Companies Find Host of Ways To Pare Retirement Payouts
By ELLEN E. SCHULTZ Staff Reporter of THE WALL STREET JOURNAL
When International Business Machines Corp. announced the latest changes in its pension plan last year, David Finlay, a senior engineer in Colorado, went to his basement and hauled out boxes of benefits brochures collected since he joined IBM in 1972. It wasn't too hard for him to figure out that through the 1970s and 1980s, various changes had been for the good. It took a lot longer to figure out what happened in the 1990s.
When he was done, months later, what he discovered dismayed him. In the past decade, the company made change after change to its pension plan, reducing Mr. Finlay's future benefits each time, by his reckoning. According to the 55-year-old engineer's calculations, he will retire in 10 years with a $57,700 annual pension, compared with $71,200 it would have been without the revisions of the 1990s.
IBM, which declines to comment on Mr. Finlay's analysis, is a case study in the manifold, complex ways large companies have been whittling away pensions over the past decade, a pension-paring spree that hasn't ended yet. An examination of hundreds of federal filings reveals such cuts at a host of big companies, including Ameritech Corp., Duke Energy Corp., Dow Chemical Co., Kmart Corp., Lucent Technologies Inc. and Southern Co. The upshot of the pension changes, which are often poorly explained to employees, is that millions of people will retire with pensions that are sharply lower than they once would have been.
"If your pension has changed in the 1990s, it probably changed for the worse," says Norman Stein, a pension-law professor at the University of Alabama at Tuscaloosa.
Profit Center
Sometimes companies cut pensions when business is bad, but that isn't what's happening here. Employers are imposing the pension cuts at a time when profits are lush and when most pension funds are fully funded or overfunded, thanks to the long-running bull market. Paring future payouts, in such an environment, renders plans even more overfunded.
This isn't just a comforting feeling to companies. For some, it is also a new profit center. That's because accounting rules allow excess pension income to flow to the bottom line, where it can boost operating income and smooth earnings. ------------------------------------------------------------------------
Common Ways Companies Cut Pensions
An annual benefit under a traditional pension plan generally multiplies three factors: years of service, final average pay and a multiplier. For example:
25 years of service x $50,000 average salary over past three years x 1.5% multiplier --------------------------------------------------------- = $18,750 annual pension at age 65
***
To reduce the pension, change one or more of the three items. Here's how:
* Cut pension multiplier from, say, 1.5% to 1.0%. * Change the definition of compensation to exclude bonuses or make the pay more 'variable,' so less might qualify for a pension. * Calculate the final average pay using the past 10 years or five years of compensation, instead of the final three years. Or use the average of all years - a 'career average' formula. * Cap the number of years of service counted, at 25, for instance. * Freeze the plan, so future years of service and compensation increases won't boost the pension. * Convert to a cash-balance or pension-equity formula, which produce more of a career-average compensation effect and eliminate the early-retirement subsidy. * Implement a change at midyear or before a prior change has been fully phased in. This can reduce the value of a transition benefit. * Offer lump-sum payouts that exclude an early-retirement subsidy.
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Some of the changes are so complicated that even government pension experts aren't sure how they work. Created by consulting firms and companies' finance departments, the maneuvers flourish with little oversight. They go well beyond the "cash balance" system that caused an outcry last year after The Wall Street Journal reported that the new-style plan could cut older workers' pensions as much as 50%.
Some companies make subtle changes to the benefit-calculation formulas of traditional pension plans. Others take advantage of pension-law loopholes to eliminate early-retirement subsidies, and still others adjust compensation formulas to lower the amounts that count toward a pension.Says Brooks Hamilton, a lawyer who runs a pension consulting firm in Dallas: "Never have so few plundered so much from so many."
'Changes,' Not 'Cuts'
Federal law bars employers from retroactively cutting benefits an employee has earned. But it is perfectly legal to cut the rate at which benefits are to be earned in the future, or to eliminate future benefits altogether.
