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1999
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(12/6/01) - Further evidence emerged yesterday that the days of defined benefit pension schemes could be numbered. Instead of looking forward to a comfortable company retirement pension based on final salary and time served, more and more employees are becoming more directly dependent on the vagaries of the stock market with defined contribution schemes.

According to the latest annual survey by the National Association of Pension Funds, 46 companies ditched their final salary schemes in the year to October. This compares to 18 the year before.

The employers give many reasons for abandoning defined benefit schemes -usually for new employees only - and they are mostly entirely understandable, from a corporate point of view.

The gyrations of the stockmarket, they say, makes them unwilling to commit to set levels of future payouts. Legislation - such as the 1995 Pensions Act - regulation, red tape and the new accounting standard FRS17, which will oblige companies to offset pension fund shortfalls against profits, are all mentioned as contributors to the decline of final salary schemes.

Some of Britain's traditionally most paternalistic employers are among those to have thrown in the towel - corporations such as BT, Lloyds TSB and Sainsbury.

Last month Marks & Spencer announced it was bringing down the shutters on its final salary scheme for new staff and last week supermarket chain Iceland demonstrated the financial millstone such schemes can become when it revealed it was having to increase its contributions from £4m to £14m to assure the pensions of 25,000 staff (though the Booker scheme it inherited last year when the two companies merged had just enjoyed the benefit of a six-year pensions holiday).

There is one flaw in the arguments of those ditching final salary schemes. If the rationale behind the decision is simply all about accounting standards and red tape why do the vast majority also slash their contributions, by about a third, when they move to a new defined contribution scheme?

This has the unmistakable whiff of another scandal in the making, just like the pensions misselling affair, when people realised they had been persuaded into policies which would leave them worse off.

It is the current crop of twenty- and thirtysomethings who are likely to be the biggest losers because the switch to defined contribution schemes could take years to have a substantial impact.

Indeed, such a long time that it is unlikely to be a priority for this government as the present crop of politicians will be long gone by the time this particular waste matter makes contact with the wind machine.

This quote is from “Firm commitment,” by Cecily Fraser (CBS.MarketWatch.com):

“While companies aren't allowed to set age requirements, they are making it a point to search for candidates with a solid work history, (David) Pascualy said. ‘They don't want someone who's been a job hopper, so that leads me to believe they want to sign people who've been stable in the marketplace for a long time.’"

But hold on a minute. The whole purpose of the cash balance pension plan conversion was to cater to job-hoppers. Companies were praising “the new mobile workforce.”

Could it be that this was not the real reason for the conversion? Could it be that the real reason was to transfer pension money from employees to the companies' bottom line?

If companies truly want job-hoppers, there are plenty of people who would like to work for a couple of weeks to pick up some beer money. When they run completely out of money, they would be willing to work for another week or two. Now, companies are revealing that they do not really want job-hoppers.

Did anyone actually believe the “mobile workforce” hogwash anyway? Not only were most cash balance conversions a disaster for employees, but the companies could not even come up with a decent cover story. They did not want to come right out and say: “We want your pension money.”

If companies have realized that they really do want committed employees, the very least they can do is to honor the pension and health promises made to those employees. If they are not willing to do this, then all they deserve is Job-hopping Joe (he’ll work two weeks, and then not show).

PGEpension.com is a new pension website that you should take a look at. Employees of every company affected by pension scams should have their own site.

These sites serve to inform other employees of information that the companies try to suppress. They also give prospective new employees a heads up on what to expect.

PGEpension.com tells of the pension problems that Portland General Electric have faced. The problems are almost universal. Check out other employees sites to get a good overview of what we are all up against.

PGEpension.com

The past 12 months or so brought a revelation to many 401(k) participants: Stocks can actually lose money. This knowledge throws into sharp relief the serious flaws in the burgeoning defined-contribution retirement system. The average 401(k) account held just $41,919 -- woefully inadequate to meet the needs of the typical retiree, even allowing for further contributions and investment growth.

Some commentators, including Barron's Editorial Page Editor Thomas G. Donlan, have praised a bill from Rep. John Boehner, an Ohio Republican, that would allow plan administrators to contract with finance professionals to provide advice to participants running their 401(k) and similar accounts.

