Cash Balance Plans: Implications for Retirement Income (Letter Report,
09/29/2000, GAO/HEHS-00-207).

Pursuant to a congressional request, GAO provided information on cash
balance plans for retirement income, focusing on the: (1) prevalence and
features of cash balance plans; (2) factors employers considered in
making a decision about whether or not to use a cash balance formula;
(3) effects of using cash balance formulas on the adequacy of individual
workers' retirement income; and (4) effects of current disclosure
practices on plan participants' ability to address issues regarding the
adequacy of their retirement funds.

GAO noted that: (1) its survey of 1999 Fortune 1000 firms indicated that
about 19 percent of these firms sponsor cash balance plans covering an
estimated 2.1 million active participants, more than half of these plans
have been established within the last 5 years; (2) firms in many sectors
of the economy sponsor these plans, but greater concentrations are found
in the financial services, health care, and manufacturing industries;
(3) of the firms GAO surveyed that sponsor such plans, about 90 percent
previously covered their workers under a traditional defined benefit
plan; (4) as with traditional defined benefit plans, there is
significant variation in the design and operation of cash balance plans;
(5) cash balance plans have had such visibility in recent years that
most firms GAO surveyed had at least considered adopting such a plan;
(6) these firms reported that their decisions to adopt or not to adopt a
cash balance plan were based on many factors, including corporate
philosophy, the need to remain competitive, and the potential impact on
workers; (7) cash balance plans offer both opportunities and challenges
to workers seeking to ensure adequate retirement income; (8) cash
balance plans generally are structured such that workers accrue benefits
earlier in their careers than they would under most traditional defined
benefit plans; (9) this feature, combined with the lump sum payouts also
common to such plans, provides opportunity for more mobile workers to
secure and retain higher benefits, even when they change jobs, than they
would under most traditional defined benefit plans; (10) older workers
may be disadvantaged if their employer converts from a traditional
defined benefit plan to a cash balance plan or if they leave a firm with
a traditional plan for one with a cash balance plan; (11) to mitigate
the impact of conversion, many Fortune 1000 employers provide transition
provisions for workers previously covered under their traditional
defined benefit plans; (12) because the decisions of individual
participants play a more significant role in maximizing retirement
income under such balance plans than under traditional defined benefit
plans, cash balance plan participants have a particular need for clear
and timely information about their plans; (13) most plans provided
insufficient information to allow a participant to make informed
career-and retirement--related decisions; and (14) GAO found a wide
variation in the quantity and quality of information that firms provided
to participants in cash balance plans.

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

 REPORTNUM:  HEHS-00-207
     TITLE:  Cash Balance Plans: Implications for Retirement Income
      DATE:  09/29/2000
   SUBJECT:  Tax law
	     Information disclosure
	     Income taxes
	     Statistical data
	     Employee retirement plans
	     Retirement benefits
	     Retirement pensions

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GAO/HEHS-00-207

Appendix I: Scope and Methodology

42

Appendix II: Comments From the Department of Labor

44

Table 1: Selected Differences Between Defined Benefit and Defined
Contribution Plans 9

Table 2: Comparison of Effect of Changing Jobs on Annual Pension
Benefit Under a Traditional Final Average Pay Plan and a Cash Balance Plan
27

Figure 1: Example of Traditional Final Average Pay Formula Used to Calculate
an Annual Pension Benefit 8

Figure 2: Example of Annual Increase in Pension Benefit Under a
401(k) Defined Contribution Plan 9

Figure 3: Example of Annual Increase in a Hypothetical Account
Balance Under a Cash Balance Formula 11

Figure 4: Percentage of Fortune 1000 Firms' Cash Balance Plans, by Number of
Participants 14

Figure 5: Numbers of Firms Adopting Cash Balance Formulas Since
the 1980s 15

Figure 6: Comparison of a Cash Balance Accrued Benefit With the Hypothetical
Account Balance 22

Figure 7: Comparison of Annual Changes in Accrued Benefits for a
Cash Balance Plan and a Final Average Pay Plan 24

Figure 8: Comparison of Annual Change in Benefit Accruals for Cash Balance
Plans With Differing Age-Weighted Formulas 25

Figure 9: Percentage of Fortune 1000 Firms Maintaining a 5-Year
Vesting Requirement After Conversion 30

Figure 10: Annual Accrued Benefit With Mid-Career Change From Traditional
Final Average Pay Plan to Cash Balance Plan 34

Figure 11: Percentage of Participants With Expected Benefits
Protected by Transition Provisions 35

ADEA Age Discrimination in Employment Act

BLS Bureau of Labor Statistics

ERISA Employee Retirement Income Security Act of 1974

FAP final average pay

IRS Internal Revenue Service

PBGC Pension Benefit Guaranty Corporation

PEP pension equity plans

PWBA Pension and Welfare Benefits Administration

SPD summary plan description

Health, Education, and
Human Services Division

B-286323

September 29, 2000

The Honorable Charles E. Grassley
Chairman
Special Committee on Aging
United States Senate

Recognizing that pensions are an important source of income for many
retirees, the Congress provides preferential tax treatment under the
Internal Revenue Code (the Code) for pension plans that meet certain
qualification requirements. Congress estimates that in fiscal year 2000 the
Treasury will forgo about $76 billion due to the tax treatment of qualified
employer-sponsored pension plans. Pensions are the largest of such "tax
expenditures" in the federal budget, exceeding those for home mortgages
and/or health benefits.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. Recently, firms that sponsor plans and plan participants have
expressed concern about the application of these qualification requirements
to newly emerging plan designs, particularly "cash balance" formulas.2

In response to such concerns, you asked us to describe (1) the prevalence
and features of cash balance plans and (2) the factors employers considered
in making a decision about whether or not to use a cash balance formula and
to discuss (3) the effects of using cash balance formulas on the adequacy of
individual workers' retirement income.

We also discuss the effects of current disclosure practices on plan
participants' ability to address issues regarding the adequacy of their
retirement funds.

To address your questions, we surveyed a random sample of 420 firms on the
1999 Fortune 1000 list and asked these firms about the types of pension
plans they sponsor. To examine the characteristics of cash balance plans, we
reviewed summary plan descriptions and other plan documents from cash
balance plan sponsors identified among the Fortune 1000 firms. We selected
Fortune 1000 firms for two reasons. First, they are a well-recognized group
of some of the largest publicly traded firms in the country. Second, pension
experts advised us that these firms would be among the most likely to
sponsor cash balance plans. Because the Fortune 1000 list is selected solely
on the basis of revenues and does not include nonprofit firms, the results
cannot be generalized to all firms or even to all large firms. We also
conducted indepth interviews with officials from 14 firms, including two
nonprofit firms, with cash balance or similar plans. We discussed reasons
why they adopted such plans and obtained information about how firms
communicated pension plan changes to plan participants. To examine the
effect of cash balance plans on the adequacy of retirement income, we
interviewed pension consultants and actuaries, performed a review of the
relevant literature, and created simplified simulations of plan formulas to
illustrate certain design features associated with these plans.

