provided by the two formulas at any point in time upon
conversion until retirement.44

In seeking to compare how workers fare in the event of a conversion to a
cash balance formula, we use a benefit formula to represent a traditional
defined benefit plan in place before conversion. The traditional defined
benefit formula we model is based on a multiplier times the worker's
completed years of service times the average of the worker's last 5 years'
earnings. At any given time, this formula provides a deferred annuity
benefit (or a series of annual payments) that commences at the plan's normal
retirement age, defined as age 65 in our model.

We chose to simulate benefits provided by a traditional defined benefit plan
using a final average pay formula because most participants in defined
benefit plans are covered by plans with a final average pay formula.
According to 1997 data from the Bureau of Labor Statistics (BLS) on defined
benefit plans sponsored by large and medium-size firms, 56 percent of
covered employees participated in a plan based on terminal earnings or
earnings during a specified number of years at the end of a worker's career.
The BLS study indicates that 78 percent of employees covered by a terminal
earnings formula in 1997 received pension benefits based on a 5-year
averaging period. Also, a recent study by PricewaterhouseCoopers found that
78 of the 100 plan conversions it surveyed provided pension benefits based
on a final average pay formula prior to conversion. Annuity benefits are
calculated by the model because defined benefit pension law and regulations
require all defined benefit plans to express accrued benefits in the form of
an annual payment commencing at normal retirement age.45 Traditional formula
benefits are computed from the age of initial employment until the normal
retirement age.

Cash balance plans are defined benefit plans that provide participants with
hypothetical accounts. The balances in these accounts are determined by a
plan-specified formula that specifies a percentage of annual pay for each
employee and pays interest on this amount at a rate or index of rates. In
the event of conversion, plan sponsors generally establish opening balances
by determining the present value of accrued benefits under the prior benefit
formula at the time of conversion.

The model computes benefits provided by cash balance formulas after a
conversion from the traditional defined benefit formula to a cash balance
account formula. The cash balance formula provides hypothetical account
balances and determines benefits on the basis of pay credits and interest
credits contributed to workers' accounts. To facilitate a comparison, we
computed the benefits provided by the cash balance formulas we model from a
worker's age at conversion until the plan's normal retirement age.

Conversion from the traditional final average pay formula to the cash
balance formula is based on computing the present value of the accrued
benefit provided under the final average pay formula at conversion. Our
survey of firms on the 1999 Fortune 1000 list indicates that plan sponsors
who converted to a cash balance formula generally established opening
account balances by determining the present value of prior accrued benefits.
Mortality assumptions based on unisex 1983 Group Annuity Mortality rates and
an interest rate prescribed by Internal Revenue Code (IRC) section 417(e)
are used to determine the present value of the prior accrued benefit
(annuity provided by the old formula) payable at the time of conversion.46
The conversion to the cash balance formula is assumed to have been
operational on January 1, 1998.

Our survey of 1999 Fortune 1000 firms indicates that there is a wide variety
of cash balance plan designs among the firms that sponsor these plans. Thus,
the simulation model does not seek to model any "typical" cash balance plan
but permits analysis of a broad range of cash balance plan features common
among actual plans. Because there is a variety of cash balance plans, we
modeled numerous cash balance formulas including basic cash balance formulas
that provide level annual pay credits to workers regardless of age and
service as well as more complex cash balance formulas with age-weighted pay
credits or enhanced opening balances. All the cash balance formulas we model
are based on common features found in employer-sponsored cash balance plans.
All simulations are illustrative, the model is not used to simulate pension
benefits provided by any particular employer's plan, and the model does not
simulate pension benefits for any particular employer's workforce. Instead,
simulation results help explain how cash balance formulas provide pension
benefits compared with traditional defined benefit final average pay
formulas.

All the simulations we report, as well as those conducted in our sensitivity
analyses, require a number of simplifying assumptions. We do not represent
the simulations we undertook to be typical; rather, they illustrate how
workers might fare under conversion to a cash balance formula. The model
calculates a pension benefit stream for each formula, which permits analysis
of the potential effects of conversion on the accrued pension benefits
workers receive. Deferred annuity and lump sum benefits the two formulas
provide can be compared at any age from conversion until retirement. Thus,
users can compare preretirement lump sum distributions that workers receive
at all possible ages of departure from the firm at or after conversion.
Users can also compare annuity benefits received at retirement.

The purpose of the model is to focus on the comparative effects on benefits
for workers in the event of a conversion to a cash balance formula. The
model does not simulate benefit portability scenarios based on turnover data
or examine pension benefits based on participation in multiple final average
pay or cash balance formulas. In reality, many individuals may have very
discontinuous work histories and may work a number of different places
before retirement. Except where specified in the text, we did not include
early retirement subsidies in the traditional formula that we modeled, and
in all cases, neither the traditional nor the cash balance formula is
integrated with Social Security. The model does not incorporate other
possible changes to a worker's total benefit and compensation package that
might accompany conversion to a cash balance formula (for example, the
addition of a 401(k) plan or an increase in an employer's match to an
existing 401(k) plan). Because the model does not allow users to model
age-based salary increases, we used BLS Economic Cost Index data to compute
an average wage and earnings growth factor to reflect 1990-98 wage growth
among private sector workers. Interest rates, including the 417(e) rate, the
conversion rate, and the annuity conversion factor (rate) used in the
computation of pension benefits, are typically fixed throughout the modeling
period, which begins at the age of employment and extends until retirement
at age 65.

