Lee D. Gold Denver Cash Balance Plans State Association of County Retirement Systems – Educational Symposium 2007 February 6, 2007

Mercer Human Resource Consulting 2 Agenda Cash Balance Plan defined How cash balance plans work Why the interest? How are employees impacted? IBM’s troubles Public Sector application Information presented here represents the experience and opinion of the presenter and does not represent in any way an official viewpoint or position of Mercer Human Resource Consulting

Mercer Human Resource Consulting 3 Cash Balance Plan Defined Is it complicated? Higher level math (as illustrated here) will not be needed to understand cash balance plans!

Mercer Human Resource Consulting 4 Cash Balance Plan Defined Like a DC Plan…but not exactly Similar to a defined contribution plan – Account grows with pay credits and earnings – Benefit is expressed as a lump sum Different than defined contribution plan – Cash balance account is a “paper account” only – Employees do not control investment options (rare exceptions) – Annuity options Often called a “hybrid” plan because it has features of both defined benefit and defined contribution plans

Mercer Human Resource Consulting 5 Cash Balance Plan Defined Career accumulation plan – Hypothetical account for each participant  Assets in the plan may be more or less than the sum of the individual accounts at any point in time. – Benefit is defined as the accumulated value of annual allocations plus interest credits Legally, Cash Balance plans are defined benefit plans, not defined contribution plans – Assets of plan available to pay benefits to all employees – Annual contributions to the plan are not equal to the annual allocations

Mercer Human Resource Consulting 6 How the Plan Works Annual allocation Rate can be a single rate (expressed as a percentage of pay) for all employees or graded by age, service, etc. Annual Allocation is the annual allocation rate multiplied by eligible earnings An Interest credit is provided each year and represents interest earned on the hypothetical account for the year – Usually tied to U.S. Treasury rates (e.g. 10 year, 30 year) – Not specific to employee elections (rare exceptions)

Mercer Human Resource Consulting 7 How the Plan Works Example Simple Cash Balance plan that provides an annual allocation of 5% of the employee’s pay. Interest credit for the year is determined as the rate of return on 10-year US Treasuries on the last business day of the prior year.

Mercer Human Resource Consulting 8 How the Plan Works Payment Options At retirement, benefit usually paid as a lump sum, although annuity option is available Plan could be designed to only offer an annuity with the value of the annuity determined directly from the cash balance account value Benefit payout could be restricted to commence only after reaching early retirement age – If “portability” is desired, this feature defeats that goal

Mercer Human Resource Consulting 9 How the Plan Works Risk Allocation Investment: Benefit is a lump sum or equivalent annuity and is not based on the performance of plan assets. If assets invested in a diversified portfolio, assets may exceed or fall short of the hypothetical account values in any given year. Sponsor will be responsible for making up any shortfall. Pre-retirement Inflation: Prior year benefits only grow with interest credit, not with changes in salary. However, interest crediting rates generally are related to inflation. Longevity: If Employee takes lump sum (most do), the employee assumes all the risk of outliving his/her assets

Mercer Human Resource Consulting 10 History First developed for Bank of America in 1985 Lots of interest during the late 1990’s Interest has waned due to IRS moratorium on determination letters and law suits Will interest rise again due to “blessing” of Pension Protection Act of 2006? Source: GOA report on Cash Balance Plans September 2000.

Mercer Human Resource Consulting 11 Why the interest in Cash Balance Approach? There is no single reason that applies to all conversions to a cash balance plan, but here are some you might see: – Benefit is easy to communicate  Benefit statements read like a bank statement – Portability was seen as an important design element  Seen as a better fit for a mobile workforce – Limits the sponsors risk of having retirees who live a long time (longevity risk) – Limits pre-retirement inflation risk – Design more in line with pay-for-performance philosophy  Two employees who contribute equally to the business are rewarded equally – eliminates age-based component of benefit value in today’s dollars – Depending on design, plan could be less expensive. Improves balance sheet and income statement items.