We conducted our work between November 1999 and August 2000 in accordance
with generally accepted government auditing standards. A more detailed
description of our scope and methodology appears in appendix I. In
conjunction with this report, we are also issuing a report that provides
additional information on cash balance plans, particularly on the
implications of converting traditional defined benefit plans to cash balance
plans.3

Our survey of firms from the 1999 Fortune 1000 list indicated that about 19
percent of these firms sponsor cash balance plans covering an estimated 2.1
million active participants; more than half of these plans have been
established within the last 5 years. Firms in many sectors of the economy
sponsor these plans, but greater concentrations are found in the financial
services, health care, and manufacturing industries. Of the firms we
surveyed that sponsor such plans, about 90 percent previously covered their
workers under a traditional defined benefit plan. As with traditional
defined benefit plans, there is significant variation in the design and
operation of cash balance plans. For example, some plans provide the same
annual hypothetical pay and interest credits for all participants while most
select from a wide variety of options to provide extra benefits for
participants who are older or who have been with the firm for a long period
of time.

Cash balance plans have had such visibility in recent years that most firms
we surveyed had at least considered adopting such a plan. These firms
reported that their decisions to adopt or not to adopt a cash balance plan
were based on many factors, including corporate philosophy, the need to
remain competitive, and the potential impact on workers. Key reasons firms
gave for adopting a cash balance plan included lowering total pension costs,
increasing the portability of pension benefits, and the ease of
communicating the value of plan benefits. Key reasons firms gave for not
adopting a cash balance plan included possible adverse effects on workers
who are older, longer-tenured, and less mobile; uncertainty about possible
changes in the regulation of cash balance plans; the impact of adverse
employee and public reactions to cash balance plan conversions; and
increased costs.

Cash balance plans offer both opportunities and challenges to workers
seeking to ensure adequate retirement income. Cash balance plans generally
are structured such that workers accrue benefits earlier in their careers
than they would under most traditional defined benefit plans. This feature,
combined with the lump sum payouts also common to such plans, provides
opportunity for more mobile workers to secure and retain higher benefits,
even when they change jobs, than they would under most traditional defined
benefit plans. The extent to which such workers realize this opportunity can
depend on their career and investment choices. Whether they stay in the plan
long enough to vest, for example, is crucial to whether they will benefit
from earlier pension accruals. Special challenges exist for workers who
accrue part of their retirement benefits under a traditional defined benefit
plan, where they accrue few benefits until late in their career, and accrue
part of their benefits under a cash balance plan. Older workers may be
disadvantaged if their employer converts from a traditional defined benefit
plan to a cash balance plan or if they leave a firm with a traditional plan
for one with a cash balance plan. These workers may have little time to make
up for benefits expected under a traditional plan. To mitigate the impact of
conversion, many Fortune 1000 employers provide transition provisions for
workers previously covered under their traditional defined benefit plans.

Because the decisions of individual participants play a more significant
role in maximizing retirement income under cash balance plans than under
traditional defined benefit plans, cash balance plan participants have a
particular need for clear and timely information about their plans. We found
a wide variation in the quality of information that firms provided to
participants in cash balance plans. However, most plans provided
insufficient information to allow a participant to make informed career- and
retirement-related decisions. For example, more than half of the Fortune
1000 firms we surveyed did not inform participants that the individual cash
balance account was hypothetical in nature. Documents we reviewed that
Fortune 1000 firms provided to plan participants did not provide an
explanation of the difference between the accrued benefit and the
hypothetical account balance. Participants would need such information to
assess accurately the impact of career decisions on their pension benefits.

We are making recommendations to the Secretary of Labor concerning the
improvement of disclosure requirements to help provide plan participants
with the information they need to make informed decisions affecting their
retirement income.

With respect to private pensions, the Congress has used the Code to
encourage employers to sponsor pensions to help workers achieve adequate
income for retirement. In exchange for providing preferential tax treatment,
Congress has imposed requirements that plans must meet for tax qualification
through the Code and the Employee Retirement Income Security Act of 1974, as
amended (ERISA). The administration of ERISA for new and ongoing plans is
divided between the Department of Labor's Pension and Welfare Benefits
Administration (PWBA) and the Internal Revenue Service (IRS). IRS is tasked
with ensuring that plans meet the qualification requirements for receiving
tax preferences. PWBA is responsible for ensuring that plans are operated in
the best interest of their participants. The Pension Benefit Guaranty
Corporation (PBGC) insures most private defined benefit plans, including
cash balance plans, within certain limits.

The Internal Revenue Code defines pension plans as either defined benefit or
defined contribution plans and has established separate requirements for the
two types of plans. In a defined benefit plan, the retirement benefit is
expressed as an annual payment that would begin at the normal retirement age
specified in the plan.4 The retirement benefit is determined by a formula
based on a worker's years of employment, earnings, or both. The employer is
responsible for funding the plan at a level sufficient to pay the promised
benefit and to insure a portion of that benefit through PBGC. According to
the Bureau of Labor Statistics,5 most participants in large- and
medium-sized firms' defined benefit plans are covered by a formula referred
to as "final average pay" because the formula uses only the earnings in the
most recent years?those closest to the employee's retirement date?to
calculate benefits.6 As shown in figure 1, under a defined benefit plan with
a final average pay formula, the retirement benefit is a percentage of the
participant's final years of pay multiplied by his or her length of service.

In a defined contribution plan, the retirement benefit is expressed as the
account balance of an individual participant. This balance results from
contributions that the employer, the worker, or both make and subsequent
investment returns on the assets in the account. Retirement benefits are not
guaranteed, and employees bear the risk of poor investment performance. The
best known of these defined contribution plans is the 401(k) plan, named for
the section of the Code that sets out rules for providing tax preferences to
such plans. The 401(k) plan generally provides that a specific percentage of
pay be contributed to an individual account, by either the employer, the
employee, or both (see fig. 2). The principal in the account is typically
invested based on options specified in the plan. The sum of principal and
investment earnings or losses minus administrative expenses?the individual
account balance?determines the pension benefit.

Federal pension law defines any pension plan that does not provide actual
individual accounts as a defined benefit plan.7 Furthermore, while firms
sponsoring defined benefit and those sponsoring defined contribution plans
may pay pension benefits in a lump sum amount, ERISA requires that defined
benefit plans provide participants with the option of receiving benefits as
an annuity, specifically, a series of payments for life beginning at the
plan's normal retirement age.

For a summary of selected key differences between defined benefit and
defined contribution plans, see table 1.

   Characteristic       Defined benefit plan     Defined contribution plan
                                                Determines amount regularly
 Benefit formula      Determines pension due at contributed to individual
                      normal retirement age.
                                                account.
                      An annuity--a series of
 Form of benefit      payments beginning at the A single lump sum
 expressed by formula plan's normal retirement  distribution at any time.
                      age for the life of the
                      participant.
                      Annual funding is based
                      on an actuarial formula
                      subject to strict limits  Annual contributions and
 Funding              set by the Code and is    investment earnings are
                      not equivalent to annual  held in an individual
                      increases in pension      account.
                      benefits.
                      Employee is guaranteed
                      benefits regardless of    Employee bears the
                                                investment risk, which can
 Investment           investment returns on     result in higher investment
 risk/profit          trust. Employer is        returns or the loss of
                      responsible for ensuring
                      sufficient funding to pay previously accumulated
                      promised benefit.         pension benefits.
                                                Depends on insurance
 Insured benefit      Generally insured by      provided by individual
                      PBGC.
                                                investment vehicle, if any.