The model operates through parameters for which users can select and input
values. The parameters allow the manipulation of different factors, which
then influence the model's results. Our initial simulations for workers of
various ages and tenure constitute a baseline scenario that models
conversion from a traditional final average pay formula to a basic cash
balance formula. All other simulations use sensitivity analysis, or the
modification of one or more parameter values used in the baseline
simulations, to analyze the potential effects of different types of cash
balance formula design assumptions on workers' pension benefits after
conversion.

Parameters that the user can input values for are grouped into three broad
categories.

1. Worker characteristics:

ï¿½ worker age at conversion,

ï¿½ worker salary at conversion,

ï¿½ worker tenure (completed years of service) at conversion, and

ï¿½ worker salary increase factor.

2. Pension formula parameters:

ï¿½ traditional formula multiplier (a percentage),

ï¿½ cash balance formula interest credit rate,

ï¿½ cash balance formula pay credit rate (level percentage or age-weighted pay
credits),

ï¿½ an extra amount to a worker's opening account balance (possible to add a
flat dollar amount chosen by the user to opening account balances), and

ï¿½ preretirement mortality factor (which is used for all simulations and each
pension benefit calculation in simulations requiring mortality factors).

3. Interest rate parameters:

ï¿½ 417(e) rate (which is always the plan-specified 30-year Treasury rate and
must be used to calculate actuarial equivalents to the accrued benefits
(deferred annuities) provided by defined benefit plans),47

ï¿½ conversion rate (converts the prior accrued benefit to a lump sum value,
which is used as the worker's opening account balance), and

ï¿½ annuity conversion rate (converts projected cash balance accounts to
annuity equivalents).

To establish a baseline from which to examine the potential effects of
conversions to different types of cash balance formula design parameters and
changes to other parameters such as interest rates, we modeled the
conversion of a final average pay formula to a basic cash balance formula.
Modeling conversion to a basic cash balance formula enabled us to
demonstrate what can happen to the pension benefits of individual workers
when a plan sponsor changes from a final average pay formula to a cash
balance formula. (See table 5.)

            Factor                              Assumption

 Traditional final average pay Based on 1.25 multiplier times years of
 formula                       service times final average 5 years' salary
                               (high 5)
                               "Basic" formula design based on 5 percent
                               level pay credits and 5.63 percent interest
 Cash balance formula          credits (1997 annual yield on 1-year
                               Treasury bonds) contributed to worker
                               accounts
                               Based on analysis of March 1999 Current
 Worker salary at conversion   Population Survey data by age and gender for
                               full-time workers who participated in a
                               pension plan

 Annual salary increase        3.4 percent, based on analysis of BLS
                               Economic Cost Index data

 Mortality factors             1983 Group Annuity Mortality table unisex
                               rates

 Conversion ratea              Converts prior accrued benefits, or
                               annuities, to opening account balances
                               Discounts annuities to present value: 5.99
 Plan-specified discount rate  percent, or the rate of return on 30-year
                               Treasury bonds in December 1997

 Annuity conversion rate       Converts cash balance accounts to age 65
                               annuity equivalents

aThe value we selected for the conversion rate in our baseline scenario
established opening account balances as the present value of prior accrued
benefits in accordance with IRC 417(e)--governing the determination of lump
sum distributions from defined benefit plans. Unless we note otherwise in
the text, all simulations we modeled converted prior accrued benefits using
this rate.

The parameter values we selected for our baseline simulations, including the
traditional and cash balance formula parameters, reflect common features and
factors found among actual plan designs. We selected all the assumptions
used to specify the formula parameters for the traditional final average pay
formulas and basic cash balance formulas we model on the basis of our
consultation with knowledgeable consultants and actuaries.

ï¿½ The traditional final average pay formula accrual factor. We selected
1.25, which is below the average accrual factor of 1.48 for final average
pay plans BLS reported in its 1997 survey of large and medium-sized defined
benefit plan sponsors.

ï¿½ Pay credits. The level pay credit of 5 percent we selected is based on our
review of level pay credit rates that actual cash balance plans provide and
our consultations with actuaries. Our survey of 1999 Fortune 1000 firms
indicates that about 35 percent of cash balance sponsors use a level pay
credit in their formulas. According to a recent PricewaterhouseCoopers
study, 28 of 100 sponsors surveyed that converted to a cash balance formula
use a level pay credit, and the median rate is 4.5 percent.

ï¿½ Interest credit rates. The interest credit rates we assume in our
simulations are common among actual cash balance plans. The majority of cash
balance plan sponsors we identified in our survey of 1999 Fortune 1000 firms
use a rate tied to a Treasury security, such as the rate on the 30-year or
the 1-year Treasury bond, to credit interest to participants' hypothetical
accounts. According to PricewaterhouseCoopers, the rate of return on 1-year
Treasury bonds is the most commonly used rate (40 of 100 cash balance plans)
to credit interest to participant accounts.