A company that is reducing future pension accruals of its employees is supposed to make this clear to them. Few do. In regulatory filings, companies typically cite "changes" or "modifications," not "cuts" or "reductions," and the brochures given to employees are typically vague. In IBM's case, a brochure for some 1995 changes did contain a reference to "lower value" for certain workers. Still, in 1999, even while IBM employees were complaining bitterly to lawmakers about adoption of a cash-balance plan, almost none realized that the 1995 changes had already transformed their plan. 'Phased Retirement' Option for Workers Is Mainly a Boon for Their Employers
One of the most common ways companies cut pensions is by changing the formula they use to calculate monthly retirement checks. Under traditional plans, payments generally are based on three items: years of service, an average-salary figure and a multiplier, such as 1.5%. All three can be changed. Southern Co., for instance, reduced its multiplier to 1% from 1.7%. Benefits were reduced 25% to 33%, by a Southern official's calculation, although employees of the Atlanta utility age 35 or older could remain subject to the old formula.
It might seem the years-of-service and average-salary elements would be immutable, but in fact, companies can manipulate these elements, too. They can cap the years of service that count toward a pension. And on salaries, instead of taking the employee's highest three years of pay, they can take an average of 10 years or even an entire career.
Wearaway
Kmart and Manpower Inc. froze their pension plans, so that neither future salary increases nor added years of service could increase the benefit. When Kmart froze its pension plan in 1996, itquickly turned it from underfunded into overfunded -- and pumped $63 million of pension income into its bottom line for 1998. A spokeswoman for Kmart says employees have the opportunity to participate in 401(k) retirement plans that supplement the pension. Manpower, which froze its plan at the end of February 2000, has no comment.
When a company changes its pension formula, employees can face months or years before their expected future retirement benefit gets back up to where it was before the change. In the meantime, they are essentially earning no benefit. "Wearaway," pension designers call this phenomenon.
Duke Energy made a complex adjustment in the early 1990s to the way it incorporates Social Security into its pension formula, a move that halted the accruals for the oldest workers for months or even years, the company acknowledges. Duke later converted to a cash-balance plan, again reducing accruals for some, although this time the change didn't affect those closest to retirement. Wearaway doesn't violate the law against cutting already-earned pensions so long as the employer provides the original, larger benefit to anybody who departs before working his or her way through the wearaway period.
At IBM, pension cuts began in 1991 when the company lowered the multiplier in its traditional plan to 1.35% from 1.5%. Mr. Finlay calculates that this and other 1991 changes reduced the pension he would draw at 65 to about $69,500 a year from $71,200. IBM also capped the pension, meaning that years worked beyond 30 wouldn't increase it.
Asked about Mr. Finlay's conclusions, IBM said in a written statement: "We are not saying your information is correct. We are saying only that we have decided not to participate" in an article about the changes.
Dropping a Subsidy
IBM's next significant move came in 1995. The company wanted to drop an early-retirement subsidy, which it had added to the plan in 1991 to encourage older workers to leave. The subsidy, which let 55-year-olds retire with nearly the pension they would have at 65, "encouraged departures," so it "served us well," Donald Sauvigne, then head of retirement benefits at IBM, told an actuaries' conference in Vancouver, British Columbia, in 1995, according to a transcript. But IBM found it also had the unwelcome effort of encouraging people to stick around until at least age 55. "So we had to design something different," Mr. Sauvigne said.
What they came up with was, indeed, very different: a pension-equity plan. This is a hybrid that consultants Wyatt Co. (now Watson Wyatt Worldwide of Bethesda, Md.) devised for RJR Nabisco Holdings Corp. in January 1993, when Louis V. Gerstner Jr. headed RJR. In April 1993, Mr. Gerstner arrived at IBM, and soon it, too, began planning a shift to the new structure, though it isn't clear what Mr. Gerstner's role was. Ameritech, Dow Chemical, Motorola Inc. and U S West Inc. (now part of Qwest Communications International Inc.) all have adopted similar plans since then.
Like its better-known cash-balance cousin, a pension-equity plan wipes out any early-retirement subsidy and produces smaller retirement payments for many older workers. Both plans differ from traditional pensions, under which employees earn as much as half their ultimate benefits in their last five to 10 years on the job. In contrast, under these newer types of pensions, the value of a worker's benefit grows at a more level rate throughout his or her employment.
A cash-balance plan provides employees with hypothetical accounts that grow with an annual company contribution, usually based on salary plus interest on the hypothetical balance. In contrast, the "accounts" in a pension-equity plan grow each year when the company contributes an amount representing the multiplication of a person's average pay over the prior five years or so by a factor that increases with service. There's also usually interest credited to the account, but it is embedded in the calculation and isn't evident to employees. "The plan took me months to understand," IBM's Mr. Sauvigne told his actuarial colleagues at the conference -- and he was a 25-year benefits veteran.
