What does the cash balance plan controversy mean for company valuations? A recent study by Bear Stearns & Co., New York, has spotlighted the significance of pension plan income for corporate earnings. Pension income is, generally, earnings generated by assets in the pension plan in excess of pension plan liabilities. According to the report, in 1998 pension income accounted for 3% of operating income at the companies in the Standard & Poor's 500 index. In other words, 3% of corporate income is generated by assets sitting in pension plans.
As this accounting reflects, defined benefit plan assets are generally regarded, by corporations and accountants at least, as corporate assets. Since a corporation is liable if its plan is underfunded, it should have the assets if the plan is overfunded. Whoever bears the downside risk gets the upside potential.
The Bear Stearns report does not question that pension income should be reflected on corporate books, only that it should be reflected as investment income, rather than operating income. Which seems a fair point, as income on pension assets is generated by money management, not by corporate operations.
But, for some companies, it isn't clear that the surplus is a corporate asset at all. A company that maintains a traditional defined benefit plan and intends to continue it for the foreseeable future can use the surplus to reduce future contributions. That surplus could be regarded as working for the employer, because it will be used to compensate workers for future services, which will increase earnings.
But, what if an employer decides the traditional defined benefit plan is no longer competitive, because it rewards older, career employees, and the company is dependent on younger, short-time employees? A defined contribution plan benefit design works best for those employees.
In this situation, many benefits consultants would suggest converting a traditional defined benefit plan to a cash balance plan. But why? Can't you accomplish almost everything a cash balance plan accomplishes by freezing your DB plan and adopting a defined contribution plan? Not if the DB plan is overfunded. Recouping the excess pension assets is an expensive proposition these days, thanks to the reversion tax.
A cash balance plan, on the other hand, seems like the perfect solution. It allows an employer to use the surplus to finance a more competitive benefit and pay for expensive "grandfather" transition benefits.
Until, that is, Sen. Daniel Patrick Moynihan, D-N.Y.; Sen. Tom Harkin, D-Iowa; and Rep. Bernie Sanders, I-Vt. -- each with his own piece of legislation -- try to frustrate or prevent your cash balance conversion.
First, you will be required to describe what's going on in terms that almost dare employees to fight back -- through internal pressure, unionization and litigation.
Second, key plan design tools, such as the ability to "wearaway" unrealistic lump sum values, will be taken away. Third, you'll be required to grandfather a large group of employees in the old plan formula.
And then the lawsuits start. You are accused of age discrimination, because that wearaway hits older employees much more than younger ones. In addition, there is this provision of the tax code (and the Employee Retirement Income Security Act and the Age Discrimination in Employment Act) which some -- including the lawyer suing you -- think makes all cash balance plans illegal. Then there is the claim that the cash balance plan is just part of a larger conspiracy to force old-style (read: older) employees out of your business.
And when you're done buying off the litigants and appeasing the legislators with more generous grandfather benefits, your surplus has gone up in smoke. Which, in the long run, is OK, because the cash balance plan fits the work force you need, and the traditional defined benefit plan didn't. But in the short run, your profitability suffers.
So, in what sense did that defined benefit surplus belong to the corporation? It belonged to the corporation only so long as the corporation didn't touch it -- that is, so long as it was used to finance the traditional defined benefit plan.
Some of the proposals in Congress could do major damage to the defined benefit system. They attack one of the fundamental elements of the defined benefit deal: that as long as the employer has the downside liability for plan underfunding it is entitled to the upside benefit of any overfunding.
If employers cannot, because of legislated changes, make effective use of overfunding in a traditional defined benefit plan, they will underfund, or they'll simply get out of the DB business.
Is it possible the legislators leading the attack on cash balance plans already have written off the defined benefit system? The reality is, for most of Rep. Sanders' constituents, for instance, there will be no new, start-up defined benefit plans, only 401(k) plans. And maybe he and his colleagues have concluded that all that's left to fight over is the surplus in the defined benefit plans that remain. That fight is between those who want to use that surplus to provide a traditional defined benefit plan, which benefits primarily older employees, and those who want to use it to provide a defined contribution-like benefit, which doesn't.
From this point of view, the cash balance plan debate now raging is in fact a rearguard action over defined benefit plan surpluses.
Arguments can be made on both side of this dispute. But the most significant point for investment professionals is that there is a dispute.
Which presents the following question: How should a company with a sizable defined benefit plan surplus -- which annually throws off significant pension income, whose work force needs are not served by a traditional defined benefit plan design -- be valued?
The question presupposes that, for some companies at least, an overfunded traditional defined benefit plan is no longer a useful compensation tool. And, in the view of some, it does not matter what damage is done to the defined benefit system, because that system is, for all intents and purposes, dead.
Others -- perhaps a majority of those involved -- would call this view grossly unfair. Some argue that a defined benefit plan, even today, can still be put to good use. It is a convenient vehicle for providing transition benefits in converting to a defined contribution design. It is useful as a continuing vehicle for early retirement windows -- incentives for more senior employees to retire -- and it can be a vehicle for attracting mid-career hires.
What can be said is this: A corporation's pension "asset" has been the source of constant controversy for several years. Those who maintain there are other "stakeholders" in that asset besides the corporation have not, and probably will not, go away. And some re-evaluation of the pension income's significance to the corporate P&L may be helpful.
Mike Barry is president of Plan Advisory Services Group, a Chicago-based firm that consults with financial services institutions on legal and regulatory issues of their plan sponsor clients