Innovation in plan designs has resulted in "hybrid" plans that have the
characteristics of both types of plans. The most well known of the hybrid
plans is the cash balance plan. A defined benefit plan under the law, the
cash balance plan contains features that resemble a defined contribution
plan. Cash balance plans are not specifically identified in the law, but IRS
guidance describes a cash balance plan as "a defined benefit plan that
defines benefits for each employee by reference to the amount of the
employee's hypothetical account balance."8 The cash balance formula, like
all defined benefit plan formulas, determines the amount of pension benefits
to be paid rather than the amount to be contributed. The cash balance plan
resembles a defined contribution plan in that the formula expresses pension
benefits as a lump sum rather than a series of payments. It also bases the
lump sum amount on periodic pay and interest credit contributions to
employee "accounts," as shown in figure 3. Pay credits are specified as a
percentage of salary, such as 5 percent, and interest credits are often
fixed to the yield on a particular Treasury security, such as the yield on
30-year Treasury bonds.

Note: For purposes of illustration, we assume an annual salary of $20,000.

The relationship between the account balance and plan funding is a key
difference between cash balance plans and the defined contribution plans
they resemble. In a defined contribution plan, the account represents actual
funds held on behalf of the individual participant, whereas in a cash
balance plan the amounts are purely hypothetical. In a defined contribution
plan, the account balance is equivalent to actual assets held in trust for
the individual plan participant. Under cash balance plans, employers make
annual contributions to a pension trust fund on behalf of all participants.
These annual contributions are not equivalent to the annual increases in
hypothetical account balances but are determined based on complex federal
rules designed to ensure that the trust has sufficient assets to pay
expected benefits without allowing unwarranted tax expenditures. As a
result, the trust fund for a cash balance plan is not required to?and often
will not?have assets equal to the sum of all individual account balances.
Furthermore, trustees rather than individual plan participants have
investment control over all assets in the cash balance pension trust.
Hypothetical account balances are related to the interest rates specified in
the plan rather than the actual investment returns on assets in the plan's
pension trust; hypothetical accounts are not credited with actual investment
gains or losses.

Federal law does not require that employers sponsor pension plans nor does
it mandate the value of the benefit provided by plans that the employer
voluntarily sponsors. The law does, however, set specific requirements for
tax-qualified plans relating to the accrual rate, or the rate at which plan
participants must earn the right to a retirement benefit. Firms are
prohibited from amending a plan's benefit formula to reduce benefits that
have already accrued. However, the law does not protect future benefit
accruals under the plan's formula. Consequently, firms can change the plan's
benefit formula to reduce or freeze the future rate of accrual. For example,
defined benefit plan formulas can be amended on a prospective basis to
reduce the percentage of final pay used to determine the annual benefit or
to limit the number of years over which benefits accrue. The Age
Discrimination in Employment Act (ADEA), the Code, and ERISA prohibit a
defined benefit plan from ceasing accruals or reducing the rate of accrual
because of the attainment of any age.

Firms can also terminate their pension plans altogether. Defined benefit
plan sponsors that terminate their plans are subject to a tax on any surplus
assets in their pension trusts. When defined benefit plans that are
overfunded terminate and surplus assets revert to the plan sponsor, these
assets are counted as income to the corporation. As such, the assets are
subject to corporate income tax. In addition, an asset reversion excise tax
of up to 50 percent can be levied on the same assets if certain conditions
are not met.

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 describing the terms of the plan. Furthermore,
whenever there is a significant change to the plan (a plan amendment), firms
must provide participants with a summary of the changes, known as a "summary
of material modification," no later than 210 days after the end of the plan
year in which the changes are adopted. 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.

The number of firms sponsoring cash balance plans has increased in the last
few years. While few firms sponsored such plans before the early 1990s, by
the year 2000, 19 percent of Fortune 1000 firms sponsored one or more cash
balance plans. Although these plans can be found in many sectors of the
economy, greater concentrations are found in the financial services, health
care, and manufacturing industries. Although there is continuing interest in
cash balance plans, few firms we surveyed expected to adopt such a plan in
the near future. As with traditional defined benefit plans, there is
significant variation in plan design among cash balance plans.9

About 19 percent of Fortune 1000 firms sponsor cash balance plans, covering
an estimated 2.1 million active participants. It is difficult, however, to
determine the total number of cash balance plans and affected participants
because pension plan data collected annually by the government cannot be
used to identify all plans that use cash balance formulas. Determining the
extent to which small plans use cash balance formulas is particularly
difficult because little is known about the structure of small plans.
Pension experts have generally described the use of cash balance formulas as
a large employer phenomenon, although pension practitioners have provided
anecdotal information about the recent interest of small firms in such
plans.10

Similar to traditional pension plans, many cash balance plans that we
identified do not cover all workers at a firm. Instead, these plans cover
particular segments of a firm's workforce, such as management, salaried
employees, or certain workers in a firm's subsidiary. An estimated 69
percent of the cash balance plans we identified in our survey have fewer
than 10,000 active participants (see fig. 4). Eight percent of these plans
have no active participants because benefit accruals are frozen.11 The most
common reason for a frozen cash balance plan was that it was acquired as
part of a merger or acquisition, and the firm did not want to continue with
a cash balance plan.

Cash balance plans have become more prominent since the early 1990s.12 As
shown in figure 5, the earliest a firm in our survey had adopted a cash
balance plan was 1985; over 60 percent of the cash balance plans in our
survey had been adopted in the last 5 years. Firms sponsoring these plans
exist in many sectors of the economy, but 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 that had been covered by different plans. Participants in
about 90 percent of the cash balance plans had been covered previously by a
traditional defined benefit plan. Firms had either frozen the benefits of
the plan and begun a new plan or they had amended an existing plan formula.
Firms where participants had no previous defined benefit plan started cash
balance plans as their first pension plan, supplemented existing defined
contribution plans, or added a cash balance component without changing the
existing defined benefit plan.

Although pension practitioners, employer associations, and agency officials
spoke to us of the continuing interest in cash balance or similar hybrid
plan designs, few firms we surveyed expected to adopt a cash balance plan in
the future. About 3 percent of firms we surveyed told us that they were
considering the adoption of a cash balance plan within the next 5 years and
about one-third of these, or 1 percent of Fortune 1000 firms, told us that
they were considering or planning to adopt a cash balance plan next year.
All the firms considering the adoption of a cash balance plan told us that
continued uncertainty about whether such plans violate pension and age
discrimination laws might discourage them from doing so.

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 under age 30 that increases in increments up to 11 percent for
participants age 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 are
integrated with Social Security, provide participants with higher pay
credits on pay above the Social Security wage base.13 For example, two plans
provide 4 percent of pay for earnings that are subject to Social Security
taxes ($76,200 in 2000) and 8 percent for earnings that are 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 tie 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 based on the rate of return to
30-year Treasury bonds, but some cash balance plans credit interest based on
the rate of return to 1-year Treasury bonds or another Treasury index.

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 the need to
address changing workforce demographics. For example, some firms decided to
adopt cash balance plans 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 plan change.

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 for 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 survey of 100 cash balance plan sponsors by
PricewaterhouseCoopers 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.

