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Investigate cash balance plan conversions

Posted: Thursday, June 01, 2000

DENVER (AP) -- Conversions to cash balance pension plans may result in benefit reductions for workers, particularly older workers, but companies making those conversions don't always make that clear to their employees, warns a retirement expert at the College for Financial Planning.

''No one quarrels with a company's legal right to change or even terminate its pension plan,'' says Jim Stone, an academic associate at the college. ''The problem is that companies don't communicate the impact of those changes in meaningful, understandable language. Workers may be losing benefits and not even realize it.''

Many companies, particularly larger ones, have been switching from traditional pension plans to cash balance plans in recent years. These plans are defined benefit plans that guarantee the retired employee a specific payout, but with features similar to defined contribution plans such as profit sharing plans. The ultimate retirement benefits from a defined contribution plan depend on how much is put into the account and how well the invested assets perform.

Under a cash balance plan, a ''hypothetical'' account is created for each employee. The employer contributes annually to each account, typically based on a set percentage of pay for all participants. For example, each participant might be credited with an amount equal to four percent of pay. The employee also earns an ''interest credit'' that's based on an interest rate set annually by the plan. The employee can thus watch his or her account grow, though in reality the money is pooled with the money from the other participants and invested by the company. Unlike a defined contribution plan, the cash balance plan guarantees the employee a specific retirement benefit.

Cash balance plans also differ from traditional pension plans in important ways, says Stone.

''Traditional pension plans typically calculate benefits weighted on the final pay of the employee. That is, the benefit might be based on the employee's average pay for the last three or five years, which normally will be the highest pay of the employee's career. Benefits from cash balance plans are based on pay averaged over the entire career of the employee.''

Stone provides an example of how employees, especially older employees, can lose out from a conversion to a cash balance plan.

Under a traditional pension plan, employee Bill might be guaranteed 1.67% of pay for each years of service, up to 30 years for a maximum of 50% of pay averaged over the final three years. Bill is 55 years old, has worked for the company for 20 years, and earns $40,000 this year. When he retires at age 65, at pay of $54,536 a year, he would receive annual benefits of $27,268.

Now let's say Bill's employer converts to a cash balance plan. It tells Bill what a great plan it is and how he can more easily understand his benefit statement. But unless Bill thoroughly investigates the conversion, he may not understand what he is losing, says Stone.

The cash balance plan might contribute five percent of Bill's pay and credit the ''account'' with six percent interest each year. But here's what's overlooked, says Stone.

''The catch for Bill is that the company will most likely defer contributions to him and other older participants until such time as contribution credits under the cash balance plan exceed the accrued benefit credited to the plan from the pre-amended defined benefit plan. In cash balance plan parlance, that's known as wear-away,'' he said.

''The company most likely will not contribute anything for Bill until the wear-away expires, but he won't know that because he doesn't understand the language by which he is told. Who would? That's the point. It's not clear to anyone but actuaries and other pension trolls. In Bill's case, because of the wear-away, the company won't contribute anything for three years.''

The net result of the new plan and the wear-away provision is that Bill ends up with considerably less at retirement than he originally would have, says Stone. Under his old defined benefit plan, he would have had a pension benefit worth $252,236 when he retired in ten years. Under the new cash balance plan, the retirement benefit would be $122,203.

Stone goes on to say that a young worker starting out under a cash balance plan will typically do better than an older worker caught in a conversion from a traditional plan, though Stone thinks younger workers can do much better with other types of retirement plans.

What particularly bothers Stone is that he feels that too many companies don't explain the financial consequences-usually a cut in benefits-of switching from a traditional pension plan to a cash balance plan. He cautions any employee, young or older, to work with a professional financial adviser to determine the true financial impact of a cash balance plan versus other plans, and any potential loss in a conversion situation.

''Don't depend solely on the glossy communication pieces issued by the company,'' Stone says.

End advance for Thursday, June 1, and thereafter



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