Cash-Balance Pension Plans: A Wolf in Sheep's Clothing?
Defined-benefit fans tout this hybrid, but taxpayers need protections.
Across the country, the pension reform debates have spurred a lot of talk about how to fix the mess created by runaway defined benefits plans that promised more than they could deliver. So it's no wonder that pension skeptics are suspicious about the latest scheme to emerge from traditional pension advocates, notably the labor groups and many in the actuarial community, who have proposed "cash balance" plans as the new panacea.
Rumor has it that a long-awaited back-room pension reform deal is expected to emerge next month from the Democrat-dominated California legislature and that it will include a cash-balance plan. So now seems a good time to explain the issues that should be aired before the legislators approve a bill — apparently without public hearing — in a last-minute fait accompli to beat the November ballot deadline.
How they work. For those unfamiliar with cash balance plans, they are sometimes known as "defined-benefit plans in drag." Cash balance plans offer some of the features of both defined-contribution (DC) and defined-benefit (DB) plans. Participants are still guaranteed a minimum benefit and can collect a life annuity upon retirement — which provides more security from investment risks and longevity risks than a private-sector 401(k)-type individual DC account. In some plans, including public sector plans, there's market upside for participants if investments perform better than the guaranteed floor rate. Each participant is credited annually with interest (accretion) on the employer and employee contributions, but instead of controlling an individual account and making their own investment decisions, that's all done by the pension board. Small wonder that plan administrators, investment managers, consultants, actuaries and everybody who's making a living from pension funds like this idea: They all enjoy job security with this plan.
The cash-balance account of each employee is then credited each year with a minimum return, often set at something close to the government bond yield. So, their money grows at a rate that typically runs a little ahead of inflation and is fully guaranteed by the plan. But the system also tracks the fluctuating returns on its investment portfolio and can distribute a "special dividend" or a phantom value to the employee if markets outperform a stated threshold. Some cynics would call this having your cake and eating it too. Upon retirement, the employee converts the value of the account into an annuity-pension based on the better of the base rate or the phantom values if the markets have been friendly. The actual mechanics are more complicated than that, but those are the key concepts.
Note that the employer still bears actuarial risks under this arrangement, not the employees or the retirees. If the actuaries price the life annuity incorrectly, the plan will suffer a loss. If investments fail to produce the guaranteed floor rate, as some of them did in the past decade, the employer is likely to be left on the hook one way or another unless the plan accumulates a loss reserve from excess earnings in the fat years. Taxpayers still underwrite this system in most cases. The big difference, therefore, is that the minimum crediting-rate guarantee of the cash balance plan is far lower than the discount rate typically used for traditional defined benefit pension plans that presently assume a 7.5 to 7.75 percent rate of return on average. And there are fewer opportunities for employees to game the system with enhanced benefits, because the employee's account balance "is what it is." The contributions are defined at the payroll site and everything else is left to the pension plan, not to legislative meddling or collective-bargaining abuses.
Pros and cons. Proponents of the cash-balance structure like its institutional features: (1) lower investment costs through pooled institutional investments that are clearly less costly than the individual mutual fund accounts typically used in 401(k)-like defined contribution plans, and (2) pooled longevity risk so that nobody can outlive their money. Both of these are strong positives. Opponents of the cash-balance plan include taxpayer groups who still distrust the employer's underwriting risks, and the U.S. Chamber of Commerce which resents the political intervention and meddling of the large pension plans in corporate governance when some of the same plans have failed notoriously to clean their own doorsteps first. Needless to say, the Investment Company Institute and the mutual fund industry would prefer individual accounts, but that is industry self-interest at work.
There is a good case to include a cash-balance feature in the retirement options provided to public employees. To meet the taxpayers' litmus test, three important controls that should be incorporated in the plan design are (1) a conservative guaranteed floor rate that does not exceed 10-year government bond yields, and unless a substantial reserve is first accumulated, (2) a portfolio mix that invests no more than 50 percent in equities in order to minimize investment risks borne by taxpayers during "lost decades" such as 1970-79 and 2000-09 and (3) the crediting rate for any phantom accounts must discount the plan's investment portfolio returns by the implicit annual premium cost of the "put option" that the employees all enjoy by virtue of the guaranteed floor rate. The latter provisions are needed to prevent "shoot for the moon" gamesmanship by pension trustees who want to play the spread between bond yields and historical stock market returns at the taxpayers' risk. Finally, the actuarial tables used to price the life annuities upon conversion must be sufficiently conservative so that the plan offers a better deal than a profit-making private insurance company, but not the giveaway pricing that many public pension plans have offered previously with their "air time" and "DROP" accounts. Otherwise the plan will still retain at least half of the risks now borne by taxpayers in pension funds — and the virtues of the cash balance plan will be wasted away at the back end. Experience has shown that self-interested employees will spend countless hours finagling to game the system, and these potential abuses need to be boxed out completely in the plan design.
