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Thelen Reid Brown Raysman & Steiner LLP
Employers
are converting traditional defined benefit retirement plans
to cash balance plans. Employees are suing.
Reports are appearing in the media. Congress is considering
comprehensive disclosure rules.
What is a cash balance plan? What is all the fuss
about? Should you be converting your plan? Why?
How? When?
In a defined contribution plan, a formula defines the
contribution (e.g., 5% of salary). The contribution is made
to a plan and an account is established for each participant.
When the participant retires, the account balance (contributions
plus earnings) is distributed to the participant.
In a defined benefit plan, a formula defines the benefit
(e.g., 50% of final average salary per year for life).
Actuaries determine how much should be contributed in order
to provide enough money to pay the benefits.
Defined contribution plans are much easier to understand
than the traditional defined benefit plan. An employee
can easily understand a statement that indicates he or she
has $100,000 in his or her account, but will be confused
by a statement that indicates he or she is entitled to $1,000
per month at age 65.
A cash balance plan is a hybrid plan. It is
technically a defined benefit plan, but it looks and feels
like a defined contribution plan. The current value
of the benefit is defined in terms of an account balance.
Each year, that hypothetical account balance is adjusted
by crediting the account with hypothetical contributions
(e.g., 5% of salary) and hypothetical earnings (e.g., 5%).
The principal reason for the fuss is that defined benefit
plans generally favor long-term workers, but cash balance
plans, like defined contribution plans, generally favor
younger workers and short-term workers. So when a
traditional defined benefit plan is converted to a cash
balance plan, long-term workers are often hurt. Cash
balance plans can be designed with transition rules so that
long-term workers are not hurt, but not all conversions
include transition rules.
Many participants complain that employers have not done
an adequate job of explaining to their employees how the
conversion affects them. Congress is reacting to employees'
confusion and complaints by considering legislation that
would require more disclosure, and perhaps even require
individual statements.
Should you be converting your defined benefit plan?
Conversion makes sense for many employers and for most employees.
All employers who maintain traditional defined benefit plans
should be considering the possibility of converting to cash
balance plans, particularly if their plan has a substantial
surplus.
Many issues need to be considered. Some of the common
issues that arise are: setting the initial balance, the
formula for determining contributions, age and service weighting,
integration, the earnings rate, participant election of
earnings rates, early retirement subsidies, early retirement
windows, age discrimination, matching after-tax contributions,
and protections for participants close to the age of retirement
at the time of conversion.
Conversion is not for everyone. The conversion process
is complicated, expensive and raises litigation risks that
are difficult to quantify. Many employers are better
off continuing, freezing or terminating their defined benefit
plans. Many other employers, however, are leading
the charge into the cash balance world. So many, in
fact, that these plans are no longer mere novelties.
Some of the largest plans in the country have made the conversion.
Each situation is unique. The cost to the employer
and the impact on each different category of employee should
be carefully considered. Effective employee communication
is extremely important. And, of course, the employer
will have to comply with the yet-to-be-enacted disclosure
rules and meet all of the technicalities of ERISA, the Internal
Revenue Code, and other legal requirements.
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For more information about the issues covered in this report, please contact David S. Foster in our San Francisco office at 415-369-7020 or at dsfoster@thelen.com or contact your Thelen attorney. For more information about Thelen's Construction and Government Contracts Department, click here.
©1999 Thelen Reid Brown Raysman & Steiner LLP
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