Finlay Digs In
It also challenged Mr. Finlay. When he started studying IBM's pension moves in 1999, the engineer would bicycle home from work to a subdivision on the outskirts of Boulder, Colo., and stare at his computer till nearly midnight. He spent weekends developing spreadsheets and reverse-engineering the algorithms with the information he hauled up from his basement. He even took his laptop computer to a genealogical conference his wife was attending in Colorado Springs so he could fiddle with the material. His wife, MaryAnn, didn't mind. "We want to know where we stand," she says.
One thing Mr. Finlay eventually says he figured out was that the embedded interest rate went down with age. It was 5% for employees under age 45, 4% for those 45 to 55, and 0.5% for years above age 55. Yet it was other aspects of the formula shift that were reducing his pension, not this. By his calculation, the 1995 changes reduced his prospective pension to about $57,700 annually from the previously estimated $69,500.
"I'm a Goldwater conservative, a Vietnam vet and a Republican, but I'd support a union coming in here if it would force the company to open up its books on what it's doing," he says. "If I were 10 years younger, I would have left. It tells you something about a company when it does something like this to people."
That most IBM employees didn't protest back in 1995 isn't surprising. Like most companies, IBM unveiled the pension-equity plan as a move that involved "changes" and "a new formula," according to its government filings. In its handouts to employees, IBM said the changes were "the result of a recent study which concluded that the plan should be modified to meet the evolving needs of IBM and its increasingly diverse work force, and align more with industry practices and trends."
The brochure did note that employees "will see varying effects" and that those retiring early will "see lower value." Mr. Finlay didn't think much about the change at the time, and neither did many of his colleagues. "I did not realize the significance," says software engineer Ken Buckingham, 44, a 20-year, second-generation IBM employee in Charlotte, N.C. "I had not a clue that this wasn't a traditional pension plan. They have a right to make these changes, but I resent the surreptitious nature in which they made them."
Lucent's Changes
Companies sometimes communicate pension reductions so poorly they're mistaken for enhancements. Consider the changes Lucent made in 1998. It cut the multiplier in its traditional pension plan to 1.4% from 1.6%, reducing future accruals. Yet a company brochure given to employees said: "For most employees, these changes will provide a greater annual pension benefit than the amount currently provided by the plan."
A Lucent spokesman says the brochure wasn't misleading because of other modifications, such as a 401(k) change and an updating of the salary part of the pension formula. But that update was a routine one made periodically to advance the period on which the salary average would be based, and would have been made even if the multiplier hadn't been cut.
Other companies improve their 401(k) savings programs when they cut pensions, obscuring the cuts by emphasizing "total" retirement benefits, including whatever an employee might save in his or her 401(k). On this front, Lucent did something more complicated in 1998. It reduced the amount it matches when employees put money into their 401(k) accounts to 50 cents on the dollar from 66.6 cents, but it added a "variable" match based on earnings-per-share growth. "We took the base down but gave employees more upside potential," the spokesman says, adding that in the past two years, the combination has resulted in a larger corporate contribution.
Employers rarely say that the reason they are changing their retirement plan is to save money. Instead, no matter what kind of change they are making, companies generally tell employees roughly the same things. "The changes keep us competitive with others in our industry," noted Lucent in an employee brochure that is typical. "Lucent's success depends on attracting, retaining and motivating top performers." A Lucent spokesman says the changes were intended to take away a "sense of entitlement" among employees and to reward performance.
Similarly, when IBM converted to the pension-equity plan in 1995, it sent a memo to managers saying the goal was "to attract and retain the people we need for the future" and to "align more with industry practices and trends." When IBM switched to a cash-balance plan four years later, its brochure for the staff said the change was to help "attract, retain, and motivate" employees.
Gerstner's Explanation
Later, at the annual shareholders' meeting last April, Mr. Gerstner stressed that the company's most recent pension maneuver was accompanied by various compensation enhancements. The combined moves eliminate "a sense of entitlement," he said. IBM also has a 401(k) retirement plan, but the chairman said that its pension plan had been "woefully out of date. It did not address the realities of employee mobility in the new marketplace. Our old pension plan was created at a time when employees joined IBM for life," he said. But "we anticipate that only 10% of our new hires are likely to reach 30 years of service with IBM."