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 many cash balance
plans allows eligible workers, upon separation, to gain access to their
pension benefit.15 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
received most, if not all, of 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 for traditional
defined benefit plans before conversion to 83 percent for cash balance plans
after conversion. Most of the firms with whom we conducted indepth
interviews stated that, after conversion, the majority of vested
participants who had separated from the firm or retired opted for a lump sum
payment, indicating its popularity.

Finally, firms that decided 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, 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 401(k)
plans.16 This contrasts with the way many employees view 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 focus on the benefits of a
defined benefit plan until they near retirement age.

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.17 Instead, firms can convert to
cash balance plans and achieve economic benefits from surplus pension funds
without incurring certain 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 fully funded or overfunded; that is, the value of plan
assets would meet or exceed the value of currently accrued pension benefits.
Also, after a conversion, if the pension fund assets can achieve a higher
rate of return than the interest rate credited to hypothetical employee
accounts, plan sponsors can use these gains to fund future pension benefits.

Most firms that had not adopted a cash balance plan reported that they had
considered doing so. They cited the potential of changing plan type to have
an adverse effect on older, longer-tenured, and less mobile workers;
regulatory uncertainty; the impact of adverse employee and public reaction
to cash balance plan conversions; and increased costs as key reasons for
their decision not to adopt such plans. Increased 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.

Adequate Retirement Income

The effect of cash balance plans on retirement income varies with plan
features and participant choices, offering both opportunities and challenges
to workers seeking to ensure adequate retirement income. Cash balance plans
are generally structured so that workers earn benefits more quickly earlier
in their careers than later. This feature, combined with the lump sum
payouts also common to such plans, provides the opportunity for more mobile
workers to secure and retain higher benefits when they change jobs than they
would under most traditional defined benefit plans. The extent to which such
workers realize this opportunity depends to a large extent on their career
and investment choices. Whether they stay in the plan long enough to vest,
for example, is crucial to whether they will benefit from these earlier
pension accruals. Special challenges exist for workers who earn part of
their retirement benefits under a traditional defined benefit plan where
they earn few benefits until late in their career and earn part under a cash
balance plan. Older workers may be disadvantaged if their employer converts
from a traditional plan to a cash balance plan, or if they leave a firm with
a traditional plan for one with a cash balance plan. These workers may have
little time to make up for the benefits they expected under a traditional
defined benefit plan. To mitigate the impact of conversion, many Fortune
1000 employers provide transition provisions for workers they had previously
covered under a traditional defined benefit plan.

Certain Other Plan Types

Workers covered by many cash balance plans tend to earn or "accrue" benefits
faster the further they are from normal retirement age, compared with
traditional defined benefit pension plans.18 IRS requirements for
tax-qualified plans are part of the reason for this difference in the rates
of accrual. In accordance with IRS Notice 96-8, cash balance plans generally
treat hypothetical, future interest on annual pay credits as accruals for
the year in which the pay credit was made. Thus, future interest is included
in the determination of the accrued benefit even though the employee may
terminate employment and begin receiving a benefit before normal retirement
age. The accrued benefit in lump sum dollars will be equal to the
hypothetical account balance only when the participant reaches the normal
retirement age specified in the plan. However, as shown in figure 6, the
accrued benefit in lump sum dollars payable at normal retirement age is
higher than the hypothetical account balance up until that point.19 As a
result, as in the illustration in figure 6, a 25-year-old participant is
entitled to a pension benefit at normal retirement age based on an amount
far higher than the hypothetical account balance after 1 year of work.
Assuming a pay credit of 5 percent, salary increases of 3 percent, and a
fixed interest credit of 6 percent, at age 30, after 6 years, the
participant has a hypothetical account balance of about $7,500. However, he
or she is entitled to a pension benefit based on approximately $57,500
payable at age 65 even if he or she leaves the firm at age 30.

Account Balance

Note: For purposes of illustration, the accrued benefit payable at age 65
and the hypothetical account balance are both expressed as a lump sum and
are cumulative. For simplification, we assumed a 3-percent salary increase,
5-percent pay credit, a 6-percent interest credit, and a normal retirement
age of 65.

Cash balance plans also have a different rate of accrual than do traditional
defined benefit plans. When the increase in the cumulative accrued benefit
(expressed in lump sum dollars at normal retirement age), discussed above
and shown in figure 6, is converted into annual incremental amounts, as
shown in figure 7, the simple cash balance formula provides a larger share
of a participant's total accrued benefit earlier in the worker's career.
This is commonly referred to as "frontloading." Because the annual accrued
benefit for the cash balance plan includes all the hypothetical interest the
annual pay credit would earn until the normal retirement age specified in
the plan, the younger a participant is, then the more years of interest will
be included in the benefit accrued in any one year. This differs from the
accrual patterns of a traditional defined benefit plan, in which
participants earn higher benefits the closer they come to retirement, a
pattern referred to as "backloading." Typically, participants under a
traditional defined benefit plan using 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 generally increase the longer the worker stays with
the same employer. As shown in figure 7, plan participants in the simplified
final average pay plan in our illustration earn less than 5 percent of their
normal retirement benefit in the first 5 years of their career but almost 25
percent in the final 5 years of their career.

Plan and a Final Average Pay Plan

Note: For purposes of illustration, we assume that both plan types result in
the same benefit at normal retirement age. This assumption does not mean
that the formulas used in this illustration would provide equivalent
benefits at times other than normal retirement age or would result in
equivalent costs to the sponsor. Both the cash balance and traditional
defined benefit plans are expressed as changes in a lump sum payable at
normal retirement age. For simplification, we assumed a 3-percent salary
increase, 5-percent pay credit, 6-percent interest credit, and a normal
retirement age of 65.

Many Fortune 1000 cash balance plans exhibit features that vary from the
simple cash balance formula illustrated above. The use of more complex cash
balance formulas beyond those illustrated in figures 6 and 7 can reduce the
extent to which plan participants earn higher normal retirement benefits
earlier in their careers. Increasing cash balance pay credits for older and
longer-service workers makes annual accrual rates in cash balance plans more
like those of traditional defined benefit plans. Many cash balance plans
provide such higher pay credits. For example, one complex plan formula we
examined included as many as 1,265 different pay credits based on age and
service. The extent to which variable pay credits result in benefit accruals
more like those of traditional defined benefit plans varies depending on the
range of pay credits used in the plan. For example, one Fortune 1000 firm
has pay credits ranging from 1 to 18.6 percent. With all other factors being
equal, this would result in a benefit accrual pattern more like that of a
traditional plan than that of a firm that had pay credits ranging from 3 to
7 percent (see fig. 8).

Plans With Differing Age-Weighted Formulas

Note: For purposes of illustration, the annual change in accrued benefits is
expressed as a lump sum payable at age 65. The formulas are based on actual
plans in our survey and would not result in equivalent benefits at normal
retirement age. For simplification, we assumed a 3-percent salary increase,
5-percent pay credit, 6-percent interest credit, and a normal retirement age
of 65.

