In June 1990, Myra Drucker, assistant treasurer and chief investment officer at Xerox Corp., defined the pension agreement between sponsor and employee in a concise, fresh way that bears consideration today in the midst of the cash balance controversy.
Ms. Drucker said, in a speech at a Pensions & Investments conference, that in financial terms, ERISA effectively defined pension promises as debt issued by the plan sponsor.
"This debt is in the form of a number of promises to pay clearly defined benefits to a group of employees upon retirement," she said. "This debt is secured by a group of assets segregated for that purpose -- in effect as collateral for the debt." (It also is secured by the earning power and assets of the corporation, and the Pension Benefit Guaranty Corp.)
"The defined benefit obligation is effectively a collateralized corporate bond. Employees defer cash wages today to purchase an interest in that bond, which they will be paid at the bond's maturity -- that is, their retirement."
This concept of plan participant as bondholder has a significant implication. If the employer takes the deferred wages and invests them successfully, the employee should have no claim on excess assets, because bondholders who lend to a company that then greatly increases its earnings and assets have no claim on them. They belong to the shareholders.
Ms. Drucker did not spell them out, but this "bond" has other significant characteristics.
First, the payout is most often made as an annuity. Second, when a lump sum is an option, it generally is available only at retirement, not on preretirement departure from the company. Third, when a lump-sum payout is provided, the company sets the rate at which the monthly payments are discounted back to a present value. Fourth, the company can terminate the plan (call the bonds) at any time.
Let's now apply the bond model to the cash balance plan. What happens to the bond if a company converts its plan?
The terms of the "pension bond" have been changed unilaterally by the employer. Employees are still deferring wages to acquire the bonds, which are still collateralized by the assets of the fund. But since the final benefit is based on career-average pay rather than final pay, the investment return on the deferred wages often will be lower than under the previous plan. That is, the implied coupon is lower.
On the other hand, the availability of a lump-sum distribution at every age after vesting means the bond has, in effect, been made more liquid.
But there is not one bond issue, there are many different issues. And the holders of some of the tranches perceive themselves as being treated unfairly in the transition.
Those whose bonds are within 10 years of maturity find the terms are unchanged. They have no problem with the conversion.
The newest employees find their original bonds replaced with ones that are more liquid and have greater value than under the terms of original issue. They are happy.
Those in midcareer find their tranche might be more liquid, but if they put it back to the employer, the value is less than the accumulated value of the original bond. In addition, even the final value may be lower than it would have been under the original terms because of career averaging. The added liquidity is seen as insufficient to offset this loss of value.
The terms of their "pension bonds" have been changed without their consent. Looked at in this way, the anger of some employees is more understandable.