Too little, too late, and too expensive: Although the current system seems robust, the exodus from traditional defined-benefit plans to the employee-managed defined-contribution paradigm is a social and economic time bomb primed to explode sometime within the next few decades. Here are some of the reasons:

• Employees are not saving enough. A worker who earns a constant real salary from age 20 to 65 and saves 10% of it requires a 4% real investment return to sustain a 20-year retirement at the same inflation-adjusted salary level. But most younger workers have relatively low incomes and no savings at all; starting later, at age 30 or 40, raises the required real investment return to 6% to 8%.

• Future returns will not be nearly this high. The long-term price increase of stocks must track that of earnings and dividends. Over the past century, this has been 2% per year adjusted for inflation. New Paradigmistas point out that reinvested earnings, stock buybacks, and technology-driven improvements in productivity will result in increased earnings growth. But from 1950 to 1975, annualized real per-share earnings growth was 2.2%; from 1975 to 2000, it was 1.9%. Add a 1.45% dividend yield and you get an expected real stock return of just over 3%. The 7% real stock returns seen in the 20th century resulted from a combination of this 2% real earnings growth and dividends averaging 5%; anyone forecasting the same returns going forward should wear a sign that says, "I Can't Add!"

• The average long-term investor will receive the market return minus plan expenses. The typical 401(k) plan is an absurdly expensive vehicle with fees approaching 3%, according to benefits consultant Brooks Hamilton. Add commissions and other costs from frenetic trading at the funds. The typical fund company services participants in the same way that Baby Face Nelson serviced banks.

• Poor allocation decisions further degrade performance. At one major company surveyed by Bart Waring of Barclay's Global, almost half the participants owned only one or two funds, incurring unnecessary risk. Worse, many companies encourage purchase of company stock in their retirement plans, exposing employees to the double jeopardy of losing both paycheck and nest egg if the company fails.

Watson Wyatt Worldwide examined 252 large companies with both defined-benefit and 401(k) plans for the 1990-1995 period. It found that the defined-benefit plans bested the 401(k) plans by 2.4% per year. (The defined-benefit plans were no great shakes; from 1987 to 1999, the nation's largest pension plans underperformed a 70/30 benchmark of global stocks and bonds by an average of almost 2% per year.)

Even scarier are the results in the 401(k) plans of the most prestigious financial services corporations: For 1995-1998, the annualized returns of the 401(k) plans at Morningstar, Prudential, and Hewitt Associates were 13.5%, 10.5%, and 11.8%, respectively, versus a 21.2% return for the global 70/30 mix. If employees at the nation's most sophisticated financial companies can't get it right, what chance do folks on the assembly line at Ford have?

Given low equity returns, high expenses, and poor planning, it is likely that most 401(k) investors will obtain near-zero real returns in the coming decades. Further, a substantial minority will have disastrous results. Only a lucky few will save enough and obtain the 4% to 8% real returns necessary for a comfortable retirement (that is, aside from their bosses, who were smart enough to retain their traditional defined-benefit plans). When the boomers retire between 2010 and 2030, most will find the cupboard bare. The inevitable government bailout will make the savings and loan resolution of the last decade look like lunch at Taco Bell.

Meanwhile, a real dogfight has erupted between investment advisors and the brokerage industry over the Boehner bill. Little wonder: In the July 23 edition of Investment News, industry sources estimated the size of this market at $18 billion per year. Calculated against the total defined-contribution $3 trillion asset base, that's another 0.6% of annual return flying out of the pockets of employees and into the industry's coffers. The notion that several hours of canned questionnaires and PowerPoint presentations will turn the average corporate employee into a well-informed, disciplined investment manager is absurd to anyone with the remotest sense of financial history and human nature.

We've seen this movie before, and it doesn't end well. In the 1920s, millions read Edgar Lawrence Smith's Common Stocks as Long Term Investments and convinced themselves that they would never sell their stocks. Unfortunately, they did. The investment bestseller of the next decade was Lawrence Chamberlain's Investment and Speculation, which flatly stated that only bonds should be purchased for investment purposes. The late 1960s saw a renaissance of popular enthusiasm for common share ownership, with more than one-third of households owning stocks. Real returns over the next two decades were nearly zero, and by 1979, when BusinessWeek famously proclaimed "The Death of Equities," just 16% of households held stocks. The average participant is a long-term investor only the way that Tony Soprano is a Catholic.

