Committee on Ways and Means, Subcommittee on Oversight, 6-20-02 Testimony

Statement of Christopher W. O'Flinn,
Vice President, Corporate Human Resources, AT&T Corporation, Basking Ridge, New Jersey, and
Chairman, ERISA Industry Committee

Testimony Before the Subcommittee on Oversight
of the House Committee on Ways and Means

Hearing on Retirement Security and Defined Benefit Pension Plans

June 20, 2002

Chairman Houghton, Ranking Member Coyne, and members of the Subcommittee, good morning. I am Christopher O’Flinn. I am Vice President, Corporate Human Resources, at AT&T Corporation. I also serve as Chairman of The ERISA Industry Committee, commonly known as “ERIC.” I appear before the Subcommittee today on ERIC’s behalf.

ERIC is a nonprofit association committed to the advancement of the employee retirement, incentive, health, and welfare benefit plans of America's largest employers. ERIC's members provide comprehensive retirement, incentive, health care coverage, and other economic security benefits directly to some 25 million active and retired workers and their families. ERIC has a strong interest in proposals affecting its members' ability to deliver those benefits, their costs and effectiveness, and the role of those benefits in the American economy.

At the outset, ERIC wishes to express its deep appreciation for Chairman Houghton’s introduction and sponsorship of H.R. 2695, which clarifies the employment tax treatment of statutory stock options to reflect Congress’s intent and the IRS’s long-standing administrative practice. We are gratified that the provisions of H.R. 2695 were also included in H.R. 3762, which was passed by the House earlier this year. ERIC strongly supports this clarification of existing law and is committed to working with Chairman Houghton to secure its prompt enactment.

ERIC is also gratified that Congressman Portman has introduced H.R. 4931, which would make permanent the ground-breaking employee benefit provisions that were included in the Economic Growth and Tax Relief Reconciliation Act of 2001. ERIC was a strong supporter of those provisions, and we look forward to working closely with Congressman Portman and the members of this Subcommittee to obtain enactment of H.R. 4931.

ERIC also commends Chairman Houghton and the members of the Subcommittee for holding this hearing on retirement security and defined benefit plans. The hearing will help to focus Congressional and public attention both on the importance of the voluntary defined benefit system in providing retirement security and on the improvements that need to be made in the system.

I am pleased to present ERIC’s views both on the role and importance of voluntary defined benefit plans and on the improvements that need to be made in the defined benefit system.

A Fundamental Change in Thinking. We think that it is imperative for Congress to make a fundamental change in its way of thinking about defined benefit pension plans and the laws that govern them in order to encourage rather than discourage the formation and maintenance of such plans. Instead of thinking of defined benefit plans and the governing laws as a source of revenue to be used to achieve Congressional budgetary targets, Congress should think of them as essential tools for providing critically needed retirement benefits to millions of workers and their families. With this objective in mind, Congress should evaluate current or proposed legislation governing defined benefit plans in light of three basic questions:

Employers’ interests: Does the legislation facilitate the ability and willingness of employers to establish and continue voluntary defined benefit plans that meet employers’ business needs?
Employees’ interests:Does the legislation enhance the ability of employees to obtain retirement security?
National interest: Does the legislation strengthen the voluntary retirement system by encouraging employers to establish and maintain voluntary defined benefit plans?

Unless there are affirmative answers to all of these questions, the legislation is likely to undermine, rather than advance, the objective of providing retirement benefits to employees and their families in the context of a voluntary employer-sponsored system.

The pension reform provisions that were included in last year’s Economic Growth and Tax Relief Reconciliation Act were a good step in this direction, and we are very appreciative of the efforts of the Chairman, Congressman Portman, and the other members of the Subcommittee in seeing to it that these provisions were enacted. But more -- much more -- needs to be done.

Because ERIC’s members believe in the mission and ability of defined benefit plans to provide retirement security, ERIC’s members have retained their defined benefit plans. It has not been easy for them to do so, however. The hostile regulatory environment for defined benefit plans requires even ERIC members to reassess their commitment to these plans.

For example, the Labor Department’s Office of Inspector General (the “OIG”) recently issued a critical report regarding lump-sum distributions from cash balance pension plans.^[1] The OIG Report is based on a controversial legal theory that is contrary to both the law and sound retirement security policy.^[2] Both the OIG Report itself and the OIG’s release of related confidential information reflect such a lack of understanding and such a level of hostility toward cash balance plans that the Report could inflict irreparable damage on the nation’s defined benefit system. Attached to this statement are copies of two ERIC submissions setting forth in detail ERIC’s objections to the Report and the OIG’s unwarranted release of confidential information.

The Need for Flexibility, Creativity, and Diversity. Congress needs to foster an environment that favors the creation and continuation of retirement plans and that permits employers to adopt a variety of approaches to providing retirement security. Congress must reform the rules governing defined benefit plans to reverse the dramatic decline in defined benefit plan coverage that has occurred over the past two decades. Congress also must make the law more hospitable to defined contribution plans and to new types of plans, such as “hybrid” plans that seek to combine the best features of defined benefit and defined contribution plans in a single plan.

The same type of retirement plan is not suitable for all employers or for all workforces. Congress should seek to create a regulatory environment that --

allows employers to create plans that work best for them and their employees,
does not unnecessarily restrict employer flexibility with rigid, cumbersome rules, and
allows employers to create new types of plans that do not necessarily fall within the rigid “defined benefit” and “defined contribution” categories.