ï¿½ Nominal account balances. The cash balance formulas we model are designed
to provide workers who receive benefits from the plan with the nominal
account balance. All simulations use an interest credit rate−the rate
of return on 1-year Treasury bonds or the rate of return on 30-year Treasury
bonds--from the list of rates permissible under IRS Notice 96-8 to credit
worker accounts. According to IRS Notice 96-8, cash balance plan sponsors
who credit interest at a rate or index equal or tied to the yield on 30-year
Treasury securities may pay the nominal account balance as the benefit
distribution to a vested participant. The selection of 1-year and 30-year
Treasury rates as the interest credits rate for the cash balance formulas we
model is designed not to produce "whipsaw" effects at conversion or any time
after conversion to the plan's normal retirement age.

ï¿½ Mortality table for annuity calculation. For all simulations, we use
unisex mortality rates from the 1983 Group Annuity Mortality table. Unisex
mortality factors from this table are required by law to be used when
calculating minimum lump sum distributions payable from defined benefit
plans because the 1983 Group Annuity Mortality table is the current
"prevailing commissioners' standard table."48 Our use of the rate of return
on 30-year Treasuries is also consistent with mandatory IRC section 417(e)
requirements for calculating lump sum distributions from defined benefit
plans. Knowledgeable actuaries with whom we spoke indicated that using the
rate of return on 30-year Treasuries and 1983 Group Annuity Mortality unisex
mortality factors is appropriate for other calculations requiring the use of
mortality factors and an interest rate. Therefore, we use these assumptions
to calculate the present value of prior accrued benefits to establish
opening account balances and convert nominal cash balance accounts to age 65
annuity equivalents. Using the rate of return on 30-year Treasury bonds and
1983 Group Annuity Mortality unisex mortality factors also assured us that
we did not create a lump sum wearaway upon conversion by establishing
opening account balances at less than the present value of prior accrued
benefits.49

To compare how traditional and cash balance formulas provide pension
benefits and to assess the potential effects of conversion to a cash balance
formula on pension benefits of different workers, the user can select values
for worker age, salary, and tenure at conversion. Worker age represents how
old a worker is at the time of conversion to the cash balance formula. We
modeled workers at ages 30, 35, 40, 45, 50, and 55 at conversion to examine
the potential effects of conversion on younger and older workers. The values
selected for worker salary and tenure variables represent worker salary and
years of completed service at conversion.

The worker profiles assume that employment began at age 25 for each worker
and that the youngest worker we modeled completed 5 years of service by the
time of conversion. Salaries at conversion are based on analyses of earnings
and wage data from the Demographic Supplement to the March 1999 Current
Population Survey for full-time workers who reported participation in their
firm's pension or retirement plan by age and gender. We used the Current
Population Survey to compute earnings figures because it is the source of
official government income statistics published by the Bureau of the Census.
All salary values are median values for workers at the specific ages
modeled.

Benefits

Because cash balance plans are designed to provide lump sum benefits but
must also provide annuity benefits, a complete examination of the potential
effects of conversion on the pension benefits of workers of different ages
and tenure depends on analyzing the potential effects on both annuity and
lump sum benefits. The model we used simulates both annuity and lump sum
benefit streams provided by each formula.50

1. Annuity. The annuity provided by the traditional formula and the "annuity
equivalent" to the cash balance account (nominal cash balance accounts
converted to annuities at age 65).

2. Lump sum. The lump sum value of the accrued benefit from the traditional
formula--minimum distribution in accordance with IRC section 417(e)--and the
nominal cash balance account value, based on the establishment of an opening
account balance at conversion. Lump sum values represent age-specific
present values and are reported in nominal dollars.51

We examine annuities because cash balance plans legally are defined benefit
plans and must provide an annual benefit commencing at normal retirement
age, usually in the form of an annuity.52 The model computes two annuity
benefit streams for the traditional formula. One stream shows the
traditional formula annuity from the initial age of initial employment up to
the age at conversion, with the annuity amount frozen at conversion until
normal retirement age. The other stream shows the traditional formula
annuity from the age of initial employment to the plan's normal retirement
age.

For each year upon conversion, the model converts beginning-of-year nominal
account balances to "annuity equivalents." To calculate the annuity
equivalent to the cash balance account, the model incorporates the
methodology recommended in IRS Notice 96-8. We use the methodology
prescribed by Notice 96-8 because defined benefit plans must express
benefits as a function of the plan's normal retirement age, whether as a
series of annual payments or the actuarial equivalent of normal retirement
benefits.53 According to IRS Notice 96-8, nominal account balances are
projected to normal retirement age using interest credits specified by the
plan. The projected balance is converted into a deferred age 65 annuity. The
"annuity conversion" is calculated in accordance with the mortality factors
and interest rate prescribed by Internal Revenue Code section 417(e).54 The
annuity equivalent to the cash balance account determined by this
methodology represents an annual benefit beginning at the plan- specified
normal retirement age. The cash balance account annuity equivalent is
directly comparable to the annuity provided under the final average pay
formula.