The difference in the value of the accrued benefit and the hypothetical
account balance in a cash balance plan can be significant for all plan
participants as they choose when and in what form to receive their pension
benefit. Under current law, all defined benefit plans are required to offer
participants an annuity payable at normal retirement age. Workers covered by
plans that offer retirement benefits in the form of an annuity but do not
offer a lump sum option will receive the value of the accrued benefit at
normal retirement age rather than the hypothetical account balance if they
terminate employment before retirement. Therefore, a worker in our
simplified illustration in figure 6, without knowing the difference between
the accrued benefit and the hypothetical account balance, could assume that,
upon leaving the firm after 6 years at age 30, he or she would get an
annuity at retirement based on the hypothetical account balance of about
$7,500. In fact, the worker would get an annuity at retirement based on an
amount almost 8 times greater.

In addition to the annuity benefit, current law also allows firms sponsoring
defined benefit plans to offer workers the option of receiving their benefit
as a lump sum, either at retirement or at termination. However, workers who
are given this choice cannot determine which option would ultimately provide
the greater retirement benefit without understanding that, if they do not
select an immediate lump sum, the annuity at retirement will be based on the
projected account balance at the plan's normal retirement age rather than
the hypothetical account balance. Workers who select an immediate lump sum
need to know that the lump sum may not be equivalent to but can be larger or
smaller than the hypothetical account balance. The relationship between the
two is dependent on whether the plan-specified interest rate is the same as,
larger, or smaller than the rate used to determine the present value of the
benefit payable at normal retirement age.

Consistent with the views of many firms we surveyed, cash balance plans can
lead to greater retirement income for more mobile workers. With other
factors being equal, workers employed by more than one employer during their
career can receive more retirement income under multiple cash balance plans
than under multiple traditional defined benefit plans. This difference in
retirement benefits is a function of how benefits are accrued under each
plan type.

Workers under multiple cash balance plans can get higher benefits at the
normal retirement age than under multiple final average pay (FAP) plans. As
shown in table 2, the worker under multiple cash balance plans will receive
a larger retirement benefit than the worker who retired under multiple FAP
plans. The benefit earned by the worker who changed employment under
multiple cash balance plans will accrue a retirement benefit that is almost
22 percent larger than the benefit received by the workers under multiple
FAP plans.

Generally, the final average salary increases as the worker progresses
through his or her career due to increased experience, productivity, and the
effects of inflation. For a worker who remains under a final average pay
plan until normal retirement age, the worker will receive a benefit based on
a formula that includes total service and some measure of the worker's final
salary. However, for a worker who changes jobs under a FAP, the salary level
used to calculate the benefit from the first year of service will generally
be lower.

The accrual pattern under a FAP plan is illustrated in table 2, where we
first compare two workers employed for 30 years who have the same career
salary pattern. Both workers are continuously covered by FAP plans with
identical formulas. However, they have different employment histories; one
changed employers (and FAP plan) after 15 years, while the other remained
with the same employer and plan for 30 years. As shown, although both
workers were covered by identical FAP plans and had identical salaries, the
worker who changed employers will receive only 82 percent of the annual
retirement benefit of the worker who remained with the same employer.

                          Worker who remains    Worker who changes
                          with same employer    employers
             Salary       for 30 years
                                                after 15 years
             (starting
             at           Final      Cash
             $20,000)     average    balance    Final          Cash balance
                          pay plan   plan       average pay    plan benefit
                          benefit    benefit    plan benefit

 After 15                                       $4,538 (15%    $8,564
 years       $30,252                            of $30,252)

                                                $7,070 (15%
                                                               $5,575 (15
 After 30                 $14,139               of $47,132,    years with
 years       $47,131      (30% of    $14,139    15 years       second
                          $47,131)              with second
                                                employer)      employer)
 Final                                          $11,608        $14,139
 annual                                         (benefits      (benefits
 retirement               $14,139    $14,139    from both      from both
 benefit                                        employers)     employers)

Note: Salary for each employee is assumed to increase at 3 percent per year.
Pension benefits for the FAP plan are calculated through the formula: 1
percent x prior final average salary x years of service. The benefit for the
cash balance plan is calculated to ensure that the benefit at normal
retirement age, assumed to be age 65, with the same age and years of
service, is equivalent to the FAP plan benefit. This does not assume that
the plans would be equivalent in cost to the sponsor. The pay credit is
approximately 7 percent, and the interest rate is approximately 6 percent.

Because a key variable in the FAP formula is final salary, the retirement
benefit a worker earns for any one year of service is unknown until the
worker terminates employment or reaches the normal retirement age. In our
simplified illustration, the normal age 65 retirement benefit that the first
worker earned, after retiring with 30 years of continuous service, was 1
percent of $47,131 or $471, based on his or her first year of service with
the employer. The normal age 65 retirement benefit that the second worker
earned for the same year working for the same firm was 1 percent of $30,252
or $303.

The accrual pattern under cash balance plans is different. The worker who
switches jobs under a simple cash balance plan does not experience this
difference in accrued benefit for leaving an employer prior to normal
retirement age. The benefit earned under a cash balance plan can be
determined in the year it was earned because it is based on the worker's pay
and age that year, regardless of future earnings or service. If we were to
calculate the normal retirement benefits for the two workers under a simple
cash balance formula, their normal retirement benefits would be equal, as
shown in table 2.20 In addition, including all interest on the pay credit
until normal retirement age in the normal retirement accrued benefit,
regardless of when the participant terminates employment, partially
mitigates the effects of inflation.21

Maintaining Maximum Permissible Vesting Requirements

The extent to which younger and more mobile workers gain the benefits of
increased normal retirement pension accruals early in their career under
cash balance plans is greatly influenced by the vesting requirements the
employer has chosen to include in the plan design. "Vesting" refers to the
length of time a plan participant must work for a firm to gain a
nonforfeitable right to an accrued pension benefit. In general, federal
rules require that firms must allow participants full rights to their
accrued benefits after no longer than 5 years of service; the employee can
receive no pension benefit if he or she leaves before 5 years, regardless of
the accrued benefit he or she has earned.22

While some Fortune 1000 firms we surveyed reported that a major reason for
adopting a cash balance plan was to improve their ability to recruit younger
workers by providing them with higher pension benefits earlier in their
careers, most firms did not alter their vesting requirements to complement
this objective. As shown in figure 9, most firms retained the 5-year vesting
requirement. Although separate data on employee turnover are not readily
available for firms with cash balance plans, nationally, a majority of adult
workers are not likely to stay with their firms long enough to reach the
5-year vesting period.23

Income

Designing a plan to include a provision for lump sum benefits can have both
a positive and negative effect on the amount of money a plan participant has
available for retirement, depending on the individual participant's
preferences and behavior. The impact of lump sum benefits from cash balance
plans differs from that of lump sum benefits from traditional defined
benefit plans because of the significant differences in the rate at which
participants can accrue benefits under the different formulas.

Cash balance plans are more likely than traditional defined benefit plans to
offer participants the option of receiving their benefits in a lump sum
either at retirement or at termination of employment. Fifteen percent of
firms in our survey who converted a traditional defined benefit plan into a
cash balance plan had allowed plan participants to elect a lump sum benefit
over $5,000 rather than an annuity in their prior final average pay plans.24
After conversion, 95 percent of firms allowed a lump sum distribution,
although 13 percent limited the option by offering it only at normal
retirement age or on only a portion of pension benefits. Numerous plan
sponsors told us that they converted to a cash balance plan because they
wanted to offer a lump sum benefit. However, many were unaware that they
could legally offer a lump sum benefit in a traditional defined benefit
plan.

