FROM THE OFFICE OF PUBLIC AFFAIRS

Mr. Chairman and Members of the Committee:

I am pleased to present the views of the Department of the Treasury on issues concerning hybrid pension plans, particularly cash balance plans. Cash balance plans are expanding rapidly, and now involve millions of American workers. We appreciate the leadership that members of this Committee, including you Chairman Jeffords, have shown in this area. The Administration believes that conversions of traditional defined benefit plans to cash balance plans raise serious issues that warrant careful consideration by the agencies involved in our pension system.

Enhancing worker protections in the pension system has been a major focus of the Administration, and I welcome the opportunity to discuss with you the Administrations legislative proposal to further worker protections by improving disclosure to employees affected by conversions from traditional defined benefit pension plans to cash balance pension plans. I also look forward to addressing certain other issues that have arisen in connection with cash balance plan conversions.

It may be helpful to begin with a brief discussion of the private pension system and the legal framework governing tax-qualified retirement plans in general and cash balance pension plans in particular.

Our Nations private pension system has accomplished a great deal for many Americans. Pension benefits provided under this voluntary, employment-based system have helped millions of people maintain their standard of living in retirement. More than $4 trillion in assets are now held in private retirement vehicles. These assets are about 20 times greater than they were when ERISA was enacted in 1974. (Over $2 trillion more are held in plans of state and local governments.) Approximately 47 million workers in the private sector are earning pension benefits in their current jobs, and about two of three families will reach retirement with at least some private pension benefits. As you know, the Administration has advanced a proposal to further enhance this system through Universal Savings Accounts for workers and their spouses.

Qualified retirement plans must satisfy a number of requirements that are set forth in the Internal Revenue Code of 1986 (Code). Title I of the Employee Retirement Income Security Act of 1974 (ERISA) also contains requirements applicable to qualified and nonqualified retirement plans. The requirements in the Code are imposed in exchange for the considerable tax advantages associated with qualification. A sponsoring employer is allowed a current tax deduction for plan contributions, subject to limits, while participating employees do not include contributions and earnings in gross income until they are distributed from the plan. Trust earnings accumulate tax free in the plan. These important tax preferences for qualified plans are designed to encourage employers to sponsor retirement plans. It is often noted that pension coverage reduces the need for public assistance among retirees and reduces pressure on the Social Security system. See, e.g., Joint Committee on Taxation, Overview of Present-Law Tax Rules and Issues Relating to Employer-Sponsored Retirement Plans (JCX-16-99), March 22, 1999.

The tax-law requirements applicable to qualified plans are in large part aimed at ensuring that the plans provide proportionate benefits to a sufficiently broad-based employee population. The requirements in Title I of ERISA contain many of the same protections for employees, as well as a framework of fiduciary standards, and provide an additional enforcement mechanism to ensure compliance with these requirements.

The Internal Revenue Code prohibitions against discrimination in favor of highly compensated employees are targeted at ensuring that the broad-based population earning benefits under qualified plans includes a proportionate number of lower- and moderate-income workers, as well as those who are more highly compensated. The vesting and accrual rules found in both the Code and Title I of ERISA are designed to ensure that the benefits under a plan are delivered not only to workers who stay with a single employer until retirement, but also to those who change employers more frequently. In addition, section 411(d)(6) of the Code and section 204(g) of ERISA set forth an anticutback rule which provides that once a participant has earned a retirement benefit, the benefit cannot be reduced. Thus, while employers have significant flexibility in establishing, terminating and amending the pension plans they provide to their employees, this flexibility is not without limitations.

In order to apply the requirements of the Code and ERISA, a retirement plan must be categorized as either a defined contribution plan or a defined benefit plan. The definition of a defined contribution plan under section 3(34) of ERISA and Code section 414(i) is a plan which provides an individual account for each participant and for benefits based solely on the amount contributed to the participants account and any income, expenses, gains and losses, any forfeitures of accounts of other participants which may be allocated to such participants account. Under section 3(35) of ERISA and Code section 414(j), a defined benefit plan is a pension plan that is not a defined contribution plan.