The Decline in Defined Benefit Plan Coverage. Defined benefit plans provide valuable retirement benefits that typically are (1) not subject to investment risk, (2) guaranteed by the Pension Benefit Guaranty Corporation, (3) payable as an annuity, (4) are provided automatically to employees without any decision to participate on their part, and (5) are not contingent on employee contributions. However, although defined benefit plans provide valuable retirement security benefits to the millions of employees who participate in them, the coverage of these plans is declining, and the pace of decline accelerating. Statistics from a variety of sources point unequivocally to these conclusions:

Since the enactment of ERISA in 1974, the percentage of private sector U.S. workers covered by defined benefit pension plan has dropped from 39% in 1975 to 23% in 1995.^[3]
The percentage of workers participating in defined benefit plans shrank by 0.8% per year from 1980 to 1985, by 2% from 1985 to 1990, and by 2.3 % from 1990 to 1995.^[4]
The number of active participants in defined benefit plans has fallen since 1984 by an average of about 2% per year.^[5]
Between 1979 and 1998, the number of defined benefit plan participants fell by over 22%, from 29.4 million to 22.9 million. During the same period, the number of defined contribution plan participants nearly tripled, from 17.4 million to 50.3 million.^[6]
Between 1988 and 1999, the number of active participants in PBGC-insured defined benefit plans fell by 18%, from 27.3 million to 22.4 million -- notwithstanding the expansion of the total workforce during this period.^[7]
Virtually all of the growth in pension plan participation since the mid-1970s is attributable to the growth of § 401(k) defined contribution plans. Defined contribution plans covered 42% of the full-time employees in the private sector in 1999.^[8]

Why has this happened? From the early 1980s until 1994, Congress piled law on top of law in an effort to meet Congressional budgetary targets by squeezing as much “tax revenue” out of defined benefit plans as it could. Through these laws, Congress created a regulatory climate that micro-managed these plans. The result was to subject defined benefit plans to a bewildering array of complex, rigid, inconsistent, and unnecessarily burdensome legal requirements.

The resulting legal regime has been excessive, oppressive, and convoluted. Its primary effect has been a decline in retirement security. It has discouraged many employers from adopting new plans and encouraged many others to terminate their existing plans. For example:

New short-sighted funding rules have subjected employers to unrealistic funding assumptions and have limited employers’ ability to fund their defined benefit plans until late in their employees’ careers.
Rigid restrictions on the use of pension assets have converted a defined benefit plan into a “black hole” from which contributions cannot emerge -- even if the plan’s assets vastly exceed the amount required to fund the plan’s benefits.
Complex, and frequently amended, legal requirements, including compensation and benefit limits and distribution rules have required plans to invest a substantial portion of their resources in legal compliance and plan administration, rather than in providing benefits to participants and beneficiaries.

This regime has weakened retirement security by delaying funding, by subjecting employers to highly volatile funding requirements that are difficult, if not impossible, for employers to predict, by subjecting plans to excessive administrative costs, and, in the aggregate, by making it less attractive for employers to maintain and contribute to defined benefit plans.

The decline in defined benefit plan coverage has substantially weakened the retirement security of our nation’s workforce.

The Development of Cash Balance and Other “Hybrid” Plans. The one exception to the dramatic decline in defined benefit plan coverage has been the emergence of cash balance and other “hybrid” defined benefit plans. Although these plans are defined benefit plans, they combine many of the most attractive features of both defined benefit and defined contribution plans.

A cash balance pension plan is a defined benefit plan that defines an employee’s benefit as the balance in his or her cash balance account. The account receives periodic credits, usually a percentage of the employee’s pay, while the employee works. In addition, the account is credited with interest until the account balance is distributed.^[9]

Traditional defined benefit plans provide extremely valuable benefits to broad groups of employees in many segments of our economy, especially those where long-term employment is prevalent and where many employees remain with their employers for most or all of their careers.

In other segments of the economy, however, most of the benefits provided by a traditional defined benefit plan are allocated to a relatively small group of long-service employees, and the vast majority of plan participants receive little or no benefits. Traditional defined benefit plans often penalize older employees who want to work beyond early retirement age. Traditional plans also can restrict the mobility of younger employees who risk losing a substantial portion of their retirement benefits if they leave the employer before reaching early retirement age.

Since 1983, there has been a marked drop-off in the median job tenure for the average employee, reflecting the fact that employees now spend shorter periods of time with a single employer. This phenomenon is documented by the three tables at the end of this statement.

Because cash balance and other “hybrid” plans allocate benefits more evenly over an employee’s career, these plans correct many of the shortcomings of traditional defined benefit plans and are particularly well-suited to an employee who does not spend his or her entire career with a single employer.

Advantages to Employees:

Understandable Benefits: Unlike traditional defined benefit plans, cash balance plans provide an easily understood account balance for each participant. Employees -- who are accustomed to dealing with bank account balances, § 401(k) account balances, and IRA balances -- are comfortable with a retirement plan that provides a benefit in the form of an account balance.
Automatic Savings: Unlike § 401(k) plans, additions are made automatically to the accounts of all participants in a cash balance plan. An employee does not have to choose to participate or decide how much to contribute.
Employees Do Not Bear Investment Risk: Unlike § 401(k) plans and other defined contribution plans, cash balance plans do not require employees to bear the risk of adverse investment experience. As under a traditional defined benefit plan, the employer bears the risk that the plan’s investments will perform poorly. Sudden or even prolonged downturns in the plan’s investment performance do not affect participants’ benefits under the plan. Because they are defined benefit plans, cash balance plans are insured by the Pension Benefit Guaranty Corporation (the “PBGC”) and are subject to the stringent limits on investments in employer stock that apply to defined benefit plans.
Greater Benefits for More Employees: Under a traditional pension plan, an employee typically earns most of his or her benefit in the last few years before retirement. By contrast, a cash balance plan allocates benefits more evenly over an employee’s career, regardless of whether the employee remains with the employer until retirement. Because most employees do not remain with the same employer until retirement, the vast majority of workers earn greater benefits under cash balance plans than under traditional pension plans.
Women Benefit: Cash balance plans offer significant advantages to women and others who tend to move in and out of the workforce. Mobile workers -- not just women -- are more likely to accrue a significant and secure retirement benefit under a cash balance plan than under many other plan designs.
Release from “Pension Jail”: Because the benefits under cash balance plans tend to accrue more evenly over an employee’s career than do the benefits under a traditional defined benefit plan, and do not suddenly “spike” when an employee becomes eligible for early retirement, cash balance plans release many employees from what is often referred to as “pension jail” -- the need to remain employed with the same employer until early retirement age in order to qualify for a major portion of the benefit that their retirement plan provides.
Older Workers Benefit: The value of the benefit earned by an older worker increases at the same rate both before and after normal retirement age. By contrast, under many traditional pension plans, the value of the benefits accrued each year actually often declines when an employee works beyond a certain age (normal retirement age or early retirement age in the case of a plan providing subsidized early retirement benefits).
Portable Benefits: Cash balance benefits are portable. An employee who leaves before retirement can roll over his or her cash balance account to an IRA or a new employer’s plan.
Annuities Available: Since cash balance plans must offer annuities, a participant who wants to receive retirement benefits as a stream of income for life can receive a life annuity without incurring the cost and inconvenience of shopping for an annuity in the individual annuity market. Annuity benefits are also available to the surviving spouses of deceased plan participants.

