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Hybrid (Cash Balance) Pension Plans

Testimony Before the Subcommittee On Retirement Security And Aging

By depriving older workers - especially long service older workers - of the benefit of their increased years of service and their peak earning years (including any early retirement subsidies), employers who make this dramatic change break the implicit promises made to older workers in the traditional defined benefit pension plan. These employees have given up wages and may have made career and retirement decisions based upon the expectation of a certain pension benefit, only to see that expectation disappear -- replaced by the new cash balance plan formula under which their age precludes them from earning comparable benefits.

In addition, some older workers may suffer a wearaway period - a period of time when no new benefits are accrued under the new plan. Older workers thus experience a double whammy - loss of the more beneficial defined benefit formula, as well as the lack of time to benefit from the new plan formula (with the potential for no new benefits at all).

The conversion to a cash balance plan adversely affects older, longer service workers in at least four ways:

A traditional defined benefit plan often has a benefit formula that is based on number of years worked and final average salary. In addition, the annuity value is determined by number of years from retirement age, with greater value for those closest to normal retirement age. This final average pay benefit formula design provides smaller value in the early years of employment, with the greatest value coming in the last years of employment.

Because this plan is designed to benefit longer service workers, older workers generally can accrue larger benefits under this traditional type of formula, especially if they are long-service workers. Younger, more mobile workers receive less from this plan design. A younger worker covered by a traditional formula, in addition to being many years from retirement age, generally has a lower salary and a smaller number of years of service. The result is a small benefit after only a few years of work. As one begins to approach retirement age, and as one's salary and number of years in the plan increase, benefits begin to grow more dramatically. The bulk of benefits can be expected in the years just prior to retirement.

The effect of increasing age and higher salary can be magnified by eligibility for an early retirement subsidy. Many traditional defined benefit plans include such a subsidy, generally based on a combination of number of years of service and age. Older employees who become eligible for these subsidies can see an additional spike in the value of their pensions. Conversions commonly eliminate these subsidies.

Compounding the adverse impact of the change in benefit formula, the benefits under the new plan, in essence, may take many years to catch up to the benefits already earned under the old plan formula. During this catch-up period, the employee would accrue no new benefits. This freeze of pension accruals stands in sharp contrast to employees' expectation that their final years of service would result in the greatest increase in their retirement benefits.

Such a wearaway can occur if the employer designs the conversion to give employees an ultimate pension benefit equal to the greater of (i) their old formula benefit (earned based on service before the conversion and fixed as of the conversion) and (ii) their cash balance earned under the new formula. Under this "greater-of" approach, as long as the frozen old formula benefit exceeds the new formula benefit, the participant is not actually earning any additional benefits under the plan. The participant's total benefit is effectively frozen after the conversion until the new formula benefit grows larger than (wears away) the old. This could take 10 years or more. In the meanwhile, older participants suffer an age-based cessation of accruals. 

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