To compare the lump sum benefits provided by the two formulas, the model
calculates the age-specific present value (lump sum) of the annuity produced
by the final average pay formula. The age-specific present value of accrued
benefits that defined benefit plans provide must be determined in accordance
with IRC section 417(e). Under this requirement, annuity benefits are to be
discounted to an actuarially equivalent amount, or a lump sum distribution,
that equals the present value of the annuity generated by the formula. The
model incorporates the mortality factors and interest rate mandated by IRC
section 417(e) to determine the present value of the traditional formula
annuity benefit. The lump sum value of the traditional formula annuity
benefit is the legal minimum payment that defined benefit plan sponsors can
provide to vested participants who can receive benefits in a form other than
an annuity commencing at retirement (if permissible under the plan). The
model permits the calculation of lump sum values for the two annuity benefit
streams produced by the final average pay formula. That is, the model
calculates lump sum values for the final average pay formula annuity stream
frozen at conversion until the normal retirement age, and it calculates lump
sum values for the final average pay formula annuity stream produced from
the age of initial employment out to the normal retirement age.

Except in the case in which where we illustrate the wearaway of annuity
benefits that can occur upon conversion to a cash balance formula, we did
not simulate pension benefits provided by traditional formulas with early
retirement benefit provisions. The majority of traditional defined benefit
plans do include some form of early retirement benefit, and many include
subsidized early retirement benefits.55 Early retirement benefits are
designed into defined benefit pension plans by adjusting the accrued benefit
(the deferred age 65 annuity determined by the plan formula) as of the date
of early retirement to reflect the receipt of benefits at an earlier age and
for a longer period of time. Adjustments to normal retirement annuities are
based on early retirement factors or actuarial factors combining a set of
mortality assumptions and an interest rate. Early retirement benefits can
reflect full actuarial reductions, which discount the accrued normal
retirement benefit to the date of early retirement. Early retirement
benefits generated in this manner are termed "actuarially reduced" benefits.
Early retirement benefits can also be subsidized or can reflect adjustments
that do not actuarially reduce benefits to fully reflect receipt at the
early retirement age. That is, defined benefit plans can stipulate a set of
more favorable early retirement factors that reduce benefits on an
actuarially partial basis (benefits are worth more at the early retirement
age than if reduced on a purely actuarial basis).

The absence of early retirement benefits in the traditional formulas we
model has no effect on how the cash balance formulas we model provide
benefits after conversion. The benefit stream and rate of benefit accrual
provided by cash balance formulas after conversion are not altered by the
presence or absence of early retirement subsidies in a final average pay
formula before conversion. According to leading actuaries we spoke with,
early retirement subsidies can be eliminated as a result of conversions to
cash balance formulas but this does not affect how benefits accrue under
cash balance formulas.

Many defined benefit plan participants are covered by a plan that integrates
benefits with Social Security.56 The model results would most likely be
affected by integrating one or both of the pension benefit formulas
simulated with Social Security benefits, but it is not possible to gauge
whether the results would be more favorable or less favorable to the cash
balance formula. Also, the earning levels of individual workers influence
whether and how integration affects total pension benefits.

There are two methods for integrating employer-sponsored defined benefit
pensions with Social Security. The offset method reduces employee pension
benefits as calculated by the plan formula by a portion of primary Social
Security payments, or by the "offset" amount. Offset amounts may not exceed
limits specified by federal law. The excess method involves adding two
layers of benefits to determine the participant's total pension benefit. The
excess method applies the plan formula to determine the benefit for
participant earnings up to an "integration level," such as the Social
Security taxable wage base or a specific fixed-dollar threshold. A second
layer of benefits is computed at a higher rate for earnings above the
integration level.57 Designing Social Security integration into our model
could be more or less favorable to the cash balance formula, depending on
whether integration was built into either the traditional formula or cash
balance formula (or both) and the integration method used.

To enhance our analysis of the potential effects of conversion to cash
balance formulas on the pension benefits, we conducted numerous sensitivity
analyses by changing the cash balance formula design parameters. For
example, we simulated an additional conversion scenario to an alternative
basic cash balance plan. This alternative scenario was based on conversion
from a traditional final average pay formula with a 1.25 multiplier to a
cash balance formula that provides flat 6 percent pay credits and 5.99
percent interest based on the December 1997 rate of return on 30-year
Treasury securities. We also modeled conversion to five cash balance
formulas with age-weighted pay credits that we selected from among cash
balance plan sponsors we identified in our survey of Fortune 1000 firms. For
example, we modeled conversion to a cash balance formula with age-weighted
pay credits ranging from 3 to 8 percent, and we modeled conversion to a cash
balance formula with age-weighted pay credits from 3 to 11 percent. We also
modeled examples of conversions to cash balance formulas with enhanced
opening balances, enhanced opening balances and age-weighted pay credits,
and grandfathering provisions. These formula design assumptions did not
change our key findings.

The simulations we conducted reflect a range of features commonly found in
cash balance formula designs, including conversions. We conducted a range of
sensitivity analyses to assess the effects of changes to various model
parameters, including cash balance formula design parameters. Parameter
values for the simulations were selected on the basis of our review and
analysis of actual cash balance plans sponsored by large employers, review
of the literature on cash balance plans, and interviews with knowledgeable
pension actuaries and consultants involved in cash balance plan designs.