Advantages to Employers. Cash balance plans offer the following important advantages to employers:

Appropriate Employment Incentives: Because cash balance benefits are easy to communicate, because employees understand and value cash balance benefits, and because cash balance benefits accrue much earlier in a participant’s career than do the benefits under most traditional defined benefit plans, cash balance plans strengthen employer efforts to recruit and retain productive employees.
Appropriate Retirement Incentives: Because cash balance plans do not provide sudden “spikes” in benefits when an employee reaches early retirement age, they do not encourage productive workers to retire (and perhaps go to work for a competitor) as soon as they reach retirement age.
Benefit Funding: Under a cash balance plan, benefits accrue much earlier in a participant’s career, and the value of current accrued benefits does not depend on an employee’s future earnings. This enables the employer to fund a much larger portion of the plan’s projected benefit obligations -- the value of the benefits that employers are required to use as a funding target for accounting purposes -- than under a traditional defined benefit plan.^[10] This increases employees’ retirement security.
Benefit Communication and Coordination: Because the benefits under a cash balance plan are expressed as a lump sum, they can be more easily communicated and coordinated with other employer-provided benefits (e.g., § 401(k) plan benefits) that are also expressed as lump sums.

Advantages to the Nation:

Increased Coverage: Because cash balance and other “hybrid” plans are the only defined benefit plans currently attracting the interest of employers and employees, they currently offer the greatest hope for maintaining and actually increasing defined benefit plan coverage in the United States.
Increased Retirement Security: Because cash balance and other “hybrid” plans are defined benefit plans, they provide a reliable source of retirement security.
Increased Labor Mobility: Because cash balance plans do not encourage employees to remain employed until they qualify for early retirement, they increase labor mobility.
Greater Independence for Women: Because cash balance plans offer significant advantages to women and others who tend to move in and out of the workforce, cash balance plans provide greater financial independence for women and other mobile workers.
Less Pressure on Government Programs: The success of defined benefit plans, and cash balance plans in particular, will relieve pressure on federal and state governments to provide retirement and other financial assistance to elderly citizens.

Congress Should Act. Congress must act promptly if it wishes to reverse the decline of the defined benefit plan. Although there are many steps that can and should be taken, we suggest the following as a start:

Encourage Hybrid and Other Innovative Plan Designs: Congress should enact legislation directing the Treasury Department and other federal agencies to create an environment that encourages the development and maintenance of hybrid and other innovative plan designs.

Reform the Funding Standards: Congress should reform the current funding rules to make the funding of defined benefit plans more sound, less volatile, more flexible, and more consistent with sound funding principles. The funding standards should be designed to meet retirement security needs, not short-term Congressional budget targets.

Replace the 30-Year Treasury Bond Rate: Congress should establish a permanent replacement for the 30-year Treasury bond standard used to set the interest rate for purposes of pension funding, the variable rate PBGC premium, and lump-sum benefits under defined benefit plans. We suggest that the yield on the 30-year Treasury bond be replaced by the composite yield on high quality, long-duration corporate bonds, based on the average yield reported by a number of independent indices. The composite yield would be representative of rates of return that underlie the price of annuities sold by insurers active in the group annuity marketplace.

ERIC expects to present specific proposals on improvements in the funding standards and on a permanent replacement for the 30-year Treasury bond standard to Congress for consideration in the near future.

Permit Excess Pension Assets to be Used to Fund Defined Contribution Plans: Congress should enact legislation that permits the excess assets of defined benefit plans to be used to enhance the retirement security of plan participants by transferring them to a defined contribution plan for the benefit of participants in the defined benefit plan. The legislation should be modeled on the current provisions of § 420 of the Internal Revenue Code, which permits excess pension assets to be transferred to an account to provide retiree health benefits. Section 420 has worked well for many year, and has been extended by Congress on two separate occasions. The favorable experience under § 420 argues strongly in favor of this proposal.

As I explained at the beginning of my statement, Congress should evaluate these and other proposals in light of the following questions:

Employers’ interests: Does the legislation facilitate the ability and willingness of employers to establish and continue voluntary defined benefit plans that meet employers’ business needs?
Employees’ interests:Does the legislation enhance the ability of employees to obtain retirement security?
National interest: Does the legislation strengthen the voluntary retirement system by encouraging employers to establish and maintain voluntary defined benefit plans?

With respect to the proposals we have made, the answer to each of these questions is an unequivocal “Yes,” and we urge the Subcommittee to act on our proposals promptly.

In its deliberations, the Subcommittee should continue to be mindful of the critical role that a diverse array of voluntary employer-sponsored plans play in providing retirement security to millions of American workers and their families. Although defined benefit plans are the focus of this hearing, defined contribution plans also play a critical role in providing retirement security. Improvements in the law governing defined benefit plans should not be made at the expense of defined contribution plans.

Finally, with the reemergence of federal budget deficits, we urge the Subcommittee not to repeat the disastrous experience of the period from 1982 through 1994. Retirement plans should now be viewed as a critical vehicle for providing retirement security to workers and their families, not as a source of revenue to be used to achieve Congressional budgetary targets.

We very much appreciate the opportunity to present our views today to the Subcommittee. We look forward to working with Chairman Houghton, Ranking Member Coyne, and the other members of the Subcommittee and their staffs on the important issues that the Subcommittee has raised.