Employers who did offer lump sum benefits?under either the traditional
defined benefit plan or the cash balance plan?generally reported that almost
all employees chose that option. Furthermore, some expressed concern that,
as a result, the firm was losing a key benefit of an employer-sponsored
retirement plan, namely, the assurance that employees would have sufficient
retirement income to be able to terminate work at an appropriate time. This
concern was a key reason that some firms provided for choosing not to allow
a lump sum distribution. For example, one employer we interviewed reported
that plan participants leaving the firm prior to retirement took lump sum
payments even though the plan was designed so that the value of the annuity
payments was significantly higher. Furthermore, they told us that
terminating workers often asked that the firm distribute the lump sum for
nonretirement purposes directly to businesses such as auto repair shops.
This is consistent with numerous studies on participant behavior that found
that, in spite of incurring tax penalties, many workers who receive lump sum
distributions cash out the funds, potentially reducing future retirement
income in exchange for current consumption.25 For example, the Congressional
Research Service recently reported that 33 percent of recipients report
having reinvested their lump sum distribution in another tax-qualified plan.
In addition, they found that younger workers were less likely than older
workers to reinvest their retirement benefit; 27 percent of workers ages 25
to 34, compared with 42 percent of those ages 45 to 54, reinvested their
retirement benefit.26

Assuming that a worker preserves the lump sum benefit as retirement savings,
he or she could have more assets available for retirement than with the
benefit most often offered under a traditional defined benefit plan?a series
of payments or annuity payable at normal retirement age. There are two
primary reasons for this. First, under a cash balance plan, the value of the
benefit is not frozen at the time the worker leaves the plan. Second, the
lump sum benefit could earn greater returns on actual investments rather
than a plan-specific hypothetical interest credit. Assuming the continuation
of historical investment returns, the rates of return on individual
investment of lump sum benefits could be higher than the hypothetical
interest credit provided under a plan. For example, several cash balance
plans offered fixed interest credits of 6 percent while inflation-adjusted
returns on stock market investments have averaged roughly 7 or 8 percent
over the past 60 to 70 years.27 Nevertheless, earning higher returns would
require investing in riskier assets such as stocks. Therefore, the impact of
lump sum distributions on the income available for retirement would depend
on how workers, who may have little investment experience, invest their
pension benefit and whether they actually earn higher returns.

With the increased prominence of cash balance plans, workers are
increasingly faced with the consequences of a move from a traditional plan
to a cash balance plan. This can happen when the employer changes the type
of plan it is sponsoring or when workers change employers. The employer
changes the type of plan either by freezing or terminating a prior plan or
by amending the plan formula. Differences in the rate at which benefits
accrue over time under different types of plans can affect the amount of
money that participants who change plans receive from private pension plans.
For example, as illustrated in figure 10, if a participant begins pension
coverage under a traditional defined benefit plan and moves to a simple cash
balance plan, he or she could accrue benefits under each plan where the rate
of accrual is the lowest.28 The illustration represents a "worst case"
scenario and would result in decreased pension benefits. In contrast, a
worker moving from a cash balance plan to a traditional defined benefit plan
could accrue benefits under each plan where the rates of accrual are the
highest. Assuming that these funds are not withdrawn, a participant moving
from a defined contribution 401(k) plan to a cash balance plan would
continue to accrue interest on his or her 401(k) account balance even after
moving to the cash balance plan.29

Average Pay Plan to Cash Balance Plan

Note: For purposes of illustration, we assume that the traditional final
average pay formula and cash balance formula result in the same benefit at
normal retirement age. This assumption does not mean that the formulas used
in this illustration would provide equivalent benefits at times other than
normal retirement age or would result in equivalent costs to the sponsor.
Both the cash balance and traditional defined benefit plans are expressed as
annual changes in a lump sum payable at normal retirement age. For
simplification, we assumed a 3-percent salary increase, 5-percent pay
credit, 6-percent interest credit, and a normal retirement age of 65.

Many employers design cash balance plans to reduce the adverse effect of
changing plan type on workers. Federal pension rules require only that
tax-qualified plans guarantee the benefit a worker has accrued to date and
do not guarantee future expected benefits. Nevertheless, an estimated 84
percent of the Fortune 1000 firms that adopted a cash balance plan for
workers previously covered under a traditional defined benefit plan included
transition provisions in their plan design to mitigate at least partially
the effect of changing to a cash balance plan on workers' expectations of
future benefits. In 11 percent of cash balance plans that replaced a final
average pay plan, or 9 percent of cash balance plans in our survey, there
will be no reduction in expected normal retirement benefits for any plan
participant. Participants will experience no reduction because the plan
guarantees future expected benefits under the old plan for all current
workers, as shown in figure 11. All but one of these plans do this by
keeping current workers under the prior plan or by offering all workers the
greater of the benefits earned under both formulas until they terminate or
retire, which is commonly referred to as "grandfathering." The one exception
guarantees benefits by offering employees a choice of benefits under the old
or new formula at retirement.

Note: Determining the extent to which transition provisions for plans
categorized as "partially protected" protect the expected normal retirement
benefit of participants is based on the circumstances of each plan and the
individual worker.

The majority of plans offered partial protection by (1) limiting their
protection to only a specific group of workers, (2) limiting the period of
time the protection is offered, and/or (3) providing weighted pay credits to
a designated group, which may not fully mitigate reduction in expected
benefits. For example, 78 percent of the firms from our survey who offered
workers the greater of the benefit earned under both formulas, often
referred to as "grandfathering," limited the offer to those employees who
met specific age and/or service criteria, or limited the period of time for
employees to accept the offer, such as 1 or 5 years. One firm allowed
participants age 45 and older with at least 10 years of service to continue
accruing benefits under the prior formula. Another firm allowed participants
with a minimum combination of 60 years of age and service to receive the
better of pension benefits provided by the prior formula or the cash balance
formula at retirement. About one-half of the firms offering transition
provisions provided additional pay or interest credits or increased the
value of the benefit accrued under the old formula for workers who met
specific age and/or service criteria at the time they adopted the cash
balance formula.30 Two plans offered workers a choice of participating in
the traditional or the cash balance plan at conversion.31

The greater amount of choice often afforded to workers under cash balance
plans can complicate efforts to estimate retirement income. In general, the
traditional defined benefit plan generally expresses the replacement rate by
expressing normal retirement benefits as an annual payment that is a
percentage of the worker's pay.32 Social security benefits are represented
as a monthly allowance that can be easily converted into a percentage of
pay. To determine the effect of the lump sum on the replacement of his or
her annual income at retirement, the participant must be able to estimate
the annual value of the lump sum benefit at a future retirement age, either
through an annuity and/or through projected investment returns. This is a
complex assessment that requires making numerous assumptions, including
assumptions about expected termination or retirement date, the future value
of money, future investment returns, and life expectancy.