Cash Balance Plans and Minimum Lump Sum Distributions

IRC provides that any form of payment from a defined benefit formula other
than an annuity must be the actuarial equivalent of an annuity beginning at
normal retirement age.58 The actuarial equivalent of an annuity commencing
at normal retirement age is the present value or lump sum equivalent to the
annuity benefit. IRC defines how the actuarial equivalent of a normal
retirement age annuity must be determined. Specifically, IRC section
417(e)(3) stipulates that defined benefit sponsors that permit lump sum
distributions must calculate distributions to departing participants by
using a mandatory discount rate and a set of mortality assumptions. The
mandatory discount rate is the rate of interest on 30-year Treasury bonds,
and the current mortality table is the prevailing IRS Commissioner's table
used to determine reserves for group annuity contracts--the 1983 Group
Annuity Mortality unisex table.59 To determine the lump sum distribution of
a participant's accrued benefit under a traditional formula, the IRC section
417(e) methodology must be applied to the individual's accrued benefit. The
actuarial present value of an annuity beginning at normal retirement age
determined in accordance with federal regulations represents the minimum
lump sum distribution payable under law to a departing vested employee.

Cash balance plans must pay accrued benefits as an annuity or the lump sum
equivalent to a normal retirement age annuity.60 Cash balance plans that
provide preretirement lump sum distributions must do so in accordance with
federal regulations governing defined benefit plans. Hypothetical account
balances are proxies for the lump sum equivalent of participants' accrued
benefits. However, because cash balance plans do not initially express
benefits as annuities commencing at normal retirement age like most other
traditional defined benefit plans do, hypothetical account balances paid as
lump sum distributions must be calculated as the actuarial equivalent of
deferred annuities. This calculation ensures that cash balance plan sponsors
pay separating employees the minimum benefit they are entitled to under the
law.

Under a cash balance plan, the hypothetical account balance represented to
the participant may not equal the minimum lump sum distribution the
participant is entitled to receive. The extent to which the hypothetical
balance equals the minimum lump sum distribution payable from a defined
benefit plan depends primarily on the relationship between two key interest
rates--the rate at which the plan credits hypothetical earnings and the
mandatory discount rate. If the plan interest credit rate exceeds the
mandatory discount rate, the plan sponsor must legally pay a lump sum
benefit greater than the participant's hypothetical account balance, known
as the "whipsaw" effect. Conversely, when the hypothetical account balance
exceeds the minimum lump sum benefit payable, IRC does not prohibit a
sponsor from paying the lesser amount.61

For example, a 35-year-old worker with a hypothetical account balance of
$7,590 may receive a lump sum payment of $9,064 when the plan interest
credit rate is 6.99 percent and the discount rate is 5.99 percent (see fig.
7).

Benefit

Note: At conversion the 35-year-old worker has a $40,000 salary and 10 years
of service. See model assumptions in app. II.

Conversely, if the plan interest credit rate is 4.99 percent, the same
employee receives a lump sum payment of $5,146 (see fig. 8).

Note: At conversion the 35-year-old worker has a $40,000 salary and 10 years
of service. See model assumptions in app. II.

IRS Notice 96-8 prescribes a methodology for cash balance plans to generate
the actuarial equivalent of the annuity commencing at normal retirement age,
which represents the minimum lump sum amount that can be paid under law.
Calculating the minimum benefit amount payable under a cash balance formula
requires additional steps beyond calculating the hypothetical balance.
According to Notice 96-8, the participant's hypothetical account balance
must be projected forward to the date of retirement, using hypothetical
earnings that are based on the interest credit rate specified by the plan.
Hypothetical account balances are projected forward with interest credits to
the plan's normal retirement age because future interest credits are part of
participants' nonforfeitable benefits. That is, Notice 96-8 requires cash
balance plans to be "front-loaded"--or requires determining accrued benefits
by including all future interest earned on each year's pay credit as of the
date the pay credits were contributed to hypothetical accounts. Next, the
projected balance is converted into a normal retirement age annuity by using
a plan-specified discount rate and mortality factors. Finally, the value of
the normal retirement age annuity is discounted back to current dollars,
using the mandatory discount rate--the rate specified by federal regulation
that must be used to convert the benefit into an equivalent lump sum in
current dollars--and mortality factors.

IRS Notice 96-8 permits cash balance plan sponsors to pay hypothetical
account balances as minimum lump sum distributions to satisfy defined
benefit plan rules. To help sponsors avoid the potential for whipsaw, IRS
guidance allows plan sponsors to pay the hypothetical balance as the accrued
benefit by adopting an index from a list of recommended indexes for
crediting interest to hypothetical accounts. Plan sponsors are allowed to
credit interest on the basis of the rate of return to 30-year Treasury
securities or on one of several indexes tied to the 30-year Treasury bond
rate.

The Notice allows a sponsor crediting hypothetical interest at a rate equal
to or tied to the mandatory discount rate to pay the hypothetical balance if
the sponsor uses one of the standard indexes that appear in the notice to
credit hypothetical interest earnings.62 As we stated above, figure 7 shows
that because the 6.99 percent interest credit rate exceeds the 5.99 percent
mandatory discount rate, the plan sponsor must pay a departing participant a
lump sum distribution of $9,064, which is greater than the $7,590
hypothetical account balance. However, the sponsor in this example would be
allowed to pay a lump sum distribution of $7,590 when the interest credit
rate is based on one of the standard indexes contained in the notice, even
if that rate is higher than the mandatory discount rate, such as 6.61
percent.63 Although it is not explicitly stated in IRS Notice 96-8, federal
agency officials stated that the Notice implies that a plan adopting a
standard index may project the balance forward and discount it back, using
the mandatory discount rate. As a result, the hypothetical account balance
and the minimum lump sum benefit would always be assumed to be equal,
regardless of any differences between the rate (as determined by the
specific index) used to credit hypothetical earnings and the mandatory
discount rate. In practice, the hypothetical balance becomes the payable
benefit.

