Disclosing Cash Balance Formulas

By Russell F. Briner and Marshall K. Pitman

In Brief

Current Disclosures Don’t Provide Enough Information

Cash balance pension plans can present concerns to corporate adopters that should be addressed and properly disclosed in their financial statements. The authors have found that disclosures concerning cash balance plans were generally inadequate. Their study showed that 10 out of 39 companies surveyed provided equity (in the form of choice of plans or special benefits) to employees to prevent discrimination against older employees. A concern about the tax status of these plans remains unresolved.

The authors recommend that corporations should fully disclose the cash balance formula, including the interest rate; disclose the payment option for employees vested under cash balance plans; and continue disclosure in subsequent years, as the corporation’s way of handling the “wear-away” effect.

The pension benefits offered by employers are generally divided into defined contribution plans and defined benefit plans. A defined contribution plan requires the employer to make a specified contribution to employees’ accounts. (Employees may also be required to make a contribution.) Employees then invest the contributions in investments of their choice. The employees’ retirement benefits are dependent upon the earnings of the investments. In contrast, under a defined benefit plan, a retiree receives a predetermined benefit based on various factors, such as years of service and past earnings. Cash balance pension plans are a special type of a defined benefit plan.

In recent years, employers have increasingly adopted cash balance plans. Concerns related to whether cash balance plans discriminate unfairly against older employees have raised questions about their viability. Other concerns include the adequacy of disclosure of plan provisions to employees and investors, as well as the tax status of these plans.

Benefits of Cash Balance Plans

Although the benefits to employers generally drive the decision to use a cash balance plan, employees receive benefits as well. Under cash balance plans, an account is established for each employee. The employer contributes an amount, predetermined by a formula, to this account, which accrues interest on these contributions. The employee accounts are not set up as individual cash accounts; rather, the employer makes a lump-sum cash contribution each year to the pension trust. These contributions are then invested in a variety of investment alternatives.

For example, an employer contributes 3% of an employee’s salary, plus interest accruing at a rate based on 30-year Treasury bonds. As a result of this, the pension plan may be underfunded or overfunded after a period of years, depending on the actual contributions of the employer and the actual returns earned on the contributions. If the return earned on the employer’s contributions exceeds the 30-year Treasury bond rate used to accrue interest, the employer will benefit. Recent rates for the 30-year Treasury bond were less than 6%, but most investment portfolios have a long-term return higher than 6%. Accordingly, the employer pension expense in a cash balance plan is reduced over a period of years as compared to a regular defined benefit or defined contribution plans. The regular defined benefit plan expense is generally greater because the annual contribution is projected using estimates of payments that would be required at an employee’s retirement. In a defined contribution plan, the pension expense is the amount contributed each year by the employer, which usually must contribute at a higher rate annually than for a cash balance plan.

Another employer benefit of a cash balance plan is that the funding requirements may be lower because of the reduced overall pension liability of the plan. The cash balance plan payout is based on a constant formula, while a regular defined benefit plan payout is based on a percentage of the employee’s salary for the most recent years before retirement. Therefore, the funding requirement over a period of years for a cash balance plan would usually be less than the regular defined benefit plans.

When companies that already have a regular defined benefit plan convert to a cash balance plan, the funding need is generally reduced, resulting in a reduction of the pension liability. The difference between the projected benefit obligation of the old plan and the new projected benefit obligation liability is applied to reducing amortized prior service costs and incurred pension expenses. This benefit obligation reduction accrues to the employer’s benefit when a regular defined benefit plan is amended to become a cash balance plan.

Another potential cost reduction for the employee is how early retirement incentives operate. While a regular defined benefit plan incurs additional cost for early retirement incentives, the individual fund balance will grow enough to entice early retirement if the employee remains with the employer.

Cash balance plans also benefit employees. One example is the possible early retirement incentives that accrue through annual contributions and compound interest over a long period of time, which can result in a large employee fund balance. Another employee benefit is that the employee is usually fully vested after a short period. If the employee leaves the company and is fully vested, the employee is entitled to the value of fund. The employee is not taxed, however, until the funds are withdrawn.

To employees, cash balance plans resemble 401(k)-type plans and, therefore, are appealing. The employee can see the growth in the plan account but does not face the investment risks of 401(k) plans.

Key Concerns for Employees and Employers

Cash balance plans have suffered from negative publicity, some of it deserved. The most notable criticism, that cash balance plans discriminate against older employees, may have raised many possible concerns, but may not be accurate in all cases.

First, in a cash balance plan conversion, the accrued benefits to the employee already existing in any plan cannot be taken away. Accordingly, the employee is still credited in the new cash balance plan with those benefits.

The key concern is that some employees with a longer length of service may have to wait several years before the cash balance plan credits any new contributions to their account. This situation arises because the cash balance plan formula creates an initial balance that is below the employee’s accrued benefit. Thus, until the individual cash balance catches up to the accrued benefit, the employer is not required to make any new contributions to the employee’s cash balance plan account. The period required to catch up to the accrued benefit is called the “wear-away” period.