The defined-contribution system is broken; we just haven't realized it yet. While it may be possible to fix it by providing participants with much closer attention to expenses -- the exact opposite of what the Boehner bill accomplishes -- it makes more sense to improve the defined-benefit system with equitable vesting, portability and liability protection. These plans operate at a much higher level of efficiency and competence, with correspondingly higher and more uniform returns, than the ever-growing hodgepodge of expensive employee-run accounts.

Such a paternalistic approach may offend those who make a philosophy out of self-reliance. But most people don't build their own cars or remove their neighbors' kidney stones. We should treat retirement investing the same way. If an employee wants to manage his own retirement account, he should at least be able to show competence in the basic principles of investing, such as the differences between stocks and bonds, the fundamentals of prudent diversification, and the impact of expenses on returns.

The self-managed defined-contribution concept is fatally flawed. While Wall Street pros may (or may not) be getting it right, the overwhelming majority of employees are floundering, bewildered by a subject they only dimly comprehend. The time has come to throw workers a lifeline, in the form of meaningful pension reform, before we all drown.

The company was a media darling. Its story line: It would bring a different era to a hidebound industry, delivering it from rusty shackles to the promised land of lean-and-mean competition.

The company flew high. Then it crashed calamitously low, taking its workers and retirees, but not its corporate officers, down with it. Retirees who'd been promised much were summarily told they'd get little after bankruptcy. And they would only get that because their old-fashioned, defined-benefit retirement plan was protected by a federal guarantee.

Old men took to the streets, throwing themselves at plant gates, crawling beneath trucks. They picketed government offices. They pleaded with Congress.

Laws were passed, vows were made. Never again, lawmakers said, would the government allow a flagrant corporate fleecing to lay its retirees so low.

The LTV Corp. bankruptcy of the mid-1980s (the steelmaker entered bankruptcy again last December) was altogether different from the Enron 401(k) debacle of today. Then, important people shrieked with outrage. Now they do not even whisper concern.

The Enron workers who invested their life savings in the company's stock through its 401(k) plan are broke. They must get in line at bankruptcy court, behind the big banks and the brokerages and the energy companies who are, without question, ahead of them.

Details of the caper are shocking, if not illegal. The company fraudulently pumped up its stock price with false information. It gave employees company stock, not cash, for the 401(k) plan's company "match" and encouraged them to buy more on their own. It blocked workers from selling the stock as it was becoming worthless - even as corporate officials sold theirs.

The Enron crash is a parable. The story so far is spun out as one of loyal but gullible workers who just don't get it. The TV financial advisers are saying, of course, you should not invest your retirement money in the company for which you work. Didn't you know that?

It is dandy advice for an investing public that, surveys show, cannot necessarily tell a stock from a bond. But its very premise reveals a crisis that is truer, and deeper.

They have sold us the idea that retirement is a do-it-yourself project.

The beauty, if you are an employer, is that if something goes terribly wrong, there is no contractor to sue. Most of the cost, and all the risk, is on the worker.

In exchange, workers are told they can, on their very own, build the Taj Mahal. All they need do is use well this wonderful new tool.

That is the advertising, anyway. Here is the truth: The average 401(k) balance last year was $49,000, according to the Employee Benefits Research Institute. That was before this year's downward stock spiral.

We simply don't have pensions anymore. Fewer than half of all private-sector workers are covered by any type of retirement plan, including the savings accounts that go by the name 401(k).

This is by corporate design and congressional collusion.

The last substantial piece of pension legislation enacted was a measure allowing high-income people to invest more money in 401(k)s. The only proposal moving forward now is The Retirement Security Advice Act. It would let your employers, and the big financial companies that oversee your account money, give you advice on how to invest it. Doesn't that sound secure?

There is no apparent rush to shield workers from future Enrons. The last person who tried, Sen. Barbara Boxer (D-Calif.), got thrashed by corporate lobbyists when she tried to limit company stock held by 401(k)s. The Boxer bill was thoroughly diluted. It passed, with language exquisitely crafted to apply to no plans.

Do not ponder this mystery. The financial industry is by far the biggest source of campaign contributions to candidates for federal office. It is the driving force behind President George W. Bush's plan to take Social Security, the only guaranteed retirement income most Americans will have, and turn it into a giant 401(k).