Comments From the Department of the Treasury

(207074)

Table 1: Lump Sum Distributions From a Traditional Final Average
Pay Formula and a Cash Balance Formula After
Conversion 22

Table 2: Lump Sum Wearaway Created at Conversion for a
45-Year-Old Worker 29

Table 3: The Creation of Wearaway Periods After Conversion by Fluctuation in
the Mandatory Discount Rate for Defined
Benefit Plans 31

Table 4: Early Retirement Benefit Wearaway Payable at Age 60 32

Table 5: Assumptions for the Baseline Simulations We Report 50

Figure 1: Participant Coverage in Fortune 1000 Cash Balance
Plans 11

Figure 2: Annual Annuity Benefits Under a Cash Balance Formula
and a Final Average Pay Formula 17

Figure 3: Rate of Accrual for a Cash Balance Formula and
a Traditional Final Average Pay Formula 20

Figure 4: How Conversion to a Cash Balance Plan Potentially
Lowers Annuities 26

Figure 5: Incremental Benefit Accruals for Workers of Different
Ages Under Different Formulas 27

Figure 6: Comparison of Benefits From Weighted Pay Credit
Formulas, Basic Cash Balance Formula, and Final
Average Pay Formula 35

Figure 7: The Whipsaw Effect: Hypothetical Balance Is Less
Than Lump Sum Benefit 60

Figure 8: Hypothetical Balance Is Greater Than Lump Sum Benefit 61
  

1. Fiscal year 2000 estimate, from Joint Committee on Taxation, Estimates of
Federal Tax Expenditures for Fiscal Years 2000-2004, prepared for the
Committee on Ways and Means and the Committee on Finance, JCS-13-99, Dec.
22, 1999, p. 23. Pension contributions and investment earnings on pension
assets are not taxed until benefits are paid to plan participants. As a
result, these tax preferences largely represent timing versus permanent
differences in tax revenue generation.

2. Defined benefit plans generally pay retirement benefits on the basis of
years of service, earnings, or both. Unlike traditional defined benefit
plans, cash balance plans determine benefits on the basis of hypothetical
individual accounts.

3. The Fortune 1000 list ranks for-profit companies by operating revenue.
The results of our survey can be generalized to all 1999 Fortune 1000 firms
but not to all other firms. For purposes of this report, when we discuss the
results of our survey, we refer to firms on the 1999 Fortune 1000 list.

4. Final average pay formulas base benefits on a percentage of the
participant's final average earnings, multiplied by number of years of
service.

5. Cash Balance Plans: Implications for Retirement Income ( GAO/HEHS-00-207,
Sept. 29, 2000).

6. Another formula, called "career average," operates in the same way but
bases benefits on the employee's pay averaged over all years of service with
an employer rather than the final years.

7. Defined as a series of periodic payments over a specified period of time
or for the life of the recipient.

8. 26 U.S.C. 414(j).

9. 29 U.S.C. 623 (i)(1)(A).

10. 29 U.S.C. 1054(b)(H)(i) and 26 U.S.C. 411(b)(1)(H).

11. About 4 percent of Fortune 1000 firms that we surveyed sponsor pension
equity plans. Under pension equity plans, employees earn a percentage of
final average pay expressed as a lump sum amount. These plans are similar to
cash balance plans in that higher benefits accrue earlier in a career and
lower benefits accrue later in a career than under traditional defined
benefit plans.

12. Frozen plans have stopped participants' benefit accruals and allow no
new entrants into the plans but distribute benefits to participants and
beneficiaries.

13. Our survey of 1999 Fortune 1000 firms indicates that sponsors of cash
balance plans can adopt these plan formulas in several ways--by converting
from a prior defined benefit formula, freezing a prior plan and starting a
new cash balance plan, or starting a new cash balance plan as a first
pension plan.

14. PricewaterhouseCoopers, A UNIFI Survey of Conversions From Traditional
Pension Plans to Cash Balance Plans (Teaneck, N.J.: July 2000). The study
surveyed 100 conversions of traditional defined benefit formulas to cash
balance formulas.

15. Participants generally earn a nonforfeitable right to benefits after
meeting a plan's vesting requirement. Federal pension law sets specific
minimum vesting requirements. When firms terminate their plans, affected
participants become 100 percent vested in their accrued benefit on the
termination date.

16. Lump sum distributions received before age 59-1/2 and not rolled into an
individual retirement account (IRA) or another qualified employer plan are
subject to a 10 percent excise tax in addition to ordinary income taxes.
Generally, employers are required to withhold 20 percent of any distribution
not rolled over into an IRA or a qualified employer retirement plan.

17. Participants earn a right to a percentage of pension benefits over a
period of up to 7 years.

18. Conversely, firms deciding not to convert cited the visibility of cash
balance plans in the press and the employee response to adverse publicity
that has resulted from some conversions as a significant drawback of cash
balance plans.