Attachment 1:
May 21, 2002

The Honorable Elaine L. Chao
Secretary of Labor
U.S. Department of Labor
200 Constitution Avenue N.W.
Washington. DC 20210

Dear Secretary Chao:

On March 29, 2002 the Department of Labor Office of Inspector General (OIG) released a report regarding lump-sum distributions from cash balance pension plans (Report).^[11] Based on information collected from a "judgmental sample" of 60 companies, the Report propounds that 13 of the sampled companies failed to properly calculate the lump-sum benefit.^[12] For the reasons described below, we are writing to strongly object to and request an investigation of the violation of a promise of confidentiality by the OIG intended to induce cooperation by the companies in the sample.

On May 20, 2002 Representative Bernie Sanders (I-VT) released information to the press and media and published on his WEB site the names of the 13 companies alleged by the OIG to have underpaid participants.^[13] Representative Sanders specifically cites the Department of Labor Office of Inspector General as the source of his information.

We strongly believe that the release of the information by the DoL OIG was improper and requires an investigation and appropriate action against those responsible for leaking information that was confidential and therefore protected.

In its effort to collect information from the 60 companies in its "judgmental sample," including the 13 companies cited by Representative Sanders, the OIG specifically stated that they were conducting "an audit of the Department's oversight of defined benefit plans that have converted to a cash balance formula."

As an inducement for cooperation in obtaining information about benefit calculations and other data necessary for their audit of the Department's oversight responsibilities, the OIG specifically promised the companies that:

". . . the information you will provide is considered confidential. The results of our review of your information will be combined with reviews of other plans and will be used to develop a report to Department of Labor management officials. The report will not identify any plans or plan sponsors by name or other identifying means." (See attachment 2.)

The release of the information to Representative Sanders is a clear and egregious violation of the confidentiality promise made by the OIG to each company from which it requested information. While the report itself did not identify the companies, the release of the information to Representative Sanders nevertheless constitutes a breach of the confidentiality promised by the OIG. Moreover, Representative Sanders is well known to be strongly opposed to cash balance plans. Thus, the release of the information to Representative Sanders, particularly in light of the specific promise of confidentiality, conflicts with an objective that is consistent with the requirements of objectivity and independence of the Department's Inspector General.

The OIG's apparent release of confidential information will have a significant chilling effect on the willingness of employers and plan sponsors to cooperate with the Department of Labor in the future. It casts a shadow over the objectivity of the Office of Inspector General and raises significant questions with regard to controls within that office.

For the reasons indicated, we respectfully urge that the Department initiate an investigation of the OIG and, if the OIG is in fact the source of the breach of confidentiality, take corrective steps to ensure the integrity of the Department and the Office of Inspector General.

Very truly yours,

Mark J. Ugoretz
President

cc: Hon. Ann Combs, Assistant Secretary for Pensions and Welfare Benefits Administration
Elliott P. Lewis (Acting Deputy Inspector General for Audit, USDoL)

Attachment 2:

May 16, 2002

BY HAND DELIVERY

The Honorable Elaine L. Chao
Secretary of Labor
U.S. Department of Labor
200 Constitution Avenue, N.W.
Washington, D.C. 20210

The Honorable Paul H. O’Neill
Secretary of the Treasury
U.S. Treasury Department
1500 Pennsylvania Avenue, N.W.
Washington, D.C. 20220

Re: Lump-Sum Distributions from Cash Balance Pension Plans

Dear Secretary Chao and Secretary O’Neill:

We are writing to express our strong concerns about the report recently issued by the Office of Inspector General of the Department of Labor regarding lump-sum distributions from cash balance pension plans (the “OIG Report”).^[14]

The OIG Report threatens to damage our Nation’s private pension system by creating the impression that many pension plans are underpaying plan participants. We urge you to act promptly to dispel this erroneous impression.

The OIG Report is based on an invalid legal theory that is contrary to both the law and sound retirement security policy. Moreover, the Treasury Department, not the Department of Labor, is responsible for interpreting the statutory provisions on which this legal theory is based.

At a time when some employers are shifting away from defined benefit pension plans, and when many employees are seeking the retirement security that defined benefit plans provide, it is imperative for the Administration to support the development of defined benefit plans that meet employee needs. Because they are defined benefit plans, cash balance plans provide benefits that employees can rely on, without the risk of adverse investment experience. Because of their design, cash balance plans provide portable retirement benefits that are allocated equitably over an employee’s career.

Cash balance plans address the needs of millions of employees, including women, who do not spend their entire career with a single employer. Cash balance plans provide benefits that grow steadily over time in a fair and equitable manner. The Administration should create an environment that fosters the creation and continuation of such plans, not an environment that is hostile to them.

The OIG Report is based on a “whipsaw” theory that undermines many cash balance plans. The OIG Report uncritically propounds the whipsaw theory as established law even though the whipsaw theory violates established law and fundamentally alters the benefit promised by a cash balance plan. The whipsaw theory requires cash balance plans to violate federal law and undermines important federal policies. By altering the plan’s benefit promise, the whipsaw theory improperly restricts the freedom that employers have under existing law to determine the benefits that their plans provide.^[15]

Cash Balance Plans

Traditional defined benefit pension plans typically provide benefits pursuant to a formula that expresses an employee’s benefit as a deferred annuity, commencing at the plan’s normal retirement age (generally, age 65). A cash balance pension plan is a defined benefit plan that defines an employee’s benefit as the balance in his or her cash balance account. The account receives periodic credits, usually a percentage of the employee’s pay, while the employee works. In addition, the account is credited with interest until the account balance is distributed. Because the interest credits typically are based on a variable index, it is impossible to know in advance the rate at which a participant’s cash balance account will grow.

