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The IRS May Be Too Late To Save Cash Balance Plans

The Internal Revenue Service has finally filled in many of the blanks that have kept employers from switching to cash balance plans over the last five years. But it may be too late.

The Internal Revenue Service has finally filled in many of the blanks that have kept employers from switching to cash balance plans over the last five years – most important, defining the “market rate” interest rates that sponsors can pay without running afoul of anti-discrimination provisions. In addition, the IRS clarified some points about subsidized benefits and so-called back-loading (when the salary-credit percentage increases with age and years of service).

But it may be too late.

Too many companies have simply given up and switched to 401(k)s, frustrated by unanswered questions in the Pension Protection Act of 2006, scared off by legal rulings, and no longer willing to be bound by the unlimited liability of traditional pensions.

A decade ago, hybrid retirement plans, with features of both defined benefit and defined contribution plans, seemed to be the compromise that could save pensions. There are several variations, but under the most common, the employer every year contributes a designated percentage of pay and an interest credit into a discrete account for each participant. Thus, like a defined contribution plan, this system sets a clear limit on the employer’s financial obligation. And like a defined benefit plan, it guarantees employees a certain level of benefit and puts all the investment decisions and risk on the plan sponsor.

Not surprisingly, employers at first swarmed to convert their traditional pensions to this new version. Their share of the retirement plan universe zoomed from 15 percent in 2000 to 24 percent four years later, according to Aon Hewitt. But growth stalled over the next six years, and as of last year, the hybrids’ share had shrunk back to 16 percent, Aon Hewitt says.

The first problem was that older workers protested that their defined benefits would be cut if they were transferred to the new plans. A federal district court ruled that IBM Corp.’s plan did discriminate against them, and other companies faced similar lawsuits. (Discrimination is an issue because of the different time horizons of employees at different ages. After all, if a 30-year-old and a 50-year-old are both getting a 5 percent interest-rate credit into their accounts, the younger person will have an extra 20 years of interest-rate accumulations by retirement. )

Moreover, while the PPA endorsed the basic concept, it was vague on the particulars, such as the allowable market rate.

Now the IRS has set 5 percent as the maximum fixed interest rate, to limit the disparity. (The formula is a bit more complicated for variable rates.)

“That hybrid appeal is worth another look in light of the legal clarity provided by ... [the IRS] recent regulations,” Sibson Consulting advised clients in its March newsletter. Bob Leone, a managing principal at Aon Hewitt, predicts that cash balance plans will resume their growth, rising to 20 percent of all retirement plans in four years.

Yet it could have been much higher. During the long period of uncertainty, a lot of companies converted to 401(k)s. By Aon Hewitt’s reckoning, defined contribution plans now constitute 69 percent of all plans, more than double the percentage in 2004. Alan Glickstein of Towers Watson says that several percent of those switchers “would have chosen cash balance instead, if the regulations had been resolved.”

They won’t shift to a hybrid now. “Once you’ve gone defined contribution -- once you’ve removed the investment risk entirely -- it’s very difficult for an organization to take it back,” says Leone.

The IRS regulations are not finalized, and some consultants and sponsors are pushing for changes. Glickstein, for instance, argues that the “market rate” should be upped to 6 percent. And many benefits experts fret that the effective date of next January 1 doesn’t give employers enough time to rejigger their plan designs.

Fran Hawthorne is the author of the award-winning “Pension Dumping: The Reasons, the Wreckage, the Stakes for Wall Street” (Bloomberg Press) and “Inside the FDA: The Business and Politics behind the Drugs We Take and the Food We Eat” (John Wiley & Sons). She writes regularly about finance, health care, and business ethics.

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