Under these definitions, in order for a retirement plan to be a defined contribution plan, all assets in the plan must be allocated among the individual accounts which are maintained for each participant. Each year, the allocable share of the plans investment return is added to a participants account together with the participants share of any contributions or forfeitures. The contributions typically will be a fixed percentage of pay for all participants, or may vary in accordance with an employees cash or deferred election under a 401(k) plan. By contrast, under a defined benefit plan, a participants benefit is determined under a plan formula and is independent of the investment return. Thus, under a defined benefit plan, the employer bears the risk of investment return; under a defined contribution plan, the employees bear that risk.

The traditional models used for defined benefit plans and defined contribution plans have given rise to significant economic differences between the types of plans that transcend the legal distinctions. As noted, defined contribution plans provide for contributions allocated each year to each participant, while defined benefit plans typically state a benefit promise in terms of an annual benefit commencing at normal retirement age. This has led to a difference in the pattern under which the ultimate economic value of plan benefits is typically earned or accrued under the two types of plans.

Under a traditional defined benefit plan that provides for an annuity benefit generally based on final average pay (e.g., 1% of highest average pay times years of service), a participant typically will earn the most valuable benefits later in his or her career. The surge in benefit value under a final average pay defined benefit plan occurs for a number of reasons. First, a retirement benefit expressed as a fixed annuity payable at retirement is more valuable to a worker who is closer to retirement age than to a younger worker. This first difference applies both in the case of a final average pay plan and in the less common cases of a career average pay plan or a flat benefit plan.

A second reason for the benefit value surge in a traditional final average pay plan is that the annuity benefit is computed with reference to highest average pay which is typically earned in the workers final years of employment. As a workers pay increases, it causes an increase in the plan benefits that were earned in prior years (which were based on the workers pay in those prior years) and the amount of this increase in prior benefits is proportional to the number of past years of service under the plan. Because older workers tend to have longer service, they will derive the greatest value from this final average pay feature. A third reason is that a defined benefit plan may offer a subsidized early retirement benefit to employees who retire after a specified number of years. When an employee satisfies the eligibility conditions for the subsidy, the value of the employees benefit can increase considerably.

In contrast, defined contribution plans provide a more ratable accrual. If two employees of different ages receive the same allocation to their individual accounts, the current economic value is the same. In addition, contributions made to an employees account are based on the current years pay. Thus, unlike the case of a defined benefit plan that bases benefits on final average pay, in a defined contribution plan there is no retroactive increase in past contributions to reflect the excess of current years pay over past years pay. Defined contribution plans also do not provide for early retirement subsidies.

Cash balance plans and other hybrid plans are plans of one type -- defined benefit or defined contribution -- that also have characteristics of the other type. In some respects, cash balance plans resemble defined contribution plans. They are presented to employees using defined contribution plan concepts, with an account that increases over time as a result of interest and compensation credit. In addition, the pattern of economic accrual under a cash balance plan (i.e., each employee is credited with a hypothetical allocation which is the same percentage of that employees compensation for that year) is closer to the economic accrual under a traditional defined contribution plan than under a traditional defined benefit plan design.

However, a cash balance plan is not a defined contribution plan because an individuals benefits under a cash balance plan are not solely derived from the individuals allocated contributions plus attributable investment return. Therefore, cash balance pension plans are defined benefit plans. Accordingly, the contributions, interest credits and account balances under the plan are hypothetical allocations, interest credits and account balances, which are elements of a benefit formula under a defined benefit plan. As a defined benefit plan, a cash balance plan is subject to the funding provisions and other legal requirements applicable to defined benefit plans under the Internal Revenue Code and ERISA.