The workers of Enron were unfortunate guinea pigs. This botched experiment, if not brought to a halt, will one day produce a generation of retirees driven to throwing themselves under trucks.

Legendary stock investor Warren Buffet blasted pension fund accounting practices in a Fortune magazine article.

Mr. Buffet said: "I think that anyone choosing not to lower assumptions -- CEOs, auditors, and actuaries all -- is risking litigation for misleading investors. And directors who don't question the optimism thus displayed simply won't be doing their job."

Plan Sponsor reports that worker retention and reducing benefit expenses are the two top priorities of corporations. Have you ever seen more contradicting objectives? The report was based on a benefits study conducted by MetLife.

A well know energy company is noted for creating an endless stream of positive affirmations. They could take the opposing objectives above, and create another nonsensical affirmation: “We will retain employees by cutting their benefits to the bone.”

Companies can parrot their affirmations all they want to, but it’s not going to happen. And, since when do corporations want to retain employees? The new disposable employee was supposed to be the driving force behind cash balance pension conversions. It was clearly implied that employees are considered almost valueless by corporations. Cash balance plans were supposed to cater to the new breed of job hoppers.

The cover story was that companies now wanted employees to work only a few years and then move on. The fact that most of the pension converting companies made a killing on these conversions was downplayed. The hardships placed on loyal employees were downplayed and even denied.

Now, out of the blue, corporation want to retain employees! Did someone realize that real expertise cannot be developed in a few years? And, any expertise developed in a few years leaves the company when the employee leaves.

Now the new employer tactic of the month is to attempt to retain employees, but chop away at their benefits the whole while. There is one benefit that corporate management provides employees that cannot be improved: The entertainment value of their proposals is world-class!

Business Horizons published a compressive article, “The Effects of Adopting Cash-Balance Pension Plans,” by Mary Maury. For those without the time to read the whole article, a few quotes are offered below:

“The problem with adopting a cash-balance plan is that it will usually result in decreased benefits to long-time workers.”

“At almost every level, the cash balance is considerably less (by 50-70 percent) than the accumulated benefit…”

“…the employee benefit for long-timers is doubtful. On the other hand, the employer benefit is clearly secure…”

“The most obvious penalty to long-time workers is the wearaway feature of conversions…”

“Firms are reluctant to avoid this feature (wearaway) because they can save money during the period of five to ten years when older workers cannot earn a benefit.”

“In addition to the wearaway feature, there are other decrements to the benefits of a longtime employee that are less evident because of the lack of comparability of the plans and the reliance on numerous assumptions that the firm may not reveal.”

"IBM said its retreat was entirely driven by the employees, who barraged the company with emails and other correspondence, and used the Internet to stoke their collective anger."

“Because IBM was pressured into extending this option to include more workers, other firms may follow suit.”

“Other companies aware of the negative publicity have gone out of their way to provide greater choice to their employees. Northern States Utility, which gave every employee a choice to stay in the traditional plan or opt out for the cash-balance one, had no difficulty.”

“Employees of AT&T, who have brought suit against the company, may have had their hand strengthened.”

“Niagara Mohawk Power has revamped its (cash balance) plan in the face of employee resistance.”

“…the option to remain with the old plan is the best protection against reduced benefits for long-time employees.”

“By decreasing benefit obligations through the conversion of a traditional defined-benefit plan to a cash-balance plan, the company can reduce its liabilities and add to its surplus, thereby boosting earnings.”

“…the practice of recording income from a pension plan is ethically questionable and may, at a minimum, be misleading to investors if included in operating income.”

“At a benefits conference in 1984, consultants assured various firms that they could reduce pension costs 25-40 percent by converting to a cash-balance plan.”

Everyone is encouraged to read the article:

The Effects of Adopting Cash-Balance Pension Plans

Lee A. Sheppard (Tax Notes) offered a detailed report of the Onan cash balance pension settlement with its employees. The settlement report was very interesting:

“Onan's settlement would not only compensate the plaintiff class for what they had lost on conversion to a cash balance plan, but also would make all of them better off than they would be had they remained in the original, unconverted floor-offset arrangement…Onan itself estimated that the settlement could cost as much as $40 million, divided equally between the future increases affecting all plan participants and the retroactive correction of insufficient payouts to former participants.”

