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March 06, 2000
Cash Balance Conversions: Redistribute, But Don't Change to Save Money
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dy debunks popular notions about shift to hybrid pensions

BETHESDA, MD. The typical company realizes little, if any, pension cost savings when it shifts from a traditional pension to a cash balance or other hybrid plan design, according to a comprehensive new study by Watson Wyatt.

The study found average employer cost savings of just 1.4 percent during hybrid plan conversions, after factoring in enhancements that employers often makes simultaneously to their 401(k) plans. Overall, 45 percent of employers realized some cost savings, while 37 percent saw costs increase, and 18 percent experienced a minimal effect on costs - less than 5 percent plus or minus prior plan costs.

"Democratic Redistribution"

"The popular notion that employers shift to cash balance plans largely for cost reasons is not supported by the facts," says Sylvester J. Schieber, Ph.D., vice president of research at Watson Wyatt. "The cash balance shift is about redistributing retirement dollars democratically among workers. These plans provide a more tangible benefit for workers who stay with an employer for less than a full career or who terminate employment prior to retirement eligibility. The cash balance phenomenon is about employers using retirement programs more effectively to meet long-term workforce needs."

Moreover, Dr. Schieber warns that the debate over cash balance plans is obscuring a much larger issue - how misguided pension policy has led to a dramatic decline in the number of workers covered by pensions since the 1970s.

"Cash balance plans represent just one percent of all defined benefit plans in existence," he says. "While some policymakers grandstand on a few isolated abuses of these plans, the rest of the employer-sponsored pension system continues to deteriorate."

The Watson Wyatt study is based on a detailed analysis and financial modeling of the benefit provisions in 78 hybrid plans, representing approximately one-fifth of such plans in existence. The study also included an opinion survey of 79 employers that had made the shift to a hybrid plan to provide additional perspective on motivations for adopting one of these plans. About half of the respondents on the survey were included in the detailed cost analysis developed in the study.

Elimination of Early Retirement Incentives -- a change

The study found that when companies reduced costs in the conversion it was largely due to the elimination of subsidies for early retirement, which typically augment benefits at around age 55. "Given the current shortage of talented workers, it is not surprising that many employers can no longer afford to encourage their most experienced workers to be walking out the door while they are still highly productive. This is also consistent with federal policy, which now calls for the Social Security 'normal retirement age' to rise to age 67," says Dr. Schieber, who is currently serving a six-year appointment on the Social Security Advisory Board.

Among all plan sponsors surveyed, the most frequently cited reasons for adopting a hybrid plan were to facilitate communication (100 percent), improve employees' appreciation of the plan (97 percent), and to show benefits as a lump sum value (91 percent).

Part of the hybrid plan phenomenon might be characterized as a "regression to the mean." The richest benefit plans tended to be scaled back during a plan conversion, while the stingiest plans became more generous. Some companies apparently increased benefits in order to help employees pay for increasing retiree health expenses, which cannot be directly funded on a tax-advantaged basis.

Effects on Plan Participants

While average pension costs essentially remained flat during a cash balance transition at the company level, the study did find a significant redistribution of benefits among workers. On average, a typical 40-year-old that leaves a firm after ten years would walk away with 2.4 times the benefit under the new hybrid plan than he or she would have received under the old pension formula. For a 50-year-old leaving with 20 years service, the figure is 1.5 times the benefit in the old plan. But the average 60-year-old with thirty years of service would get only 78 percent of the benefit he or she would under the old plan.

Interestingly, the study found that even those considered "losers" under the new plan would often continue to earn benefits at a rate faster than those considered "winners," though at a lower rate than in the prior plan.

"The fundamental question remains," says Dr. Schieber. "Is it more fair to provide enhanced benefits to the vast majority of workers? Or should companies continue to direct most benefit dollars to the relatively small minority of workers who stay with a single employer for thirty years?

Three different cases

Because the cost implications of the plan conversions varied among plan sponsors, the study looked in detail at three cases - a cost-reducing conversion, a cost-neutral conversion and a cost-increasing conversion -- to determine the effect on plan participants. Overall, the majority of workers are better off with the new hybrid plan.

In the cost-reducing case, slightly less than half of workers (45 percent) do better under the new hybrid plan formula than they would have under the old one.

In the cost-neutral case, almost 80 percent of participants do better under the hybrid plan formula.

In the cost-increasing case, the vast majority of employees (97 percent) do better under their new hybrid plan design relative to the prior plan. Including the improvement to the 401(k) offered by the plan sponsor in this case, less than one percent of workers affected by this change will be worse off.

Policy Considerations

As the public debate rages over cash balance conversion, a much larger trend continues to go unnoticed by most policymakers. Since the enactment in 1974 of the Employee Retirement Income Security Act (ERISA), which ironically was intended to safeguard pensions, the percentage of U.S. workers covered by traditional pensions has dropped from 39 percent in 1975 to 23 percent in 1995. If just the same percentage of U.S. workers were covered by defined benefit pensions today as in 1975, an additional 16 to 20 million workers would be participating in this system than are doing so today.

"Decades of misguided federal policy have made pensions far less attractive for employers," says Dr. Schieber. "Most notable are rules adopted in 1987 that essentially curtailed the funding of baby boomers' retirement from the first half of their careers to the second half. We have been warning that this was a problem for years."

Government-imposed funding limits help explain some of the motivation of companies who are in fact looking to cut costs in their conversions to cash balance plans, says Dr. Schieber.

The Watson Wyatt report concludes: "If policymakers are truly troubled by the shift from traditional defined benefit plans to hybrid plans, we urge them to consider this phenomenon in the larger context of retirement policy, demographic and business conditions within which these plans are offered. Would further legislation jump-start our ailing defined benefit system? Or, would it lead to the further demise of defined benefit plans?"

The full research report, The Unfolding of a Predictable Surprise: A Comprehensive Analysis of the Shift from Traditional Pensions to Hybrid Plans, can be downloaded from Watson Wyatt's web site at

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