Hybrids for the Future

Life Time WorkerDefined-benefit pension plans have fallen out of favor with both employers

and employees in recent years. They were designed to reward long-- service employees by providing a monthly benefit at age 65, typically equal to a percentage of pay for each year of service with the company-the larger the salary and the longer the service, the larger the benefit. "Career" employees who worked many years with the same employer were amply rewarded, whereas short-service employees who terminated employment prior to retirement often had little or nothing to show for their efforts.

defined-benefit plans worked well for long-service employees, providing guaranteed benefits for the employee's lifetime. However, they were expensive to administer, often contained unfunded liabilities that had to be carried on the company books, were hard to communicate to employees, and were perceived to be useless in the eyes of younger employees with a job-hopping mentality

Raise of the 401K During the 1980s, a whole new approach to retirement savings occurred

with the birth of the 401 (k) plan. These vehicles are more like tax-benefited savings accounts. They usually are funded by a combination of employer and employee money, so generally they are cheaper for the sponsoring company to administer. Unlike the defined-benefit plan, they work well for job-hopping, short-service employees. On termination of employment, an employee can easily roll over his accumulated account balance to his new employer's plan or to his IRA if a new plan is not offered.

Cash Balance Plans In the past few years, AT&T, Xerox, and American express, among others,

have instituted a new type of "hybrid" pension plan for their employees. IBM is reportedly considering a similar move.

Cash-balance plans look much like 401 (k) plans but have some of the guarantees offered by defined-benefit plans. Under a typical cash-balance plan, the company deposits a stated percentage of pay for each employee, and an account is established in the employee's name. This account is guaranteed a certain rate of return, and the sponsoring employer makes extra deposits if needed to meet the guarantee. Conversely, future employer deposits may be reduced if investment earnings exceed the guaranteed amount. At retirement, benefits often are paid in the form of a guaranteed monthly income rather than a lump sum.

Problems With the Plan Because defined-benefit plans discount in advance for anticipated

employee turnover, mortality, and future interest earnings, they tend to accrue benefits at a very low rate during an employee's early years of employment. The accrual rate accelerates as employees approach retirement. By contrast, the accrual rate tends to be fairly level over an employee's working lifetime when a cash-balance plan is used. It is an accurate rule of thumb that young, short-service employees will accrue more benefits under the cash-balance approach, whereas those close to retirement prefer the defined-benefit approach. Because of this phenomenon, there has been some negative press surrounding cash-- balance plans, accusing employers of reducing accruals and, therefore, plan costs for older employees to pass this savings on to younger employees

Conversion Strategies and Problems at IBM the motive behind the conversion to a cash-balance approach has been

questioned. It has been implied that the real reason for this trend is not to design a plan better suited to today's workforce but to reduce pension costs by designing a plan that reduces benefit accruals as employees near retirement IBM much publicized problem in selling the conversion of their plan to its employees has contributed to the negative image of cash-balance plans.

There are lessons to be learned from IBM experience. Hundreds of other companies made the conversion from a defined-benefit type plan to a cash-balance plan with little or no complaint from their employees. When considering a fundamental change in the method of funding retirement benefits, a company must carefully develop a conversion strategy

there were other groups of employees who concluded, rightly or wrongly, that their benefits would be reduced. These employees established a web sight in protest, which reportedly was getting 15,000 hits a day during the height of the controversy Unable to win back its credibility, IBM agreed to allow these employees to elect to remain in the old plan.

Three Steps in a Conversion StrategyThe development of such a strategy begins by understanding that there is no

one plan that is perfect for every employee. There are many varieties in benefit formulas and funding methods that result in the accrual of benefits at different rates based on such factors as age, service, and salary

A second essential part of a conversion strategy requires that the employer run test models to determine how the new plan will affect benefit accruals for each employee. There are ways to protect benefit accruals for certain groups of employees, but a specific plan must be developed to do so.

This brings us to the third part of the conversion strategy: Clear communication of the changes being made to employee benefits is essential. This should include a projected comparison of the benefits generated by the existing and revised plans and full explanation of the assumptions used when making this projection.

The Take AwayConversion campaign of this type may unfold over many

months, but we believe that there is no substitute for doing it right, no matter how long it takes. A plan that is well designed, fair to all concerned, and clearly communicated should be the ultimate goal of all concerned

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