Cash balance plans offer the following important advantages:

Understandable Benefits: Unlike traditional defined benefit plans, cash balance plans provide an easily understood account balance for each participant. Employees -- who are accustomed to dealing with bank account balances, § 401(k) account balances, and IRA balances -- are comfortable with a retirement plan that provides a benefit in the form of an account balance.
Automatic Savings: Unlike § 401(k) plans, additions are made automatically to the accounts of all participants in a cash balance plan. An employee does not have to choose to participate or decide how much to contribute.
Employees Do Not Bear Investment Risk: Unlike § 401(k) plans and other defined contribution plans, cash balance plans do not require employees to bear the risk of adverse investment experience. As under a traditional defined benefit plan, the employer bears the risk that the plan’s investments will perform poorly. Sudden or even prolonged downturns in the plan’s investment performance do not affect participants’ benefits under the plan. Because they are defined benefit plans, cash balance plans are insured by the Pension Benefit Guaranty Corporation (the “PBGC”) and are subject to the stringent limits on investments in employer stock that apply to defined benefit plans.
Greater Benefits for More Employees: Under a traditional pension plan, an employee typically earns most of his or her benefit in the last few years before retirement. By contrast, a cash balance plan allocates benefits more evenly over an employee’s career, regardless of whether the employee remains with the employer until retirement. Because most employees do not remain with the same employer until retirement, the vast majority of workers earn greater benefits under cash balance plans than under traditional pension plans.
Women Benefit: Cash balance plans offer significant advantages to women and others who tend to move in and out of the workforce. Mobile workers -- not just women -- are more likely to accrue a significant and secure retirement benefit under a cash balance plan than under many other plan designs.
Older Workers Benefit: The value of the benefit earned by an older worker increases at the same rate both before and after normal retirement age. By contrast, under many traditional pension plans, the value of the benefits accrued each year actually often declines when an employee works beyond a certain age (normal retirement age or early retirement age in the case of a plan providing subsidized early retirement benefits).
Portable Benefits: Cash balance benefits are portable. An employee who leaves before retirement can roll over his or her cash balance account to an IRA or a new employer’s plan.
Annuities Available: Since cash balance plans must offer annuities, a participant who wants to receive retirement benefits as a stream of income for life can receive a life annuity without incurring the cost and inconvenience of shopping for an annuity in the individual annuity market. Annuity benefits are also available to the surviving spouses of deceased plan participants.

As the preceding discussion demonstrates, an essential feature of a cash balance plan is its ability to express an employee’s benefit as a current lump-sum value and to pay out that benefit in a lump sum equal to the current balance in the employee’s cash balance account. Without this feature, a cash balance plan cannot (1) provide readily understood benefits to employees, (2) distribute benefits equitably among employees, and (3) provide lump-sum benefits that are not subject to erratic interest-rate swings. The whipsaw theory would prevent many cash balance plans from achieving these objectives. As we explain in detail below, the whipsaw theory --

Has no statutory support;
Conflicts with the statute and the regulations;
Conflicts with other statutory and regulatory provisions;
Discourages the deferral of benefits until retirement;
Discourages participants from electing to receive annuities;
Weakens spousal protections;
Hurts employees by limiting plans’ interest crediting rates;
Favors younger employees over older employees;
Provides erratic benefits;
Provides windfall benefits;
Interferes with employer-employee relationships;
Weakens pension funding;
Risks weakening the PBGC; and
Discourages employers from adopting defined benefit plans.

The Whipsaw Theory

Under the whipsaw theory, an employee’s cash balance account must be projected forward to normal retirement age at the interest rate set forth in the plan (which is typically based on a variable index) and then discounted back to an actuarial present value using the 30-year Treasury interest rate -- the rate specified by Code §§ 411(a)(11) and 417(e) and ERISA §§ 203(e) and 205(g).^[16] If the resulting amount exceeds the balance in the employee’s current cash balance account, the lump-sum distribution payable to the employee must be increased to the amount determined under the whipsaw calculation, producing a windfall benefit to the employee -- a benefit that the plan was not designed to provide and a benefit that the employee had no reason to anticipate.

The windfall benefit mandated by the whipsaw theory is payable whenever the plan’s current interest rate exceeds the statutory interest rate (the 30-year Treasury rate). Projecting out an employee’s cash balance account at the plan’s interest rate and then discounting it back at a lower statutory interest rate will always yield an amount larger than the balance in the employee’s cash balance account.

The amount of the windfall benefit mandated by the whipsaw theory will increase the younger an employee is at the time he or she receives a lump-sum distribution. The age-based difference in amount is attributable to the fact that the interest rate differential that produces the windfall benefit will apply over a longer period for a younger employee and therefore will produce a larger windfall benefit for a younger employee than for a similarly-situated older employee. In most cases, the windfall benefit will disappear entirely for any employee at or over normal retirement age (typically, age 65) at the time of the distribution.

The windfall benefit mandated by the whipsaw theory also disappears for any employee who receives his or her benefit under the cash balance plan as a nondecreasing annuity, rather than as a lump sum. This is because the statutory interest rate does not apply to such annuities, while it does apply to lump sums.

The OIG Report

The OIG Report is seriously flawed, both procedurally and substantively.

First, the validity of the whipsaw theory is within the jurisdiction of the Treasury Department, not the Labor Department. This is because the whipsaw theory purports to be based on the vesting and benefit accrual provisions of the Code and ERISA. The Treasury Department, not the Labor Department, is responsible for interpreting and applying the vesting and benefit accrual provisions.^[17]

Second, although the Treasury has indicated that it is developing regulations that will address the whipsaw issue,^[18] the Treasury has not issued even proposed regulations. Under the circumstances, it is inappropriate for the Department of Labor’s OIG to apply the theory.

Third, the OIG appears to have misapplied the whipsaw theory in at least some cases. Our understanding is that the OIG concluded that at least one of the plans that it criticized failed to comply with IRS Notice 96-8 because the lump-sum distributions under the plan were not actuarially equivalent to the plan’s qualified joint and survivor annuity. This conclusion is completely at odds with the view of the Internal Revenue Service that a lump-sum distribution need only be actuarially equivalent to the plan’s single life annuity.^[19]

Fourth, the whipsaw theory is highly controversial.^[20] Although the Internal Revenue Service endorsed the whipsaw theory in Notice 96-8, the Service’s failure to issue proposed regulations has thus far shielded the theory from the scrutiny of a formal rulemaking. An OIG Report is not a substitute for a rulemaking proceeding nor is it an appropriate vehicle for addressing or resolving an important and controversial policy issue.