Mercer Human Resource Consulting 12 Why the Negative Press? Negative press has come about for two primary reasons – Transition approaches – Different accrual pattern of benefits Transition approach that draws fire – Example: Plan will switch to cash balance at January 1, Benefit is larger of:  A) Final average pay benefit as of December 31, 2007, or  B) Monthly benefit equivalent from a cash balance account, assuming the person had been in the new cash balance plan since inception – Individual may go years without accruing an additional benefit Older workers can be harmed significantly

Mercer Human Resource Consulting 13 How are Employees Impacted? The next few slides assume the following: – Final average pay plan (2% per year of service) is changed to a cash balance plan – Annual allocation is 10% of pay – Interest crediting rate is 5% Note: The following examples are for illustration purposes only. These two plans may or may not be similar in cost.

Mercer Human Resource Consulting 14 How are Employees Impacted? Harm to older workers has created negative press

Mercer Human Resource Consulting 15 How are Employees Impacted? Harm to older workers has created negative press Value of early retirement subsidies is reduced significantly

Mercer Human Resource Consulting 16 How are Employees Impacted? Picture becomes less clear with mid-career employees

Mercer Human Resource Consulting 17 How are Employees Impacted? Some Employees are benefited

Mercer Human Resource Consulting 18 How are Employees Impacted? It Depends!

Mercer Human Resource Consulting 19 IBM Just the basics July 31, 2003 – Federal District Court ruled that IBM’s cash balance plan violated age discrimination requirements (Cooper v. The IBM Personal Pension Plan) The participants’ argument with respect to the cash balance formula was as follows: – Cash balance credits provided under the formula produce higher rates of accrual for a younger employee than for an older employee with the same service and salary, if the rate of accrual is defined in terms of the amount of annual benefit payable at normal retirement age

Mercer Human Resource Consulting 20 IBM Age Discrimination Illustration Court ruled that the larger annuity benefit provided at age 65 to the younger employee makes the cash balance plan age discriminatory

Mercer Human Resource Consulting 21 IBM Update August 7, 2006: US Court of Appeals for the Seventh Circuit ruled that IBM’s cash balance plan does not discriminate on the basis of age (Cooper v. IBM Personal Pension Plan) Appeals court found that the plaintiffs (and the lower court) should not have focused on the plan’s “outputs” (the amount of the age-65 benefit), but should have focused on its “inputs” (the amount of the pay credits). The court saw no reason to treat cash balance plans differently from economically equivalent defined contribution plans. The court said that it is possible “for litigation about pension plans to make everyone worse off,” noting that since the litigation began IBM had eliminated its cash balance plan for new workers and “confined them to pure defined-contribution plans.” August 17, 2006: Pension Protection Act signed into law for plans governed by ERISA. Act specifically states that cash balance plans are not age-discriminatory as long as certain minimal requirements are met. Prospective application only. Supreme Court has refused to hear the case

Mercer Human Resource Consulting 22 Application to Public Sector Employers Many public sector pension plans already have a cash-balance-like feature – Employee contributions with interest Going to full cash balance – Employer contribution also used to provide an account-based benefit – Allocation rate my be higher than contribution rate  Example: ­Plan requires 5% contribution from both the employer and employee ­Plan could provide an annual cash balance credit of 12% (instead of 10%) with the extra 2% being covered by expected plan earnings above the interest crediting rate

Mercer Human Resource Consulting 23 Application to Public Sector Employers There are many different options for employers to achieve desired goals for their retirement programs: – Allocation Rates: can be based on service, age, or both (points) – Interest Crediting Rate – Vesting schedule – Payout options: lump sum, annuity, or choice – Commencement: at termination or retirement only – Transition benefits, if any Cash balance plans may make sense for employers who like the benefit growth pattern of a DC plan, but want other features of a DB plan (early retirement subsidies, windows, annuity payouts, etc.)