What You Need To Know About Pension Changes
New Law and Court Ruling Mean More Companies May Convert
Plans to 'Cash Balance' Model
By Ellen E. Schultz and Theo Francis
The Wall Street Journal
Tuesday, August 15, 2006
If you're covered by a traditional pension plan, the odds
that your employer will change to a "cash balance" pension
plan have just increased.
These new-style pensions, which currently cover roughly a
quarter of the 22 million private-sector workers with
pensions, have been controversial because switching to them
reduces pensions for older workers -- sometimes
significantly. This has led to lawsuits and proposed
legislation to slow their spread, causing some employers to
hesitate about changing.
But last week, a federal appeals court ruled that
International Business Machines Corp.'s cash-balance pension
didn't violate age-discrimination laws. Just days before
that, Congress approved a measure that would deem
cash-balance plans legal. While the ruling will be
appealed, and the bill has yet to be signed into law by
President Bush, employer groups say the recent actions are a
green light for employers to change their pensions.
For employers, switching to a cash-balance pension plan
reduces future payouts and boosts earnings. That, in turn,
can result in big gains in executive incentive pay, which is
tied to earnings.
Researchers at Cornell University, the University of
Colorado at Boulder and the University of California at
Irvine examined hundreds of companies that converted their
pensions to a cash-balance formula, and they found that the
average incentive compensation for the chief executive
officers jumped to about four times salary in the year of
the pension cut, from about three times salary the year
before. Companies that didn't change their pensions saw
little change, says Julia D'Souza, a Cornell associate
professor of accounting and lead author of the study, which
is currently under review by an accounting journal.
For example, filings show that when Cooper Tire & Rubber Co.
converted its pension to a cash-balance plan in 2002, the
CEO's incentive pay rose to $1.5 million -- the highest
level in a decade -- from $702,000 the year before. After a
similar move by Clorox Co. in 1996, the incentive
compensation for G. Craig Sullivan, its chief executive,
jumped to $5.6 million from $961,000 the year before.
A spokesman for Cooper Tire called any correlation between
its CEO's pay and its pension changes "completely
coincidental." Clorox didn't respond to requests for
The bottom line is that companies can boost their profits by
converting to cash-balance plans and now face little legal
risk in doing so. Unless you have already retired -- in
which case your pension won't change -- here's what it may
mean for you:
What is a cash-balance plan?
Cash-balance plans are pensions in which you have a
hypothetical account that grows by an annual credit, say 3%
of your pay each year, plus interest. When you leave your
job, you usually can roll the amount into an individual
retirement account or cash it out. If you're joining a
company with a cash-balance plan, the mechanics are simple.
But if you're at a company that switches from a traditional
pension, things can get complex.
What happens to my pension when it's changed to a
Most traditional pensions are designed so that if you work a
full career at a company, the pension will replace about a
quarter of your final pay when you retire. While formulas
vary, a plan might give you an annual benefit starting at
age 65 equal to 1.5% of pay for each year of service. So,
if you've worked 20 years at the company, and your average
salary was $50,000, that's a pension of $15,000 a year (.015
x $50,000 x 20).
When your employer converts to a cash-balance formula, the
first thing it does is "freeze" the pension you've earned
under the old formula. (This means it doesn't grow any
more.) Your employer then calculates what this frozen
pension would be worth if it were paid out in a lump sum of
cash. This frozen pension value becomes the "opening
account balance," which will grow with future contributions
Note that a cash-balance account is only virtual, or
hypothetical. The pension plan hasn't changed -- it's the
same pool of money, which your employer funds and manages.
A cash-balance "plan" is simply the same old pension plan,
with a new formula for determining your benefit.
How can a cash-balance plan reduce my pension?
Because traditional pension benefits build up fastest in the
later years, as much as half of a person's pension may be
earned in the final five years on the job. When this older
formula is frozen and the employee's pension grows only with
the annual "interest" credits, the pension in retirement can
be 20% to 40% lower than if the prior formula had remained
Your pension could be reduced even further. Some companies
lowball the opening account balances, giving someone an
"account" worth, say, $100,000, even if the frozen pension
is worth $120,000. As a result, you'd have to wait until
your annual pay credits and interest build your "account"
back up to $120,000 before you begin building any additional
This is one reason older employees complain of age
discrimination; however, the bill Congress passed would ban
some of the more-controversial practices.
Why do employers change to cash-balance plans?
Companies can save money and boost profits. If a company
has a pension surplus (most that converted in the 1990s did,
and some that are converting today do), it can use the
surplus assets to "fund" the contributions to workers --
offering the company a cash savings for a 401(k)-like
benefit that it wouldn't have if it actually switched to a
What's more, changing to a cash-balance plan reduces
pensions, and thus a company's pension obligation. Under
accounting rules, companies calculate how much they expect
to pay out in pensions over the lives of their employees --
including amounts workers haven't earned yet -- and then
reflect that amount as a liability on their books. When the
pensions are cut, the estimated amounts that will no longer
be paid out instead get added to income.
What kinds of companies change to cash-balance formulas?
Companies with work forces closer to retirement were more
likely to change from traditional pension to cash-balance
formulas, Ms. D'Souza found.
If you're a salaried worker, your pension is more likely to
be changed. If you're covered by a collectively bargained
contract, your employer typically must negotiate with your
union before changing to a cash balance plan.
Since the early 1990s, roughly 400 companies -- commonly
utilities, defense contractors and manufacturers -- that
together have at least 1,200 pension plans have shifted to
the new-style pensions.
Are cash-balance plans better for younger workers and
Employers say cash-balance pension plans are better for
younger and more mobile workers because these workers can
build up a better benefit than under traditional pensions,
and take it with them when they leave. But last year, the
Government Accountability Office concluded that most workers
-- regardless of age -- get lower retirement benefits when
employers switch from traditional pension plans to
What's more, workers get nothing if they leave before they
are "vested," which usually takes five years. The GAO says
more than one-third of workers in both traditional and
cash-balance plans fail to vest, making cash-balance plans
no better for job-hoppers than traditional pensions. (And
most companies automatically cash out pensions with values
below $5,000, effectively already giving young mobile
workers pension portability.)
What steps can I take if my pension is converted?
About half of employers making the switch provide a
transition period to protect older workers, such as letting
them stay under the prior formula for five years.
But some older workers choose the cash-balance option,
because they like the idea of walking away with a lump sum.
This is almost always a bad deal. Lump sums are often worth
less than what you could get with a monthly pension at
retirement age -- especially if you're in your late 40s to
late 50s and have been at the company for many years.
Before deciding, ask to see the value of your pension in all
possible forms: not just the cash-balance account, but the
pension you'd get at age 65 if you chose to remain in the
old plan, and that value converted to a lump sum.
Remember, your employer can still cut a cash-balance
pension. In coming years, it can reduce the annual pay
credit, or even freeze the plan. (Sears Holdings Corp. and
Verizon Communications Inc. froze their cash-balance plans
this year, and IBM announced it will freeze its plan at the
end of 2007.) So you need to save as much as you can in a
401(k) account or elsewhere.
Cash-balance plans could be even riskier going forward,
because the new pension law would allow companies to use an
interest crediting rate that could turn negative,
potentially wiping out all the interest credits previously
Write to Ellen E.
firstname.lastname@example.org and Theo Francis at