Has IBM Built the Next Generation’s 401(k) Plan?

The Big Reveal

For better and worse, IBM IBM creates retirement-plan headlines. When the firm debuted its 401(k) plan in 1984, that decision signaled that defined-contribution accounts were the wave of the future. After all, Big Blue was the world’s largest and most prestigious company. Fifteen years later, IBM’s “reforms” of its defined-benefit plan exemplified the corporate cutbacks of the 1990s. (The action also triggered a lawsuit, which the plaintiffs first won, then lost on appeal.)

The company is now making waves once again, by completely eliminating its 401(k) match policy. The organization currently matches the first 5% of salary that employees contribute to their 401(k) accounts, dollar for dollar. Effective New Year’s Day, that perk will disappear, replaced by a “Retirement Benefit Account.”

The RBA, to abbreviate the term, will receive the 5% of employee salaries that were removed from the 401(k) match program. Those moneys will instead be diverted, regardless of the employee’s 401(k) contribution rate, to the RBA. Once inside that account, they will earn a fixed interest rate, which IBM has set for the next three years at 6%.

In short, the RBA is a defined-benefit plan. Unlike traditional pension plans, however, it vests rapidly, after one year. It is also portable. That is, whenever employees leave IBM, whether after the initial 12 months or a full 40 years, the RBA will go with them. When that event occurs, those assets may be rolled over into either another employer-sponsored plan, or an IRA.

A Rose is a Rose

If you are familiar with such things, you may think that the RBA sounds suspiciously like a “cash balance” plan. I believe that it is. When I asked an IBM source if that characterization was correct, she demurred, perhaps because the plan has not been publicly announced. (The news was leaked from an internal release.) Neither, though, did she deny the comparison.

Whatever its name, the introduction of the RBA converts IBM’s employee-retirement plan into a hybrid scheme. It will now consist partially of a defined-contribution plan and partially of a defined-benefit plan. Such arrangements are not unique, but they are unusual—particularly when openly coupled with the decision to cancel the company’s 401(k) match program.

The Drawbacks

Not all IBM employees are happy with the change. To start, the company made a small adjustment that will lower their overall retirement-plan benefit. In addition, substituting the 5% of salary that IBM contributed to 401(k) plans with an equally sized stake in a fixed-interest account could reduce participants’ long-term rate of return, as that cuts the maximum amount that they can invest in equities.

While the first issue is specific to IBM’s plan, the second carries a broader implication. If IBM’s approach were to become the industry standard, participants would no longer to able to hold extremely high stock weightings. The level would depend upon the size of the defined-benefit plan, but as a rough estimate, the equity limit for hybrid plans would be about 80%. That could be a shortcoming.

So as well might be the spillover effect with target-date funds. As they are designed to serve as stand-alone selections, combining target-date funds with a fixed-interest account muddles the investment math. This is not an insurmountable problem, but addressing the issues either requires a customized target-date lineup that adjusts for the situation (a credible solution for a giant plan like IBM’s), or excellent communications from the plan sponsor.

Potential Advantages

That said, several aspects of IBM’s new arrangement are intriguing:

1) Higher Participation Rates

Once the mandated one-year wait is completed, the RBA program will reach 100% of IBM’s employees. Achieving that goal is no great advancement for IBM, which thanks to the nature of its employee base and the automatic-enrollment program that it uses for its 401(k) plan enjoys a 97% participation rate (!) in its 401(k) plan, but it certainly would represent progress elsewhere. For example, Vanguard reports that its 401(k) clients have an overall participation rate of 83%.

2) Risk Sharing

Adding a defined-benefit segment addresses a common complaint about 401(k) plans: They shift corporate risk to employees. With traditional pensions, companies bore the investment responsibility. Not so for 401(k) plans. Although that development pleases investment-savvy workers, the rank and file is less enthralled. For example, when given the choice between a defined-benefit or a defined-contribution plan, four in five public-sector workers have selected the former. Offering a hybrid scheme partially allays such concerns.

3) Investor Psychology

In theory, investors are best served by adopting an overall portfolio approach, evaluating all their financial assets from a single perspective. In practice, as evidenced by the ongoing popularity of “bucket” strategies, most investors prefer to segment their holdings. Commonly, they hold one relatively conservative account that gives them a measure of security, while taking greater chances with their remaining securities. This, of course, is what the hybrid scheme permits.

Summary

It would be naive to imply that when performing its analysis, IBM relied solely, or even predominantly, on such considerations. As an industry insider reminded me, while businesses certainly wish to improve their employees’ financial futures, they necessarily care first and foremost about their own bottom lines. The best retirement plan, for a company seeking to maximize shareholder value, is one that costs the company the least, while satisfying the needs of most employees.

No worries. As Adam Smith informed us, self-interest can generate the best overall solutions. Perhaps IBM’s retirement plan change will once again justify the hypothesis. I will be watching, with interest.