Most of the recent controversy relating to the use of cash balance pension plans has focused on conversions of traditional defined benefit plan structures into cash balance plans. When an employer amends a defined benefit plan that has a traditional final average pay defined benefit formula to provide for a cash balance plan formula, there is a very real change in accrual patterns that can adversely affect certain workers. Older workers who were nearing the peak years of their economic accrual under the traditional plan formula will be deprived of the opportunity to realize those large accruals. These workers might quite understandably view the plan change as tantamount to a pay cut.

Some employers have been sensitive to their older workers expectations and have designed grandfathering rules, transition credits, or employee choice provisions to help preserve the increased value that would have been provided under the old plan formula in later years. Other employers have not taken such steps, and some have reduced the overall level of spending on the plan. Many conversions have also involved elimination of early retirement subsidies on future accruals. Of course some employers that reduce overall pension benefit levels have taken steps to offset the reduction by enhancing other parts of their employees compensation and benefits package (improving 401(k) plans, providing stock options, etc.) in connection with the conversion.

In addition, many workers are uncertain whether they will be better or worse off after the plan amendment. The new cash balance formula is expressed as a hypothetical allocation to an account. The old benefit was expressed as an annuity payable at retirement. Most employees are unable to make the apples to oranges comparison that is needed to analyze whether their benefit package has been enhanced or cut back. Some plan sponsors undertaking conversions have given their workers extensive information to enhance their understanding of the effects of the conversion. Other employers, however, have merely complied with the minimum legal requirements, both with respect to benefit protections and with respect to disclosure (as will be described later in this testimony). In addition, we are concerned that in some instances employers might not have satisfied even these minimum requirements.

Section 411(d)(6) of the Code and section 204(g) of ERISA set forth certain participant protections that apply whenever an employer amends a plan. Under these sections, an amendment cannot reduce any benefits that have accrued prior to the plan amendment. Thus, if a plan participant accrued a benefit under a defined benefit plan of $1,000 per month payable at age 65 prior to a plan amendment, the participant after the amendment is entitled to an accrued benefit of at least $1,000 per month payable at age 65.

In 1984, Congress provided that the protections of Code section 411(d)(6) and ERISA section 204(g) apply in a similar manner to optional forms of benefit and early retirement subsidies. For example, if prior to a plan amendment a participant had an accrued benefit equal to $1,000 per month and had the right to elect to receive a lump sum using a specified set of actuarial factors, after any amendment the participant must -- at a minimum -- be entitled to a lump sum with respect to the $1,000 monthly benefit using those same actuarial factors. The protections afforded to early retirement benefits are similar, except that, in the case of an early retirement benefit or retirement-type subsidy that has a minimum service requirement, a participants service after a plan amendment must continue to be recognized for purposes of satisfying such a requirement.

The requirements of Code section 411(d)(6) and ERISA section 204(g) must be satisfied whenever an employer amends a plan, including when an employer changes from a traditional defined benefit plan formula to a cash balance plan formula. There are a number of ways in which the requirements can be satisfied, but the two most common ways are known as or additive formulas and greater of formulas.

Under a sum of formula, the benefits after the amendment are defined as the sum of the benefits before the amendment plus additional future service benefits under the amended formula. Under the greater of formula, the benefits after the amendment are initially determined under the new formula based on a participants service both before and after the amendment date and are then compared with a frozen benefit equal to the participants benefit as of the date of amendment. If the frozen benefit is greater than the new formula benefit, the plan complies with Code section 411(d)(6) and ERISA section 204(g) by providing that greater benefit. In such a case, the participant does not actually earn additional benefits under the plan after the amendment, because the benefit the participant ultimately receives is attributable entirely to preamendment service. This phenomenon is sometimes called a wearaway. The participants excess benefit (i.e., excess of the frozen benefit the participant is entitled to under Code section 411(d)(6) and ERISA section 204(g) over the benefit for the participants past years determined under the plan as amended, without regard to the frozen benefit) is worn away through the mechanism of not providing additional benefits under the new formula until the new formula benefits catch up with the frozen benefit.