Did Onan executives agree to give up the cash out of the goodness of their hearts? No. They came clean because the employees sued their pants off. Occasionally, justice prevails, but only for those who demand it.

What will greedy corporations do without the money taken from employees through cash balance pension conversions? Well, executives could always hang out in alleys, and snatch purses from little old ladies.

Onan Settles Retirement Plan Lawsuit

An Illinois district court judge recently ruled that Xerox Corporation's cash balance plan was using the wrong interest rate assumptions to calculate pre-retirement lump sum payments for terminated vested participants, and ordered the plan to recalculate lump sums for all participants who have received such distributions since January 1, 1990. The case is Berger v. Xerox Corporation Retirement Income Guarantee Plan, (2001 WL 930142 (S.D. Ill.)). This ruling, similar to rulings in related cases of Edsen v. Bank of Boston (229 F. 3d 154 (2nd Cir. 2000)) and Lyons v. Georgia Pacific (221 F.3d 1235 (11th Cir. 2000)), again demonstrates the perils of using anything other than the so-called "417(e) rate" in determining interest credits under a cash balance plan.

The Big Picture

The Xerox case is now the third in a line of cases in which cash balance plan participants have challenged their plan's method for calculating pre-retirement lump sum distributions. So far, cash balance plan sponsors have been on the losing side in all three cases.

By way of background, IRS and Treasury have taken the position that:

1. all defined benefit plans — including cash balance plans — must define participants' accrued benefits in terms of a life annuity commencing at normal retirement age, and

2. all pre-retirement lump sum distributions from defined benefit plans — including cash balance plans —may not be less than the present value of that accrued benefit, determined according to the method spelled out in Code Section 417(e)(3) and accompanying regulations.

According to IRS and Treasury, cash balance plan sponsors must use the so-called "417(e) rate" — currently the 30-year Treasury rate and previously, the PBGC interest rate to calculate the present value of participants' accrued benefits for purposes of lump sum distributions. Thus, if a cash balance plan's interest crediting rate differs from the 417(e) rate, it will be projecting benefits to the participant's normal retirement age using one rate, and discounting them back to the present time using another rate, potentially resulting in a prohibited "cut-back."

The Xerox Cash Balance Plan

Under the terms of Xerox cash balance plan, Xerox periodically allocates pay and interest credits to participants' hypothetical accounts. The pay credits equal 5 percent of the participant's annual compensation; interest credits are based on an average of the one-year Treasury bill rate for the previous year, plus one percent (the Interest Crediting Rate).

If vested participants leave Xerox before reaching the plan's normal retirement age of 65, they can defer payment of their benefit until that time or elect an immediate lump sum distribution. Pay credits end when a participant's employment ends, but interest credits continue until the participant's entire benefit attributable to his or her hypothetical account has been distributed.

The Xerox cash balance plan provided that when the plan pays a pre-retirement lump sum benefit, rather than using its regular Interest Crediting Rate, it uses the lower 417(e) rate to project the cash balance benefit to normal retirement age. The purpose of using an interest rate lower than the plan's Interest Crediting Rate for this projection is to avoid the so-called "whipsaw" problem. The whipsaw effect occurs in a cash balance plan when calculating the lump sum benefits an employee takes when leaving a job. Generally, the participant's current account is projected forward to age 65 at the plan's stated interest-crediting rate, and then converted to an annuity. If the participant is leaving service, the annuity is converted back to a lump sum, and then discounted back to the participant's current age using the required 30-year Treasury rates. This very complex calculation is the whipsaw. If the plan uses a higher interest-crediting rate than the Treasury rate in calculating the benefits at retirement age, the participant's lump sum benefit when leaving employment would be much higher than the current account balance.

Case Summary

The lead plaintiffs in the case, David Berger and Gerry Tsupros, are former Xerox employees who received pre-retirement lump sum distributions from the Xerox plan in 1995 and 1998, respectively. Berger and Tsupros challenged the manner in which Xerox determined their lump sum payments. In particular, they claimed that ERISA and the Internal Revenue Code require Xerox to project their hypothetical balances to normal retirement age using the plan's (higher) Interest Crediting Rate, discount that amount to a present value using the (lower) 417(e) rate, and distribute the resulting amount (which would be higher than the value previously communicated to them as their hypothetical account balance in the cash balance plan).