Individual participant choices play a more significant role in maximizing
retirement income under many cash balance plans than under most traditional
defined benefit plans. Consequently, participants need clear and timely
information to make choices that will increase rather than decrease their
future retirement income. Current disclosure requirements provide minimum
guidelines that firms must follow concerning the type of information they
provide participants about plan provisions. We found, however, that many
employers do not provide such information. These findings supplement those
we reported on in a concurrently issued report that focuses on issues of
conversion from one plan type to another rather than on cash balance plans
in general.33

ERISA establishes specific requirements concerning disclosure of information
to plan participants, including a written summary of plan provisions.
Department of Labor regulations implementing the summary plan description
(SPD) requirements provide that the material must be "sufficiently
comprehensive to apprise the plan's participants of their rights and
obligations under the plan." However, we found significant variation in the
quality of information explaining the cash balance formula that was provided
to plan participants. For example, about three-quarters of the SPDs we
reviewed provided no information that would allow participants to understand
the difference between the accrued normal retirement benefit and the
hypothetical account balance. Also, documents we reviewed that firms
provided to plan participants did not address these differences directly.

We found a range in the quality of information contained in the SPDs we
reviewed. Some SPDs provided a clear statement about the nature of the cash
balance plan, indicating that the accounts were hypothetical and that
employees did not own the assets in the accounts. One plan, for example,
described the hypothetical nature of the account as follows:

A cash balance account differs from a traditional pension plan in that you
have a "cash balance account" for recordkeeping purposes. Your cash balance
account is only a bookkeeping account because even though it represents the
actual lump sum amount you are entitled to under the Plan if your employment
terminates, no assets are segregated into a separate account for your
benefit. Therefore, when this summary indicates that contributions will be
made to your cash balance account, it means that the Plan's records will
reflect that your cash balance account is being increased by the amount of
the contribution.

The information provided in some SPDs, on the other hand, could easily lead
participants to believe that the cash balance formula or hypothetical
account was similar to a 401(k) plan. For example, one plan described the
cash balance plans as a plan that "… sets up an account in your name.
Each year, your account receives a basic credit, an additional credit (if
eligible) and interest." Not stating that the accounts are hypothetical
and/or making claims that the cash balance accounts are similar to 401(k)
plan accounts prevents plan participants from understanding how cash balance
plans work and what benefits they are entitled to receive.

Understanding that the cash balance is hypothetical is also essential to
understanding the difference between the hypothetical account balance and
the accrued benefit payable at normal retirement age. While 60 percent of
SPDs we reviewed advised participants that interest credits continue after
termination of employment with the firm, no SPD explained that there was a
difference between the hypothetical account balance and the accrued benefit.
In fact, some SPDs specifically stated that the account balance was
equivalent to the accrued benefit. As a result, workers do not have
sufficient or accurate information to assess the effect that changing jobs
or the implications of choosing a lump sum payment rather than an annuity
payable at normal retirement age will have on the amount of money available
to them at retirement.

Cash balance pension plans provide opportunities and challenges to
individual participants seeking a safe and secure retirement. Under many
cash balance plan designs, workers do not have to wait until late in their
careers to earn significant retirement benefits. These plans also often have
a lump sum payment option upon separation, which can be reinvested. Some
firms have adopted new cash balance plans or have converted from traditional
defined benefit plans precisely because these features are attractive to
younger workers who exhibit greater labor market mobility. Provided that
they are invested in a prudent manner, larger early accrual rates and lump
sum payments can lead to greater retirement income.

Yet these features also pose challenges to retirement security. Cash balance
plans can make more retirement money available to younger workers who are
historically more likely to spend the funds for current living expenses than
those closer to retirement. Because cash balance plans feature lower rates
of accrual later in an employee's career, younger workers who fail to invest
responsibly early on may have less opportunity to make up these losses when
they are closer to and more focused on retirement. Older workers,
particularly those affected by a conversion to a cash balance plan, may be
more focused on saving for retirement but have fewer years to reach it and
could accrue benefits under a cash balance plan at a lower rate than they
would under a defined contribution plan such as a 401(k).

For all workers, cash balance plans place a greater reliance on personal
responsibility and choice. For workers to take advantage of this greater
choice, they must have the information necessary to understand the
implications of their choices for their future retirement income. However,
our work has shown that cash balance plan participants do not generally get
the information they need to make informed choices. We found wide variation
in the quality, clarity, and comprehensiveness of the information disclosed
to employees covered by cash balance plans. At a minimum, employees should
know how their benefit accruals differ from previous or supplemental plans
the employer has offered them. They should also have clear and
understandable information to allow them to calculate the benefits they have
earned and detailed instructions about what to do if this information is not
forthcoming.

We recommend that the Secretary of Labor direct the Assistant Secretary of
the Pension and Welfare Benefits Administration to amend the disclosure
requirements under their respective authorities, as provided under ERISA for
Summary Plan Descriptions, to include

ï¿½ a clear statement regarding the difference between the hypothetical
account balance and the accrued benefit payable at normal retirement age
under the cash balance plan,

ï¿½ specific information about the impact the timing of interest crediting has
on deferred pension benefits for terminating workers, and

ï¿½ standardized language providing plan participants with their rights to
contact PWBA and/or IRS if they are unable to understand the information
provided and the relevant addresses and telephone numbers necessary for such
contacts.

We provided Treasury and Labor with the opportunity to comment on a draft of
this report. Labor's comments are included in appendix II. Labor generally
agreed with our findings and conclusions, noting that the report was
consistent with an administration proposal to amend current law regarding
the disclosure provided to pension plan participants. Labor is currently
giving consideration to the appropriate action to be taken in response to
our recommendations. Treasury and Labor also provided technical comments,
which we incorporated as appropriate.

We are sending copies of this report to the Honorable Major R. Owens,
Ranking Minority Member, Subcommittee on Workforce Protections; the
Honorable Robert E. Andrews, Ranking Minority Member, Subcommittee on
Employer-Employee Relations, House Education and Workforce Committee; the
Honorable William J. Coyne, Ranking Minority Member, Subcommittee on
Oversight, House Committee on Ways and Means; and other interested
congressional committees. In addition, we are providing copies to the
Secretary of Labor, the Secretary of the Treasury, the Chairwoman of the
Equal Employment Opportunity Commission, and the Executive Director of the
Pension Benefit Guaranty Corporation. We will also make copies available to
others on request. If you have any questions concerning this report, please
contact me at (202) 512-5491, Charles Jeszeck at (202) 512-7036, or George
Scott at (202) 512-5932. Other major contributors include Lise L. Levie, Dan
F. Alspaugh, Jeremy F. Citro, Andrew M. Davenport, and Roger J. Thomas.

Sincerely yours,
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 firms
among the 1999 Fortune 1000 firms with cash balance plans as of July 2000.34

We obtained plan documents, including Summary Plan Descriptions 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 included data on whether the plan was a new
or converted plan, participation and vesting requirements, procedures for
establishing opening balances, cash balance plan features, and whether
transition provisions were provided.

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

We conducted indepth 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 the reasons that employers converted
to cash balance plans and the ways in which plan sponsors implemented those
conversions. We selected firms 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 were nonprofit organizations.
Information from these interviews is included in the body of this report to
provide relevant examples and context. We provided a pledge of
confidentiality to firms that provided us proprietary information. We
therefore do not mention the names of firms to preserve confidentiality.