Paired plans. Finally, it makes sense to offer the cash-balance option along with a traditional defined contribution plan, as the primary options for new employees. This allows employees who want more aggressive investment options to control their own investments through individual accounts and enjoy the portability of qualified defined contribution plans. The two plans will have very distinctive risk-return characteristics. Those who want guarantees would elect the cash-balance plan and must accept lower potential returns on the upside. (My hunch is that over 70 percent of public employees are risk-averse and will select the cash balance plan if it offers some reasonable upside.) Kansas legislators proposed exactly that combination in a recent bill that has cleared its house of representatives, and I expect we'll see more pairing along that line. The employees who elect into the individual accounts can also be given a cross-walk option to buy a retirement annuity from the cash-balance plan once they retire. Such a combination should satisfy partisans on both sides of the legislative aisles. Although it adds complexity, I would even support a benefits menu that also includes a reformed pension option for new hires if its design features follow the outlines I have suggested in previous articles. Such a DB option should include sustainable longevity-adjusted, higher retirement ages, 50-50 cost sharing, and the pension multiplier must be funded actuarially at a discount rate that does not exceed the coupon yield on the Barclay's Aggregate Bond index. This menu would properly present risks, guarantees and appreciation potential to the entrants who will see that guaranteed lifetime income has a price, and higher retirement income potential comes with risks that they must accept and share.
The cash balance concept has also been promoted in some states as a solution for private-sector employees. I've already voiced my opinion on that idea in a previous column and won't repeat it here. Let's refine the cash balance model in the public sector as a way to reduce taxpayer costs and risks, and once that job is done and the results validated, we can talk someday about whether it's even possible to make such plans risk-free to taxpayers and not the start of another special-interest entitlement program that will invite legislative mischief and intergenerational warfare.
Plan conversions for incumbents. Cash balance plans have been used in the past to convert private sector pensions into a DC structure and get the employer out of the retirement-risk business. That alone would be a worthwhile provision in the public sector — for states to enable public employers to make conversions, where courts haven't elevated vesting to the heights of absurdity. Just think of where the world would be today if public pension plans had been converted to cash balance structures in 1999-2000, instead of awarding employees massive retroactive benefits increases and pension contribution holidays for politicians. (Answer: Taxpayers would now be better off by a half-trillion dollars.)
A bankruptcy alternative or option? In the wake of last week's bombshell pension-plan bankruptcy filing in the U.S. commonwealth of Northern Marianas, a cash-balance conversion could be a solution for distressed pension plans. This would allow current employees an option to convert their underwater traditional defined benefit pension plan's benefit into a cash-balance account, at the actuarial present value of their current plan — but adjusted for its actual funding ratio to reflect the plan's fiscal distress. For example, if the plan is 78 percent funded on a market-value basis, the employee could convert to the cash balance plan at 78 percent of the actuarial present value of accrued benefits. Those who wish to take their chances with the traditional pension plan can stay put if they think the sinking ship will right itself and the employer will not take them through bankruptcy to freeze or cut their pension. If state-supervised double-barreled* pension bonds could be used prudently to finish the job and permanently reduce overall risks to taxpayers, I'd even accept a bonus POB infusion to sweeten the deal halfway between market and par value for the participants.
This remedial structure would probably require state-level statutory authorizations and possibly a federal fix of some arcane federal tax laws or regulations that senselessly make certain DC plan conversions taxable (as "constructive receipt") under the current administration's interpretation. When I look at the problems of desperately underfunded pension plans of distressed employers, a cash-balance conversion option would sure beat bankruptcy as the way to fix the pension mess facing localities whose unsustainable benefits plans are crowding out essential public services and impoverishing their communities. And a mandatory cash-balance conversion could be a viable tool for bankruptcy receivers if nothing else works better.
A similar solution has worked before in the private sector, in somewhat analogous situations. The recent Ford Motor proposal heads in this direction but reportedly offers cash rather than a replacement benefit plan; most public employers and plan professionals would likely prefer the latter for the reasons I've explained above. If public pension advocates would be willing to also work toward that end-game remedy, as well as a two-plan option for new hires along the lines from Kansas and the taxpayer protections described above, I'd warmly embrace the cash balance option.
*A double-barreled bond pledges two sources of security to investors, typically the issuer's general obligation plus a revenue stream such as sales tax revenue. In this application, state-shared taxes or subventions payable to a locality can be pledged and "intercepted" by bondholders as additional security for such bonds if the issuer fails to make timely debt service payments, thus enhancing the credit and reducing the market interest rate. The New York City control board employed this structure in the 1970s, as part of that distressed city's workout plan.