Cash Balance Plans

Practical Law Legal Update 6-525-8647 (Approx. 4 pages)

Cash Balance Plans

by PLC Employee Benefits & Executive Compensation

Basic Principles of Cash Balance Plans

Under a cash balance plan, each participant has a hypothetical cash balance account. This hypothetical account is similar to an individualized account under a 401(k) plan and serves as a theoretical repository for pay credits and interest credits.

Pay credits are calculated with an allocation formula similar to the formula that would be used to calculate a nonelective employer contribution under a defined contribution plan.

Interest credits are calculated as either a fixed rate or a variable rate linked to an index such as the rate of return on a Treasury security.

No money is actually deposited into the cash balance accounts. Instead, employers make annual contributions to a pension trust fund on behalf of all participants. Annual contributions are determined actuarially to ensure that the trust has sufficient assets to pay benefits. Plan trustees have investment control over the assets in the cash balance pension trust and the hypothetical accounts are credited with interest credits, not with the actual investment gains or losses experienced by the trust. If the trust assets grow at a rate greater than the promised interest credits, the plan sponsor can expect over time to make contributions less than the promised pay credits.

PLC's Practice Note, Cash Balance Plans, co-authored with Stephen Pavlick & Ashley McCarthy, McDermott Will & Emery LLP provides an overview of cash balance plans and analyzes cash balance plan controversies.

Conversions of Pre-existing Defined Benefit Plans to Cash Balance Plans

Employers sometimes convert their defined benefit plans to cash balance plans, which they do by amending the defined benefit plan to replace the defined benefit formula with the cash balance formula. Benefits are then calculated based on the pay credit and investment credit.

A conversion is subject to the same rules that apply to any defined benefit plan amendment, including:

Accrued benefits may not be reduced.
Participants must be given notice before the rate of future benefit accruals is reduced.
The rate of future benefit accruals may not be reduced because of the attainment of any age.

Before the Pension Protection Act of 2006 (PPA), neither the IRC nor the ERISA required plan sponsors to follow a particular method for implementing cash balance plan conversions. Employers could instead choose from several conversion methods. The PPA provides minimum conversion requirements that apply to plan amendments adopted and effective after June 29, 2005.

Advantages of Cash Balance Plans

Cash balance plans offer many benefits to both plan sponsors and participants, including:

Ease of communication to participants.
Cost.
Smaller financial risk for plan sponsors.
Increased funding of benefits.

Communication

Cash balance plans are easier to communicate to participants than defined benefit plans since participants can easily comprehend and appreciate the value of their benefit when it is expressed as a lump-sum amount that will increase over time at a specified rate.

Cost

Cash balance plans are generally less expensive than traditional defined benefit plans.

Financial risk

Cash balance plans present less financial risk for plan sponsors than traditional defined benefit plans, which are exposed to both:

Asset risks through their investments.
Liability risks (liabilities rise as interest rates fall).

From the participants' perspective, the investment risk remains with the plan sponsor.

Funding

The deduction for contributing to a cash balance plan is in addition to the maximum allowable deduction for contributions to a defined contribution plan. Even if an employer already sponsors a defined contribution plan, a cash balance plan permits increased pre-tax funding of retirement benefits.

Cash Balance Controversies

Despite their advantages, cash balance plans have generated controversy in recent years relating to:

Plan conversions and wear-away. This can occur in a conversion where a participant's benefit is converted into a hypothetical opening account balance. If this opening account balance is less than the present value of the benefits the participant has already accrued, the participant may experience a wear-away, which may cause the participant to have to work several years before accruing any additional benefits under the cash balance plan.
Back-loading. This can occur when the rate of benefit accruals in a cash balance plan increases as years of service increase. Back-loading results can result in a disproportionate amount of benefit accruals for participants for later years of service than for earlier years.
Whipsaw effect. This can occur when a cash balance plan participant terminates employment before normal retirement age and elects to receive his plan benefits as a lump-sum distribution by converting his hypothetical account balance to an annuity payable at normal retirement age and then discounting the annuity to a lump sum. The basic issue is whether the lump-sum payment equals the current account balance or the present value of the accrued benefit expressed as an annuity beginning at normal retirement age.
Age discrimination. This can occur since cash balance plans generally guarantee future interest credits at the time the underlying pay credit is allocated to a participant's hypothetical cash balance account. The value of a particular pay credit is less for an older employee than a younger employee because as an employee ages, there will be fewer years of interest credits associated with an underlying pay credit.

The PPA has relaxed some of the rules surrounding cash balance plans that were responsible for many of these controversies. However, establishing and maintaining a cash balance plan still requires an understanding of these controversies and how to comply with the rules. For more information on these rules, see Practice Note, Cash Balance Plans.

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