The district court — relying heavily on the 2nd Circuit's decision in Bank of Boston and the 11th Circuit's opinion in Georgia Pacific (see sidebar, p. 3) — ruled in favor of the plaintiffs. According to the court, "there is no longer any dispute that cash balance plans must comply with the requirements imposed on defined benefit plans." These requirements, the court pointed out, include defining a cash balance plan participants' accrued benefit in terms of a life annuity commencing at the plan's normal retirement age instead of the balance in their hypothetical cash balance accounts.

Interest Rate Assumptions

Next, the district court turned its attention to the interest rate assumptions Xerox uses to project cash balances to normal retirement age and to discount that amount to a present value. As described above, when the Xerox plan pays a pre-retirement lump sum based on a participant's cash balance account, it projects the benefit to normal retirement age using the lower 417(e) rate rather than its regular Interest Crediting Rate in order to avoid the whipsaw problem. The issue — which is identical to the issue in the Bank of Boston case — is whether Xerox can do this without violating ERISA's vesting requirements. The district court reached the same conclusion as the 2nd Circuit: it cannot. In order to satisfy the vesting requirements the district court specified that the Xerox plan must project each participant's cash balance account "to normal retirement age at the Interest Crediting Rate in effect as of the date of distribution."

Conclusion

The plaintiffs plan to ask the court for total damages of between $100 and $300 million. Xerox intends to appeal the district court's decision. Assuming Xerox follows through on its appeal, the 7th Circuit will be given an opportunity to weigh-in on these issues. If that court overturns the district court decision, that may set the stage for review of these principles by the Supreme Court. (Note that both Georgia Pacific and Bank of Boston appealed the result in their respective cases to the Supreme Court. The Supreme Court has announced that it would not review the 11th Circuit's decision in Georgia Pacific, and that case has been returned to the district court level to determine damages. Bank of Boston decided to settle its case before the Supreme Court had the opportunity to rule on its petition for review.)

The Xerox and Bank of Boston cases make clear that for plans that use an interest rate that exceeds the section 417(e) rate for determining interest credits to participants' accounts generally, it will not be permissible to switch to a lower 417(e) rate to project benefits for terminated participants in order to avoid the whipsaw problem. Thus, in order to avoid potential legal problems, many cash balance plan sponsors may want to simply use the 417(e) rate as their interest crediting rate.

Lyons v. Georgia Pacific

In Lyons v. Georgia Pacific, (221 F.3d 1235 (11th Cir. 2000)), the cash balance plan paid pre-retirement lump sums to participants based solely on their cash balance account balances. When challenged, Georgia Pacific argued that the applicable Treasury regulations overstep their statutory bounds — and thus are invalid — to the extent they require defined benefit plans to use the Section 417(e) method to calculate all pre-retirement lump sum distributions. The statutory language of 417(e) now in effect indicates that it applies only for purposes of determining if a terminated vested participant's accrued benefit can be cashed out without his consent.

The 11th Circuit rejected Georgia Pacific's claim and upheld the validity of the Treasury regulations, with respect to lump sum distributions occurring before 1995. Because the lump sum distributions at issue in that case occurred before 1995, the court analyzed the Treasury regulations in the context of the 417(e) language in effect at that time. Before Congress amended the provision in 1994, 417(e) included language that arguably suggested it applied to all defined benefit plan lump sum distributions. The court did not decide if the 1994 amendments — which, among other things, deleted the relevant language — jeopardize the validity of the existing regulations.

Esden v. Bank of Boston

In Esden v. Bank of Boston, (229 F.3d 154 (2nd Cir. 2000)), the cash balance plan followed the Section 417(e) present value method to calculate pre-retirement lump sum distributions, but projected cash balance accounts forward to normal retirement age using a different — and smaller — interest rate than the plan's interest crediting rate and the 417(e) rate.

The 2nd Circuit ruled this violated ERISA's and the Internal Revenue Code's vesting requirements because terminated vested participants who elected an immediate lump sum received a benefit that was less than the actuarial equivalent of the benefit they would have received if they had deferred the distribution until they reached the plan's normal retirement age.

Retirement Blunders May Cost Xerox $300 Million