Fifth, notwithstanding the controversial nature of the whipsaw theory, the OIG Report accepts it as a “given.” The Report utterly fails to consider whether the whipsaw theory is consistent with applicable statutory and regulatory provisions and does not address the very powerful arguments that the whipsaw theory is simply wrong. ^[21]

As we explain below, the whipsaw theory -- the Report’s lynchpin -- is inconsistent with applicable statutory and regulatory provisions and with important federal policies.

The Whipsaw Theory Is Invalid

The Whipsaw Theory Has No Statutory Support. The whipsaw theory appears nowhere in the Code, ERISA, or the regulations. Where the plan’s interest credit rate is based on a variable index, projecting the current rate forward to normal retirement age (perhaps 30 or 40 years into the future) is inherently nonsensical. There is no reason to believe that current interest rates are predictive of future rates, and there is no reason to believe that Congress intended them to be used to predict the annuity benefit a participant would be entitled to receive many years in the future.

The Whipsaw Theory Conflicts with the Statute and the Regulations. The whipsaw theory conflicts with the statutory and regulatory provisions that govern how an accrued benefit expressed in the form of an annuity beginning at normal retirement age is to be derived in the case of a plan that does not define its benefits in that way.

Under both the Code and ERISA, if a plan (such as a cash balance plan) does not provide an accrued benefit in the form of an annuity beginning at normal retirement age, the statutory “accrued benefit” -- which must be used to determine the minimum amount of a lump-sum distribution -- is an annuity beginning at normal retirement age that is the actuarial equivalent (determined under Code § 411(c)(3) and ERISA § 204(c)(3)) of the accrued benefit under the plan.^[22]

Actuarial equivalence under Code § 411(c)(3) is determined using the assumptions specified by Code § 417(e). This is made clear both by the statute and the regulations. Code § 411(c)(3) refers to Code § 411(c)(1) & (2). Under Code § 411(c)(2)(B), an account balance is converted to an annuity beginning at normal retirement age based on the assumptions specified by Code § 417(e). The corresponding ERISA provisions say the same thing. ^[23]

Similarly, the implementing regulation, Treas. Reg. § 1.411(a)-7(a)(1)(ii), provides that where a defined benefit plan does not provide an accrued benefit in the form of an annuity beginning at normal retirement age, “accrued benefit” means an annuity beginning at normal retirement age that is “the actuarial equivalent (determined under § 411(c)(3) and § 1.411(c)-5) of the accrued benefit determined under the plan.”^[24] The IRS guidance under Code § 411(c) provides that actuarial equivalence is to be determined using the interest rate assumptions of Code § 417(e), not the interest credit rate set forth in the plan.^[25]

The Whipsaw Theory Conflicts with Other Statutory and Regulatory Provisions. A statute must be interpreted in a manner that harmonizes all of its provisions.^[26] As we explain in the following paragraphs, the whipsaw theory produces results that conflict with the objectives of other statutory and regulatory provisions.

A Plan’s Use of the Whipsaw Method Would Be Unlawful Because It Discourages the Deferral of Benefits until Retirement Age. A plan that used the whipsaw method would violate Code § 411(a)(11) and ERISA § 203(e) -- the very sections that are claimed to be the basis for the whipsaw theory.

Under the whipsaw theory, an employee who terminates employment before normal retirement age faces a dilemma. If the employee does not agree to receive an immediate lump-sum distribution, and instead leaves his or her benefit in the plan until normal retirement age, the employee will forgo the additional benefit mandated by the whipsaw theory. For younger employees especially, the amount at stake could be substantial.

However, the regulations under Code § 411(a)(11) forbid a plan from putting an employee in this predicament. They specifically prohibit a plan from imposing a substantial detriment on any employee who does not consent to an immediate distribution.^[27] The Internal Revenue Service has found a substantial detriment to exist as a result of plan provisions with far less consequence than what is at stake here.^[28] The whipsaw theory cannot be valid if it requires a plan to violate the very statute on which the whipsaw theory is based.

The Whipsaw Theory Discourages Participants from Electing to Receive Annuities. Because the whipsaw theory rewards employees who elect to receive their benefits as immediate lump sums, it conflicts with the provisions of the Code and ERISA that favor the distribution of benefits in the form of an annuity.^[29] Because benefits paid in the form of a nondecreasing annuity are not subject to the present value requirements of the Code and ERISA, the whipsaw theory does not apply to them. Because annuitants do not receive whipsaw benefits, the whipsaw theory discourages employees from electing to receive their benefits as annuities.

The Whipsaw Theory Weakens Spousal Protections. Both the Code and ERISA go to great lengths to protect employees’ spouses. A defined benefit plan is required to protect the spouse with a qualified preretirement spouse’s annuity (a “QPSA”) before the employee retires and with a qualified joint and survivor annuity (a “QJSA”) after the employee retires -- unless the employee elects otherwise with his or her spouse’s consent.^[30] By providing a powerful economic incentive to elect to receive lump-sum benefits, the whipsaw theory undermines this important federal policy.

The Whipsaw Theory Hurts Employees by Limiting Plans’ Interest Crediting Rates. According to Notice 96-8, whipsaw can be avoided if the plan’s interest crediting rate does not exceed the statutory interest rate under Code § 417(e) and ERISA § 203(e). This creates incentives that are contrary to the interests of employees. Because the whipsaw theory imposes unintended liabilities only on plans with interest crediting rates exceeding the statutory interest rate, it discourages employers from offering a plan with an interest rate exceeding the statutory rate. This clearly conflicts with the objectives of the Code and ERISA, which are designed to encourage employers to provide benefits to their employees. Contrary to federal policy, whipsaw punishes employers for being generous to their employees.