In the case of a cash balance conversion, using the sum of formula would mean that the hypothetical account balance under the cash balance plan would only reflect hypothetical allocations for periods after the conversion and by definition there would be no wearaway. In order to use the greater of formula, the employer typically establishes an opening cash balance account balance to provide a benefit based on an employees service prior to the amendment and adds to that account balance hypothetical allocations for periods after the conversion. If the opening account balance plus subsequent hypothetical contributions and interest credits results in a smaller benefit than the frozen accrued benefit a participant is entitled to under section Code section 411(d)(6) and ERISA section 204(g), the plan complies with those requirements by providing the higher frozen benefit.

Whether a wearaway occurs in connection with a cash balance conversion, and the length of any wearaway period, depends on a number of different variables. For example, some employers choose to establish an opening account balance equal to the present value of an employees accrued benefit payable at normal retirement age, using the interest rates set forth in Code section 417(e) and provide hypothetical interest credits using the same rate. In such a situation, if the employee retires at normal retirement age and the section 417(e) interest rate is unchanged, the benefit derived from the opening account balance will always equal the pre-amendment accrued benefit. Accordingly, in such a situation there would be no wearaway.

However, if the prior plan provided for a subsidized early retirement benefit and the participant retires early, the sum of the opening account balance and the hypothetical interest credits on that balance would generate an equivalent early retirement benefit that is less than the protected subsidized early retirement benefit. In such a case, there would be a wearaway of the early retirement benefit (even though there is no wearaway of the accrued portion of the normal retirement benefit). Similarly, if interest rates decline after the opening account balance is established, there will be a period of wearaway that might not have been anticipated when the conversion occurred; conversely, if interest rates increase, the wearaway may disappear.

In other cases, a period of wearaway can result from a deliberate plan design. For example, if the employer uses a higher interest rate to establish the opening cash balance, it can reasonably be expected that there will be a period of wearaway. If a participant accrued a benefit of $1,000 per month prior to a cash balance conversion, and the opening account balance is based on an interest rate that exceeds the section 417(e) interest rate, when that opening account balance is converted back to an annuity it might be equivalent to $800 per month. In such a case, the period of wearaway will continue until the hypothetical allocations credited to the cash balance plan after the amendment exceed $200 per month.

Some employers have argued that a lower opening account balance as a way to manage a risk the plan takes on when it establishes an opening account balance. That risk is most easily described in the context of a lump sum distribution. Under a traditional defined benefit plan, a participants lump sum amount will often fluctuate in accordance with changes in interest rates. As interest rates increase, the lump sum diminishes, and vice versa. Accordingly, the plan and the employee have a symmetric interest rate risk.

However, once an employer establishes an opening account balance as part of a cash balance conversion, the interest rate risk is no longer symmetric. If interest rates fall, the employee is entitled to a higher lump sum, as is the case in a traditional defined benefit plan. If interest rates rise, however, the cash balance plan generally would still provide the opening account balance even though it is larger than the lump sum equivalent of the preamendment accrued benefit. Some employers are similarly reluctant to include the full value of any pre-amendment early retirement subsidy in their determination of an opening account balance, because such a calculation would give an employee the value of the early retirement subsidy even if it turns out that the employee does not retire early.

The Administration is addressing cash balance plan conversion issues at both the administrative level -- with respect to the application of current law to these transactions -- and the legislative level. At both levels, the Administrations approach has been focused on worker protections, while remaining sensitive to the need to maintain an environment in which employers will want to continue sponsoring pension plans under our voluntary system.

IRS Chief Counsel Stuart Brown has discussed in his testimony the administrative approach being taken by the Internal Revenue Service and the Department of the Treasury with respect to the issues raised by cash balance plan conversions. We take these issues, particularly those involving age discrimination in conversions, very seriously. We are committed to ensuring that a thorough review, with appropriate coordination with the Department of Labor, is made of all of these issues and that the review of age discrimination issues is coordinated fully with the Equal Employment Opportunity Commission and the Department of Labor.