19. For additional information about the integration of pensions with Social
Security, see Integrating Pensions and Social Security: Trends Since 1986
Tax Law Changes ( GAO/HEHS-98-191R, July 6, 1998).

20. 26 U.S.C. 411 and 26 U.S.C. 417.

21. In a calculation of the actual benefit, the hypothetical account balance
is projected forward with interest earnings to the plan-specified normal
retirement age. Next, the projected balance is converted into a normal
retirement age annuity, using a plan-specified discount rate and mortality
assumptions. Finally, the value of the annuity is discounted back to current
dollars, using the assumptions for mortality and interest specified by
federal regulations, to convert the normal retirement age annuity into an
actuarially equivalent lump sum in current dollars.

22. The comparative design scenario calculations are additional computations
we performed outside our cash balance conversion simulations. See app. I for
more information on these scenarios.

23. We measure the rate of benefit accrual by calculating the incremental
annuity benefit added by the traditional final average pay and cash balance
formulas each year to the total annuity benefit. The incremental annuity
added by both formulas for a given year is determined by subtracting the
total annuity benefit of the previous year from the total annuity benefit of
the current year. See app. II for a discussion of how cash balance accounts
were converted to annuity equivalents.

24. 26 U.S.C. 411(a)(7).

25. Lyons v. Georgia Pacific Corporation Salaried Employees Retirement Plan,
No. 99-10640, 2000WL 1140673 (11th M.D.S.P. Cir. Aug. 11, 2000), reversing
66 F. Supp. 2d 1328 (N.D. Ga. 1999), and Esden v. Retirement Plan of the
First National Bank of Boston, No. 99-7210 (2nd Cir. Sept. 12, 2000),
reversing 182 F.R.D. 432 (D. Vt. 1998).

26. Cash Balance Plans: Implications for Retirement Income (
GAO/HEHS-00-207, Sept. 29, 2000).

27. Working with plan consultants and actuaries, we developed a model that
provides illustrative scenarios of the effects of conversion to a cash
balance plan on the benefits of workers of different ages and tenure. While
there is significant variation in cash balance plan designs, the design
features we modeled for both the traditional and cash balance formulas, and
related assumptions, are consistent with those that large firms commonly
use. See app. II for information on our simulations.

28. Steve Kopp and Lawrence Sher, "A Benefit Value Comparison of a Cash
Balance Plan With a Traditional Final Average Pay Defined Benefit Plan," The
Pension Forum (Schaumburg, Ill.: Society of Actuaries, 1998).

29. Lower annuity benefits accrued after conversion to a cash balance
formula may be offset to the extent that sponsors increase other benefits at
the time of conversion. For example, several representatives of firms we
spoke with stated that firms increased contributions to their defined
contribution plan or added a stock-purchase plan to the benefit package.

30. Except where indicated, the traditional final average pay formula we
modeled does not include an early retirement subsidy, and neither the
traditional formula nor the cash balance formula we modeled is integrated
with Social Security. See app. I for more information.

31. Worker age refers to the age of a worker at conversion to a cash balance
formula. The 45-year-old worker has a salary of $45,000 and 20 years of
tenure at conversion, and the 50-year-old worker has a salary of $47,000 and
25 years of tenure at conversion. App. II discusses the hypothetical worker
profiles we developed.

32. For all three workers whom we modeled, salary is $40,000 and tenure is
10 years at conversion.

33. See app. II for a discussion of how we determined opening balances and
the assumptions we used in valuing prior accrued benefits. Except for
simulations in which we modeled a lump sum wearaway at conversion, all
opening balances were established by calculating the present value of prior
accrued benefits in accordance with IRC 417(e)(3) at conversion. To model
lump sum wearaway at conversion, we assumed a discount rate higher than the
mandatory rate used to determine minimum distributions from defined benefit
plans.

34. Assuming no change in the mandatory discount rate for determining the
minimum lump sum distribution from defined benefit plans. At conversion, the
35-year-old worker has a salary of $40,000 and 10 years of tenure, the
45-year-old worker a salary of $45,000 and 20 years of tenure, and the
55-year-old worker a salary of $47,500 and 30 years of tenure.

35. To model lump sum wearaway at conversion, we established opening account
balances upon conversion, using a discount rate higher than the mandatory
rate used to determine minimum distributions from defined benefit plans. For
these simulations, all plan features and the discount rate were held
constant.

36. PricewaterhouseCoopers, A UNIFI Survey of Conversions From Traditional
Pension Plans to Cash Balance Plans (Teaneck, N.J.: July 2000). Eighty-three
of the 100 plan conversions established opening account balances as the
present value of prior accrued benefits.

37. A 2-year wearaway on the participant's prior accrued normal retirement
annuity benefit occurred as a result of conversion to the cash balance
formula.

38. In the 10th year after conversion, the employee comes out of the
wearaway period on the early retirement benefit because the life annuity
beginning at age 60 is $9,373 annually, based solely on benefits before
conversion, and is $9,679 annually, based on the hypothetical account
balance at age 60 (which is the sum of the opening account balance
established with a 5.99 percent interest credit rate, 10 years of pay
credits thereafter from age 45 to age 55, and 15 years of interest on those
amounts to age 60 at 5.99 percent annually).