Companies have the following alternatives to alleviate this wear-away period effect:

The tax deductibility of contributions to pension plans is always a prime concern to the management of a company. In September 1999, the IRS implemented a freeze on issuing determination letters on cash balance plan conversions. Accordingly, applications to the IRS for a determination of the status of cash balance plans are on hold until the freeze is lifted. In December 2002, the Bush Administration proposed rules advising companies about how to avoid challenges based on age discrimination when they convert traditional pension plans to cash balance plans. Based upon the coments received by the Treasury Department and the IRS, the proposed regulations were withdrawn. New proposed regulations should address the potential for plan sponsors to avoid the requirements of the new compability regulations through cash balance plans.

In the late 1990s several companies that had converted to cash balance plans were accused of unfairly treating employees in the conversion. Court cases followed, but so far the courts have not ruled against an employer.

Whether cash balance plans are equitable to employees depends upon an individual’s objectives. Because cash balance plans are a type of defined benefit plan, the plan should be recognized as a legitimate vehicle for retirement benefits. Because such plans are always subject to employer abuses, the employer should provide adequate safeguards, and the employee should keep informed about all aspects of the plan.

If an employee seeks portability in a pension plan (i.e., the ability to take the accrued balance when terminating from the company), a cash balance plan provides that. If an employee seeks an identifiable accumulating account in a pension plan, the cash balance plan provides such visibility. Because the benefits that a cash balance plan provides may not be as large as those of a regular defined benefit plan or a defined contribution plan, however, the matter of equity is largely subjective.

Analyzing Company Plans

To determine the sufficiency of information provided in financial statements about cash balance plans, the authors analyzed Fortune 500 companies’ 1999 annual reports. Exhibit 1 and Exhibit 2 show part of the results of this analysis.

The survey found that only 33 had cash balance plans in effect during 1999. Additionally, six companies (Citigroup, Texaco, Bell Atlantic, Eastman Kodak, BestFoods, and Columbia Energy Group) disclosed that they would adopt cash balance plans in 2000. Exhibit 1 breaks down the firms using cash balance plans by industry.

Exhibit 2 provides information concerning three factors in a cash balance plan: 1) the criteria used by the company in the cash balance formula; 2) the type of payout option available upon retirement by employees in a cash balance plan; and 3) the information disclosed, if any, by the company concerning the transition from a regular defined benefit plan to a cash balance plan.

Cash balance formulas. Exhibit 2 indicates that most of the 33 plans use a percentage of the employee’s salary and the age of the employee in the formula for determining the amount allocated to the employee account each year. Six companies did not disclose the formula used. Only three companies disclosed the interest rate used to accrue interest each year. The information disclosed in these companies’ financial statements concerning the cash balance formula criteria was very sketchy.

Payment options. The employer is allowed to specify the types of settlement employees can select in withdrawing the funds from their retirement account. Under cash balance plans the alternatives are usually a lump-sum payout, an annuity, or a choice between the two.

Only four companies disclosed the type of payment option available upon retirement or termination (if vested). Two companies allowed a choice between a lump sum or an annuity. The employee should be aware of this option as retirement draws near; the company will probably communicate this information internally. The investor or analyst could use this information to judge future benefit obligations. The lump-sum payout provides a one-time cash outflow and does not commit the company to future obligations as an annuity would. If a large number of employees were set to retire in one year, however, then the company could be expected to need a large amount of cash in that year, and that should be considered in assessing its financial condition.

Transition disclosures. One objection raised by critics of cash balance plans has been the possible discrimination against employees, particularly employees who have had longer service with the company. This discrimination is caused mostly by the wear-away effect. An analysis of the disclosures made with regard to the transition effects from regular defined benefit plans to cash balance plans could shed light on the fairness and cost of cash balance plans.

All of the six companies that were converting to cash balance plans in 2000 supplied information concerning the transition. These companies allowed employees to either choose the cash balance plan or remain under the regular defined benefit plan. Regardless of the choice, some companies provided special benefits (e.g., a lump-sum payment) to employees with stipulated service time. One company provided early retirement incentives to employees over age 50 as a special benefit.

Of the 33 companies that had adopted cash balance plans by 1999, six either gave employees the option to remain under the regular defined benefit plan or provided special benefits similar to those described. Four companies reported that employees had received the greater of the cash balance formula at time of adoption or the balance accrued under the regular defined benefit plan. (The employees of those four companies were therefore subject to the wear-away effect.)

In total, 10 of the 33 companies made disclosures about transition effects; however, only four of the 10 companies that had converted to cash balance plans in 1999 made such transition disclosures. None of the 23 remaining companies, including six companies that converted to cash balance plans in 1999, made any disclosures about transition effects.

In summary, only 16 of the 39 companies (including the six companies that had adopted the plans in 2000) disclosed transition effects. Twelve of those 16 had eliminated the wear-away effect; four had not. The other 23 made no disclosures in 1999, making it impossible to gauge the wear-away effect for these companies.

Assessment of disclosures related to key factors. The disclosures related to the key factors of cash balance plans were inadequate and sketchy. Most companies disclosed the cash balance formulas, but only two disclosed the interest rate used. The payment option of the plan was disclosed by only three of the 33 companies. Only 16 of the 39 companies with cash balance plans disclosed their handling of the wear-away effect.

Additionally, four of the 39 companies stated in a footnote that changes in the pension plans would have no material effect on the company’s operations for 1999 (the authors assume that operations is used here as a synonym for net income). None of the companies, however, stated how large that effect on net income might be.

It is debatable whether the pension information required to be disclosed is helpful to financial statements users. The above analysis of companies indicates a need for additional disclosures in order to enhance understanding of cash balance plans.