The Administration has proposed a significant strengthening of the disclosure requirements that apply to cash balance conversions and to other pension plan amendments that give rise to a significant reduction in the rate of benefit accrual. These enhanced disclosure requirements would apply to defined benefit plans and to other plans subject to the minimum funding standards of ERISA.

The Administrations proposal follows the lead of Senator Moynihan, who sponsored S. 659, and we have worked with Senator Moynihans staff in developing the Administrations proposal. We commend Senator Moynihan, as well as his cosponsors Senators Kennedy, Bingaman and Wellstone of this Committee and cosponsor Senator Leahy, who testified earlier today, on their groundbreaking work in this chamber on the important issue of providing appropriate disclosure to participants.

We believe that the current controversy surrounding cash balance plans is in part a product of employees receiving inadequate or confusing information about significant changes in their pension plans. Some individuals have even gone so far as to suggest that, from the standpoint of the employer, one advantage of cash balance conversions is potential worker confusion -- that converting to a cash balance plan, as opposed to other approaches to changing pension benefits, makes it difficult for workers to discern the impact of the change on their pension benefits. Such disrespect for workers is unacceptable. The Administration believes it is extremely important that participants receive meaningful disclosure regarding their pension benefits. Employees need to be able to obtain complete information on the extent of a benefit reduction and understand what it means to them.

Clear and concise disclosure regarding the reduction in anticipated retirement income will permit employees to evaluate the new plan in an informed manner. Instead of speculating about the impact of the plan change based on incomplete or confusing material, participants should receive useful information relevant to their own personal situation. Employees can use these estimates, for example, to revisit their planning for retirement, and increase their personal saving if necessary. One worker might decide to contribute more to the employers 401(k) plan to take full advantage of employer matching contributions; another might decide to postpone retirement in order to earn additional pension benefits under the new plan. In some cases, adequate disclosure might cause some employees to focus on the fact that they will likely be earning little or no additional pension for a period of time, and they might even decide to take another job.

The notice mandated by current law will not adequately answer the questions employees have about plan changes. Existing disclosure requirements were developed in the context of simple and straightforward plan amendments, namely an amendment that would terminate or completely freeze pension plan accruals. ERISA section 204(h) requires merely that a plan participant be notified of a reduction in the rate of future benefit accruals; it does not require that the reduction be explained in a way that illustrates the effect of a plan change. While a simple notice may be all a participant needs to understand a straightforward (though major) change such as a plan freeze, more complicated plan amendments, like cash balance conversions, require more comprehensive explanation. The Administrations proposal helps to protect workers interests by ensuring that they receive meaningful understandable information about their benefit changes.

Employees often experience confusion about the impact of cash balance conversions, in part because it is unclear whether the new plan is a better plan for each individual worker. Workers accustomed to their traditional defined benefit plan, which expresses a pension benefit in terms of a monthly annuity, are now being told they have a single sum benefit in their cash balance account. Participants legitimately ask how the apples -- their monthly pension benefits -- compare with the being provided in lump sum form. Workers also want to know how their early retirement benefits will be affected by the change, and whether they can retire when they planned. The disclosure that would be required by the Administrations proposal would answer these questions.

The Administrations proposal would require that participants receive important information about plan changes in a straightforward and simple form. Under the proposal, the advance notice must include an explicit statement that the amendment is expected to significantly reduce the rate of future benefit accrual, together with a clear identification of the effective date of the plan change. In addition, the notice would be required to describe generally how the amendment significantly reduces the rate of future benefit accrual, and also would have to identify the class or classes of participants to whom the amendment applies. These are significant enhancements to the quality of the advance notice.