Most of IBM's leading competitors "do not provide a pension plan at all," Mr. Gerstner added. "We must find a balance between the needs of our shareholders and the needs of all our employees."
Certainly, the shareholders have fared well. At the actuaries' conference in 1995, IBM's Mr. Sauvigne said the adoption that year of the pension-equity change had some immediate payoffs. "The new plan is a lot less expensive than the predecessor plan," he said. "We took a lot of dollars out of the liability line on Day One just by flipping the switch."
Indeed, the year before, IBM had reported pension expense of $11 million. In 1995, the year it converted, it reported pension income of $252 million, of which about half was attributable to the stock market and the rest to the pension change. Over the next four years, pension income boosted the company's operating income by $1.8 billion, according to federal filings.
Then came the 1999 announcement of a switch to cash-balance, a system that by this time had become controversial. The move caused such an uproar among middle-age staffers that IBM made a partial retreat, increasing the number of older employees it let remain in the old plan. Still, the move paid off for IBM; last year, it saved an added $184 million -- 6% of pretax income -- through reduced pension expense, according to government filings.
Mr. Finlay wasn't affected because he decided to stay in the prior plan. But if he hadn't made that choice, he calculated, IBM's latest switch would have cut his annual pension to about $45,800. He says he recruited volunteers around the office to test-drive his spreadsheets.
Freezing the Plan
For employees, bad news can continue even after a conversion to a cash-balance plan. What has happened at some big companies illustrates the variety of ways managements continue to pare pension benefits. For instance, six years after Interpublic Group of Cos. converted to a cash-balance pension plan, the ad agency went further and froze the plan. CBS Inc. adopted a cash-balance plan but closed it to new employees. MCI Communications converted to cash-balance but later, following its merger into WorldCom Inc., stopped providing contributions to the hypothetical accounts in the plan. And retailer Casual Corner Group changed the compensation formula in its cash-balance plan to exclude bonuses.
Casual Corner acknowledges it made its move to save money. CBS says that it increased its contribution to 401(k) plans and that many employees will now get stock options that can be used for retirement savings. WorldCom and Interpublic decline to comment.
Companies can cut pensions even as employees walk out the door. If a plan allows departing employees to take a lump sum instead of a lifelong stream of monthly payments, the lump sum can be worth 30% to 50% less than the present value of the monthly pension. That's because federal law allows lump-sum payments to exclude the value of an early-retirement subsidy, provided employers give employees a choice between a lump-sum payment and the monthly annuity.
This helps explain why hundreds of large employers began offering lump sums in the 1990s. The savings got even greater after employers successfully lobbied Congress in 1994 to let them use a bigger discount rate when calculating the lump sums. The change results in lower lump-sum payouts.
Proposed Legislation
Last week, the House passed a pension bill with a variety of provisions that would make further pension reductions possible, including one that gives companies greater leeway to cut early-retirement subsidies. The bill would also allow companies with already-overfunded pension plans to put more money in the plans, even as their pension obligations shrink. That makes it more likely that the pension plan will contribute to the company's bottom line.
Increasingly, companies are asking employees to make irrevocable decisions about their pensions, such as whether to remain in an old plan or choose a new one. Motorola, for instance, allowed 70,000 employees to make a one-time choice in April of whether to move into a new pension-equity plan, which started July 1, or stay in the old plan.
If employees can't compare the value of the options, they can't make an informed choice. Mary Fletcher, a marketing-services trainer and 14-year veteran of IBM, was presented with a lump-sum option last year when IBM prepared to sell a unit with 3,000 U.S. employees to AT&T Corp. Only after she hired a financial adviser to help with the calculations did she realize that the lump sum was worth 30% less than the monthly pension. The annuity's present value: $101,000. The lump sum she was offered: $71,500.
Still, Ms. Fletcher, 47, took the lump sum. Almost all employees do, figuring they can invest the money and eventually end up with more.
Ms. Fletcher is simply glad to be off on her own. Even though she is "a numbers person," she says, when it came to IBM's pension plan, "they were always changing things. So we were always confused."