The Whipsaw Theory Favors Younger Employees Over Older Employees. The additional benefit mandated by the whipsaw theory also produces large age-based disparities in benefits. Under the whipsaw theory, employees of different ages who have the same pay and service history with the employer (and therefore the same account balances) will receive dramatically different lump-sum benefits based solely on the difference in their ages. A younger employee will receive a larger lump sum than a middle-aged employee, and a middle-aged employee will receive a larger lump sum than an employee who is past normal retirement age (who will in most cases receive no benefit from whipsaw at all). The adverse impact on older employees can hardly be said to promote the policy against age discrimination reflected in Code § 411(b)(1)(H), ERISA § 204(b)(1)(H), and § 4(i)(1) of the Age Discrimination in Employment Act.

The Whipsaw Theory Provides Erratic Benefits. Because whipsaw occurs only when the plan’s interest crediting rate exceeds the statutory interest rate, whipsaw causes benefits to vary erratically from one year to the next based on fluctuations in interest rates. The wide swings in the benefits provided by whipsaw are contrary to the interests of employees who will not be able to predict their benefits from one year to the next and whose lump-sum benefits in one year will significantly erode (or increase) in the next.

The Whipsaw Theory Provides Windfall Benefits. Cash balance plans are designed to provide a lump-sum benefit equal to the balance in an employee’s cash balance account. Because the whipsaw theory requires a cash balance plan to provide additional benefits when the plan’s interest crediting rate exceeds the statutory rate, whipsaw causes a cash balance plan to provide windfall benefits -- benefits that the plan was not intended to provide and that employees had no reason to anticipate.

The Whipsaw Theory Interferes with Employer-Employee Relationships. Whipsaw interferes with employer-employee relationships by encouraging employees to quit rather than to work. Because whipsaw benefits vary erratically from year to year, whipsaw encourages employees to quit, and to take lump-sum distributions, in order to capture whipsaw benefits before they disappear.

The Whipsaw Theory Weakens Pension Funding. The erratic swings in benefits under the whipsaw theory will impair sound pension funding. Unanticipated benefit increases will create or increase unfunded pension liabilities, encourage employees to terminate employment and withdraw their benefits in a lump sum, and jeopardize the plan’s funded status. Such unexpected increases in benefit liabilities and cash outflows will undermine the objective of the Code and ERISA to strengthen pension funding.^[31]

The Whipsaw Theory Risks Weakening the PBGC. Whipsaw’s adverse impact on pension funding will also impose additional and unpredictable liabilities on the PBGC, the federal agency that is required to insure terminated defined benefit pension plans. If employers are unable to fund the additional benefits that the whipsaw theory creates, those benefits will eventually be shifted to the PBGC.^[32] Whipsaw could weaken the PBGC’s financial condition and undermine the soundness of the termination insurance program.

The Whipsaw Theory Discourages Employers from Adopting Defined Benefit Plans. For the reasons identified in the preceding paragraphs, the OIG Report’s use of the whipsaw theory may discourage employers from adopting cash balance and other hybrid plans -- plan designs that, unlike many traditional plan designs, are currently attracting employers to the defined benefit plan system. But beyond that, there is the even more worrisome risk that the Report’s use of the whipsaw theory will do lasting damage to the define benefit plan system as a whole. We are concerned that the Report reflects a level of government hostility toward defined benefit plans, and a lack of understanding of those plans, that will reinforce the inclination of many employers to shy away from defined benefit plans altogether.

Conclusion

At a time when millions of employees are looking increasingly for retirement security, it is crucial for the Administration to support the development of secure cash balance and other defined benefit plans.

As a defined benefit plan, a cash balance plan provides benefits that employees can rely on, without the risk of adverse investment experience. Cash balance plans provide secure and equitable benefits that meet the needs of millions of employees, including women, who do not spend their entire career with a single employer. Cash balance plans treat all workers alike, regardless of age. Cash balance benefits provide portable benefits that grow steadily over time in a fair and equitable manner.

We urge the Departments to act promptly to strengthen the private pension system by dispelling the erroneous impression created by the OIG Report and by creating a regulatory environment that fosters the creation and continuation of cash balance and other hybrid plans that meet employees needs. Specifically, we ask the Departments to revoke both Notice 96-8 and the OIG Report.

If we can provide you with any additional information or analysis that will help you and your staffs to address the issues we have raised, please let us know.

Because of the seriousness and magnitude for the issues we have raised, we respectfully request the opportunity to meet with each of you in the near future to discuss the issues further.

Sincerely,

Mark J. Ugoretz
President

cc:            Ann L. Combs (Assistant Secretary for PWBA - Labor Department)
                Pamela F. Olson (Acting Assistant Secretary for Tax Policy - Treasury Department)
                William Sweetnam (Benefits Tax Counsel - Treasury Department)
                Elliott P. Lewis (Acting Deputy Inspector General for Audit - Labor Department)