Comments From the Department of Labor

(207087)

Table 1: Selected Differences Between Defined Benefit and Defined
Contribution Plans 9

Table 2: Comparison of Effect of Changing Jobs on Annual Pension
Benefit Under a Traditional Final Average Pay Plan and a Cash Balance Plan
27

Figure 1: Example of Traditional Final Average Pay Formula Used to Calculate
an Annual Pension Benefit 8

Figure 2: Example of Annual Increase in Pension Benefit Under a
401(k) Defined Contribution Plan 9

Figure 3: Example of Annual Increase in a Hypothetical Account
Balance Under a Cash Balance Formula 11

Figure 4: Percentage of Fortune 1000 Firms' Cash Balance Plans, by Number of
Participants 14

Figure 5: Numbers of Firms Adopting Cash Balance Formulas Since
the 1980s 15

Figure 6: Comparison of a Cash Balance Accrued Benefit With the Hypothetical
Account Balance 22

Figure 7: Comparison of Annual Changes in Accrued Benefits for a
Cash Balance Plan and a Final Average Pay Plan 24

Figure 8: Comparison of Annual Change in Benefit Accruals for Cash Balance
Plans With Differing Age-Weighted Formulas 25

Figure 9: Percentage of Fortune 1000 Firms Maintaining a 5-Year
Vesting Requirement After Conversion 30

Figure 10: Annual Accrued Benefit With Mid-Career Change From Traditional
Final Average Pay Plan to Cash Balance Plan 34

Figure 11: Percentage of Participants With Expected Benefits
Protected by Transition Provisions 35
  

1. Fiscal year 2000 estimate, from the 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. "Tax expenditures" are revenue losses attributable to
provisions of federal tax laws and include any reductions in income tax
liabilities that result from special tax provisions or regulations that
provide tax benefits to particular taxpayers. Pension contributions and
investments 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. Cash balance plans express benefits as an "account balance" based on
hypothetical pay credits (percent of salary or compensation) and
hypothetical interest credits to employee accounts. As with other defined
benefit plans, 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, nor are hypothetical accounts credited with investment gains
or losses. Employees do not own these "accounts" or make investment
decisions.

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

4. ERISA requires that tax-qualified plans allow participants to retire with
full benefits at no later than age 65 with 10 years of service. Many plans
allow normal retirement sooner than these limits.

5. Based on the 1997 Employee Benefits in Medium and Large Private
Establishments, Bureau of Labor Statistics, Sept. 1999.

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

8. 26 CFR sect.1.401(a)(4) − 8 (c)(3)(i). Section 414(k) of the Code
addresses the requirements for a combination of defined benefit and defined
contribution arrangements, which some have referred to as a form of hybrid
plan. However, section 414(k) does not address cash balance and similar
hybrid arrangements where one formula has components of both.

9. We also identified one firm that provided a nonqualified cash balance
plan exclusively for executives.

10. In addition to cash balance plans, about 4 percent of firms we surveyed
sponsor pension equity plans (PEP). Under these plans, employees earn a
percentage of final average pay expressed as a lump sum amount. PEPs 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.

11. Frozen plans have stopped participants' benefit accruals and allow no
new entrants into the plans. However, they cover the vested benefits of
employees and retirees.

12. During our indepth interviews, we identified one firm that had sponsored
a cash balance plan since 1925.

13. 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).

14. A UNIFI Survey of Conversions From Traditional Pension Plans to Cash
Balance Plans, PricewaterhouseCoopers, 2000. The report presented the
results of a survey of 100 conversions of traditional defined benefit
formulas to cash balance formulas.

15. Lump sum distributions received before age 59-1/2 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 individual retirement account or a qualified employer
retirement plan.

16. Conversely, visibility in the press and employee response to adverse
publicity resulting from some conversions were cited by firms that decided
not to convert as significant drawbacks of cash balance plans.

17. 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 as of the
date of termination.

18. The accrual rate is the change in the accrued benefit for an individual
plan participant from one year to the next.

19. In calculating the actual lump sum benefit payable before retirement,
the hypothetical account balance is projected forward with plan-specified
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 mortality
factors and the federally mandated discount rate, which is the rate
specified by federal regulation that must be used to convert the normal
retirement age annuity benefit into an equivalent lump sum in current
dollars.

20. The diversity in plan features and worker characteristics would likely
make our scenario rare. However, this illustration highlights the underlying
dynamics of the accrual patterns of FAP and cash balance plans and should be
viewed in that context.

21. In our scenario, the workers under cash balance plans did not obtain
their benefits until normal retirement age. However, making reasonable
assumptions about interest rates, these results would hold even if a lump
sum payment feature was available, either to both workers under multiple
final average pay plans and cash balance plans or to workers under multiple
cash balance plans alone.

22. Plans can offer a "graded" vesting schedule in which participants gain a
legal right to a portion of their benefits after 3 years and the requirement
for full vesting is delayed until 7 years of service have been completed.

23. The Bureau of Labor Statistics reported that, in 2000, the median number
of years any employee had with one employer was 4.7 years, while the median
number of years for younger employees was less. For example, the median
tenure for those aged 25 to 34, when cash balance plans are accruing
benefits at their fastest rate, was 2.6 years. See BLS, Employee Tenure in
2000, the Current Population Survey, 2000.

24. The Code allows both tax-qualified defined benefit and defined
contribution plans to distribute pension benefits either as a series of
payments or as a lump sum amount. It requires only defined benefit plans to
provide plan participants the option of receiving an annuity or series of
payments at normal retirement age when the present value of the accrued
benefits exceeds $5,000.

25. What Happens When You Show Them the Money?: Lump-Sum Distributions,
Retirement Income Security, and Public Policy, Leonard Burman, Norma Coe,
and William Gale, Nov. 1999.

26. Patrick J. Purcell, Pension Issues: Lump-sum Distributions and
Retirement Income Security, Mar. 14, 2000. The report is based on CRS's
analysis of the Census Bureau's Survey of Income and Program Participation.

27. Depending on the interest rate that plan sponsors credit to hypothetical
accounts, a terminating worker could be better off if he or she left the
benefit in the cash balance plan until normal retirement age rather than
opting for the lump sum payment. For example, one plan we surveyed used
interest rates as high as 16 percent in their benefit formula.

28. Changing from a traditional defined benefit plan to a cash balance plan
can result in a reduction in the rate at which normal retirement benefits
accrue at any age. However, the effect on expected retirement income is
greater the closer the participant is to normal retirement age when the
change occurs.

29. We provide a more detailed explanation of the impact of changing plan
type in Private Pensions: Implications of Conversions to Cash Balance Plans
( GAO/HEHS-00-185, Sept. 29, 2000), which we are issuing concurrently. In
this report, we model conversion from a FAP to a cash balance plan,
including periods of time when older participants may earn no additional
pension benefits while younger workers do, a phenomena commonly referred to
as "wearaway." Under the rules for defined contribution plans, employees can
withdraw their funds under certain conditions and with certain penalties.

30. These firms include some of the firms offering limited grandfathering.

31. According to some pension practitioners, choice at conversion can be
problematic because participants may not have the information needed to
decide which formula would provide the greatest benefit. Some also believe
that choice would have to be offered again any time a plan that offered
choice is amended.

32. One common measure of retirement income adequacy is the replacement
rate, which seeks to measure the retirement income for a single worker or
household in relation to a measure of preretirement earnings, such as the
earnings in the year before retirement.

33. See Private Pensions: Implication of Conversions to Cash Balance Plans (
GAO/HEHS-00-185, Sept. 29, 2000).

34. To calculate the population estimate from the sample proportion, the
assumption was 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.
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