The Administrations proposal would also make the required notice more meaningful to employees by requiring that it be provided well in advance of the plan change. Under the Administrations proposal, employers that reduce pension benefits that workers would earn in the future must generally give all affected workers notice of the reduction at least 45 days in advance. This is a decided improvement to the current-law requirement of 15 days. In addition, the proposal would repeal the existing requirement in ERISA section 204(h) that the amendment must be adopted before notice is given to employees. These proposed changes will give employees timely information well in advance of plan changes.

The Administration proposes that additional disclosure be provided when larger plans make more complicated plan changes, such as cash balance conversions. In these situations, the 45-day advance notice must describe the impact of the amendment on representative workers and illustrate the reduction numerically through examples. The illustrative examples would include estimates that provide a meaningful comparison of benefits that would be earned under the amended plan with benefits that would have been earned assuming the plan had not been amended.

The description and examples must also specifically address early retirement and wearaway, two of the most important issues for employees. The enhanced description must show, if applicable, how the amendment reduces future early retirement benefits. The examples must also describe the circumstances under which an affected participant may experience wearaway and illustrate the duration of the wearaway under certain assumptions. Straightforward information about early retirement and wearaway is crucial to employees evaluation of the plan change.

In addition, many plan participants want and need personalized information. Early disclosure concerning the effect of the plan amendment, framed in illustrative examples, will give employees important information. However, after receiving the advance description, some employees may wish to learn more about their personal situations.

The Administrations proposal addresses this in two significant ways. First, immediately after receiving the advance notice, employees can request more specific information on how benefits are calculated under the terms of the plan and amendment. The employer must make available to a participant, within 15 days after the participant=s request, information that will be sufficient to confirm the estimates in the illustrative examples. For example, a plan sponsor would have to make available the formulas, factors and assumptions used to calculate the illustrative examples. This generic information, when combined with personal information that the employee has (such as wage history), will give employees (or their advisers) the ability to estimate their projected benefits. Second, within a short time following the plan change, affected employees would have the right to a personal benefit statement showing the impact of the plan change on their pensions. Patterned after the format of the illustrative examples, the personalized benefit statement would reveal reductions in projected future early retirement benefits and uncover extended periods of wearaway for the individual participant.

The Administration anticipates that improved disclosure rules will lead to better plan practices. The prospect of preparing and disseminating more extensive and focused disclosure should discourage certain plan design techniques. Where cash balance conversions involve a reduction in future benefit accruals, the conversions can be structured in a way that minimizes the reduction or in a way that exacerbates the reduction. Enhanced disclosure will highlight the choices employers make in designing their plans. Clearer disclosure will also help preclude the risk that a cash balance conversion will have the effect of masking a reduction in benefits.

We commend the Members of this Committee who also have recognized that improved disclosure is an important first step in protecting the rights of workers and in encouraging plan sponsors to be sensitive to employee concerns. We look forward to working with you to enact meaningful legislation to improve disclosure for workers.

We note that Senator Harkin has introduced S. 1600, the Older Workers Pension Protection Act of 1999, which would go beyond disclosure and prohibit the practice of wearaway that is often associated with cash balance conversions. However, the proposed prohibition would not be limited to wearaways associated with cash balance plan conversions. We commend Senator Harkin and the cosponsors of S. 1600, Chairman Jeffords and Senators Leahy, Kennedy, Reid and Wellstone, for their deep concern about workers retirement security. As we move forward in our analysis of the issues raised by conversions under current law, we will be in a better position to consider whether further statutory protection is needed beyond the disclosure area.

As hybrid plans rapidly evolve and new variations are developed, we are working to maintain a regulatory framework that accommodates innovation and needed flexibility within our voluntary private pension system. We seek to do this within the context of our central mission: to faithfully interpret and enforce the law, to protect workers pension rights and benefits, to preserve the integrity of our tax-favored pension system, and to pursue the goal of a secure retirement for all Americans.

The Treasury Department appreciates the opportunity to discuss these important issues with the Committee, and we would be pleased to explore these matters further.

Mr. Chairman, this concludes my formal statement. I will be glad to answer any questions you or other Members may wish to ask.