[1] U.S. Dep’t of Labor, Office of Inspector General, PWBA Needs to Improve Oversight of Cash Balance Plan Lump Sum Distributions (Report No. 09-02-001-12-121) (March 29, 2002).
[2] The General Accounting Office found that there was “uncertainty” whether plan sponsors must adhere to this controversial legal theory. See General Accounting Office, Private Pensions: Implications of Conversions to Cash Balance Plans 21 (GAO/HEHS-00-185) (Sept. 2000).
[3] Watson Wyatt Worldwide, The Unfolding of a Predictable Surprise at iii (2000).
[4] Id. at 2.
[5] U.S. Dep’t of Labor, Pension & Welfare Benefits Administration, Private Pension Plan Bulletin: Abstract of 1998 Form 5500 Annual Reports No. 11 (Winter 2001 - 2002); Joint Committee on Taxation, Background Information Relating to the Investment of Retirement Plan Assets in Employer Stock 16 (JCX-1-02) (Feb. 11, 2002). Although the Private Pension Plan Bulletin shows a slight increase in the number of active participants in defined benefit plan participants between 1997 and 1998, the increase consists of fewer than 250,000 individuals, and was accompanied by a 5% decline in the number of defined benefit plans between 1997 and 1998. See Private Pension Plan Bulletin at 2, Tables E1 & E8.
[6] Private Pension Plan Bulletin, supra, Table E8.
[7] Pension Benefit Guaranty Corporation, 2001 Annual Report 14.
[8] U.S. General Accounting Office, Private Pensions: Improving Worker Coverage and Benefits 7 - 8 (GAO-02-225) (April 2002); JCX-1-02, supra, at 13, 16 -17.
[9] Another form of “hybrid” plan -- a pension equity plan -- works differently. Like a cash balance plan, a pension equity plan defines the participant’s benefit in terms of a lump sum -- but without relying on an account or interest credits. For example, a pension equity plan might define a participant’s lump-sum benefit as a specified percentage of final average pay multiplied by the participant’s years of service with the employer. For example, if the specified percentage were 8%, and the participant completed 10 years of service, the participant’s lump-sum benefit would be 80% of his or her final average pay.
[10] See Watson Wyatt, supra, at 14 - 20, 48 - 53.
[11]U.S. Department of Labor, Office of Inspector General, "PWBA Needs to Improve Oversight of Cash Balance Plan Lump Sum Distributions" (Report No. 09-02-001-12-121).
[12]For reasons explained in our May 16, 2001 letter to you and to Secretary of the Treasury Paul O'Neill, we contend that the OIG Report is based on an illegitimate and ill‑conceived legal theory, an uncritical and unsupported acceptance of that theory, and a misapplication of the Department of Labor=s authority over cash balance plans.
[13]http://bernie.house.gov/documents/releases/20020520161735.asp
[14] U.S. Dep’t of Labor, Office of Inspector General, “PWBA Needs to Improve Oversight of Cash Balance Plan Lump Sum Distributions” (Report No. 09-02-001-12-121) (March 29, 2002).
[15] We focus on cash balance plans because the OIG Report focused on such plans. However, the concerns that we voice in this letter would also apply to any attempt to apply the whipsaw theory to other types of “hybrid” plans (defined benefit plans that express their benefits as something other than an annuity beginning at normal retirement age).
[16] References in this letter to “ERISA” are to the Employee Retirement Income Security Act of 1974, as amended, and references to the “Code” are to the Internal Revenue Code of 1986, as amended.
[17] See ERISA § 3002(c); Presidential Reorganization Plan No. 4 of 1978, § 101, 5 U.S.C. App. (2000), 43 Fed. Reg. 47713 (Oct. 17, 1978); see also 29 C.F.R. § 2530.200a-2.
[18] IRS Notice 96-8, 1996-1 C.B. 359.
[19] See T.D. 8219, 53 Fed. Reg. 31837, 31840 (Aug. 22, 1988) (“There is no requirement that each form of benefit be the actuarial equivalent of all other benefit forms. Thus, a plan could have a [qualified joint and survivor annuity] benefit form that has a larger actuarial value than a benefit payable as a single life annuity and the amount of a single sum optional form could be determined based on the single life annuity. . . . Thus, a plan may satisfy [the] requirements [of Code §§ 411(a)(11) and 417(e)] even though it has a subsidized joint and survivor annuity and determines a single sum distribution based on an unsubsidized single life annuity.”).
[20] See, e.g., Sennott, Finding the Balance in Cash Balance Pension Plans, 2001 U. Ill. L. Rev. 1059 (2001); Lurie, Caught in the Jaw of the Saw: A Bum Rap for Cash Balance Plans, 89 Tax Notes 549 (Oct. 23, 2000).
[21] Courts of appeal in two of the 13 federal circuits have applied the whipsaw theory. See Esden v. Bank of Boston, 229 F.3d 154 (2d Cir. 2000); Lyons v. Georgia-Pacific Corp. Salaried Employees Retirement Plan, 221 F.3d 1235 (11th Cir. 2000). Those courts applied the whipsaw theory under the pre-1995 version of the statute, however; they did not apply it under current law. See Lyons v. Georgia-Pacific Corp. Salaried Employees Retirement Plan, No. 97-CV-980, 2002 WL 415393 (N.D. Ga. March 12, 2002). Moreover, the Esden and Lyons courtsdid not have the benefit of the arguments made in this letter, and their decisions are not binding in the remaining 11 circuits in any event. At least one court has expressed serious reservations regarding the reasonableness of projecting variable-rate interest credits forward to normal retirement age (as the whipsaw theory requires). See Eaton v. Onan Corp., 117 F. Supp.2d 812, 833 (S.D. Ind. 2000).
[22] Code § 411(a)(7)(A)(i); ERISA § 3(23); Treas. Reg. § 1.411(a)-7(a)(1)(ii).
[23] See ERISA § 204(c)(2)(B), (c)(3).
[24] The reference to § 1.411(c)-5 appears to be a typographical error; there has never been a § 1.411(c)-5. We suspect that the reference was intended to be to § 1.411(c)-1, the only regulation ever issued under Code § 411(c).
[25] See Treas. Reg. § 1.411(c)-1(e)(1); IRS Employee Plans Examination Guidelines [7.7.1] 10.3.1.A (03-11-1998); IRS Announcement 95-33, ¶ 362.1(1)(a), 1995-19 I.R.B. 14 (April 17, 1995).
[26] See FDA v. Brown & Williamson Tobacco Corp., 529 U.S. 120, 133 (2000) (“A court must . . . interpret [a] statute as a symmetrical and coherent regulatory scheme and fit, if possible, all parts in an harmonious whole.”) (internal quotations and citations omitted); Richards v. United States, 369 U.S. 1, 11 (1962) (“We believe it fundamental that a section of a statute should not be read in isolation from the context of the whole Act.”).
[27] See Treas. Reg. § 1.411(a)-11(c)(2)(i).
[28] See Rev. Rul. 96-47, 1996-2 C.B. 35 (loss of the right to choose among a broad range of investment alternatives is a substantial detriment to declining to consent to an immediate distribution from the plan).
[29] Code §§ 411(a)(11), 417; ERISA §§ 203(e), 205.
[30] See Code § 417; ERISA § 205.
[31] See Code § 412; ERISA §§ 301-08.
[32] Cf. Pension Benefit Guaranty Corp., Title IV Aspects of Cash Balance Plans With Variable Indices, 65 Fed. Reg. 41610 (July 6, 2000).