39. Our analysis of transition provisions includes cash balance plans we
identified as becoming operational through a formula amendment (conversion
of a traditional defined benefit formula) and cash balance plans started as
new plans after the plan sponsor froze a prior defined benefit formula.
Measuring the effectiveness of various transition provisions in order to
address the potential loss of expected benefits would require an analysis of
individual plan designs and firm workforce data.

40. We also modeled conversions to cash balance formulas with enhanced
opening account balances and grandfathering provisions. See app. II for a
discussion of the sensitivity analysis we performed regarding transition
provisions.

41. In contrast, if employers intend to terminate a pension plan, they must
notify everyone affected, including current participants, between 60 and 90
days before the proposed termination date.

42. To calculate the population estimate from the sample proportion, the
assumption is made that the population of 1999 Fortune 1000 companies not
selected for the survey has the same proportion of cash balance sponsors as
the number of survey respondents. Confidence intervals were computed at the
95 percent level for the number and proportion of 1999 Fortune 1000
companies sponsoring cash balance plans.

43. We modeled lifetime participation scenarios for workers commencing
employment at ages 25, 35, 45, and 55. Worker income at age of employment is
based on median incomes for full-time workers who reported participation in
a pension or retirement plan by age computed from analyses of the March 1999
Demographic Supplement to the Current Population Survey.

44. Industry studies that examine the potential effects of conversions to
cash balance formulas also model examples to provide illustrative analysis.
These studies compute benefit streams to allow the comparison of pension
benefits that workers receive under various conversion scenarios. For
example, see The Unfolding of a Predictable Surprise: A Comprehensive
Analysis of the Shift From Traditional Pensions to Hybrid Plans (Watson
Wyatt Worldwide, 1999) and Larry Sher, "A Workable Alternative to Defined
Benefit Plans," Contingencies (Sept.-Oct. 1999), pp. 4-7.

45. 26 U.S.C. 411(a)(7).

46. Converting the prior accrued benefit to a lump sum distribution in
accordance with IRC section 417(e) ensures that a lump sum wearaway period
is not created at conversion.

47. According to regulations implementing changes to IRC section 417(e) as
required by the Retirement Protection Act of 1994, defined benefit plan
sponsors have some flexibility in selecting the 30-year Treasury rate they
must use to calculate the lump sum value of accrued benefits.

48. 26 C.F.R. 1.417(e).

49. For the majority of simulations we performed, we did not create a lump
sum wearaway at conversion. Unless we note otherwise, we established opening
account balances, in accordance with IRC section 417(e), as amounts equal to
the minimum lump sum distribution of prior accrued benefits that workers
would be entitled to receive upon separation at conversion.

50. All pension benefits computed by the model are beginning-of-year
benefits.

51. Lump sum values represent the "present value" of the pension benefit at
a specific age (or nominal value). That is, the lump sum value of a
traditional formula annuity benefit for a worker at age 35 is the present
value of the worker's accrued benefit at that age. Also, the cash balance
account a worker has accrued at age 35 is the "present value" of the cash
balance formula's benefit at age 35. Thus, cash balance account balances
represent the present value of accrued pension benefits when the balance is
paid out.

52. 26 U.S.C. 414(j) and 26 U.S.C. 411(a)(7).

53. 26 U.S.C. 411(a)(7) and 411(c)(3).

54. For all calculations that convert a deferred annuity to a lump sum
value, the mortality factors used are the unisex mortality factors from the
1983 Group Annuity Mortality table. This table is the current IRS
Commissioner's standard table that IRC section 417(e) requires be used in
determining the present value of accrued benefits when defined benefit
sponsors pay out lump sum distributions to vested participants. Unisex
mortality factors used from 1983 Group Annuity Mortality tables in
conjunction with an interest rate, to establish opening account balances,
convert projected cash balance accounts to annuity equivalents, and convert
deferred annuities to lump sum values. For all simulations, the probability
of surviving to retirement age and the probability of surviving each year
beyond retirement age (once retirement age is attained) are incorporated
into all the aforementioned pension benefit calculations.

55. According to BLS' 1997 Employee Benefits Survey, 95 percent of employees
who worked at a firm with 100 or more employees and were covered by a
defined benefit plan participated in a plan that included an early
retirement benefit in 1997.

56. As we discuss above, according to BLS' 1997 Employee Benefits Survey, 49
percent of employees who worked at a firm with 100 or more employees and
were covered by a defined benefit plan in 1997 participated in a plan that
was integrated with Social Security.

57. See Dan McGill and others, Fundamentals of Private Pensions, 7th ed.
(Philadelphia: University of Pennsylvania Press, 1996), pp. 324-31.

58. 26 U.S.C. 411(c)(3) and 29 U.S.C. 1054(c)(3).

59. 26 C.F.R. 1.417(e)-1.

60. 26 U.S.C. 411(a)(7), 26 U.S.C. 411(c)(3), and 29 U.S.C. 1054(c)(3).

61. However, cash balance plan sponsors have stated that they will
voluntarily pay the hypothetical account balance when the hypothetical
balance is larger than the minimum lump sum distribution required under law.

62. Provided that the plan also uses appropriate annuity conversion factors.

63. 1997 annual yield on 30-year Treasury bonds at the time of conversion.
*** End of document. ***