Employee Benefits Bulletin, December 2002
Treasury Issues Proposed Regulations on Cash Balance Plans
What Are The Issues?
Political Background
In the late 1980s, Bank of America converted its defined benefit plan into a cash balance plan. Since then, interest in cash balance plans has mushroomed, with a healthy percentage of the Fortune 500 and many other firms converting traditional defined benefit plans into cash balance formats. Firms that have converted to cash balance plans often cite lower costs and a plan format that is more attractive to younger, more mobile employees than a traditional defined benefit plan.
In the late 1990s, the news media turned a spotlight on the darker side of cash balance plans: conversion of a traditional defined benefit plan into a cash balance plan can reduce the future benefit accruals of older employees. While many contend that the media reporting has been sensationalistic, it negatively affected the public perception of cash balance plans and in 1999 the IRS and Department of Treasury announced that they were studying cash balance issues in anticipation of issuing regulations on key cash balance questions. At the same time, the IRS froze its consideration of new requests for determination letters for cash balance plans.
On December 11th, the Department of Treasury published proposed regulations on certain cash balance issues. There is a 90-day comment period, after which the Department will issue final regulations and the IRS will again start giving formal approval to such plans. People familiar with the Department of Treasury’s thinking do not expect the final regulations to depart significantly from the proposed regulations.
This article will briefly describe cash balance plans and the features that have made them attractive to some firms and controversial to some employees; discuss the Department of Treasury’s proposed regulations; and suggest what types of businesses may want to convert a traditional defined benefit plan into a cash balance plan or adopt a new cash balance plan from scratch.
What is a cash balance plan, and why are they generally less favorable to older employees?
Defined benefit v. defined contribution plan
A cash balance plan is a type of defined benefit plan, with the look and feel of a defined contribution plan. So, to understand cash balance plans, we first must have some basic familiarity with the features of a defined benefit plan.
A defined benefit plan promises an employee a specific benefit at retirement age; the benefit is based on a formula contained in the plan. Thus, defined benefit plans are different from 401(k) and other defined contribution plans, where each employee has an investment account to which the firm and/or the employee contribute, and the employee’s retirement benefit is the account balance, which is usually paid to the employee in a lump sum. (In a defined benefit plan, the normal form of retirement benefit is a life annuity, although some defined benefit plans give the employee the option of taking a lump sum payout.)
A primary difference between defined benefit and defined contribution plans is where the investment risk falls: in a defined contribution plan, the risk falls on the employee. In a defined benefit plan--which is obligated to pay specific benefits under a plan formula-- the investment risk falls on the sponsoring employer, which has to ensure the plan has adequate assets to pay all promised benefits. In addition, benefits in defined benefit plans are often insured by the Pension Benefit Guaranty Corporation.
Traditional defined benefit plans v. cash balance plans
Traditional defined benefit plans promise employees a monthly retirement benefit at retirement. Typically, the monthly retirement benefit is calculated under a formula that takes into consideration pay and years of service. For example, a common defined benefit plan formula might calculate a monthly benefit by multiplying years of service by a percentage (say 2%) times final pay. Another common approach is to multiply service by a percentage times career-average pay. The traditional defined benefit plan, however, always defines the basic plan benefit as a periodic payment commencing at retirement.
Cash balance plans are different: they define the benefit as a cash amount. Cash balance plans set up hypothetical “accounts” for each employee. Each year, these hypothetical accounts are credited with a percentage of salary and an interest credit on the account “balance” for the last year. For example, a cash balance formula might say that an employee gets a 10% salary credit each year and 4% interest credits through retirement age.
At retirement, the benefit is the hypothetical account balance. Although the plan must offer the employee the option of using the account balance to purchase an annuity benefit, the expectation is that most employees will take the cash benefit and roll it over into an individual retirement account. And if an employee quits or is fired before retirement age, the plan generally pays them their account balance at that time.
Thus, a cash balance plan looks to employees very much like a defined contribution plan: their benefit appears to be a growing cash account.
But the plan is not a defined contribution plan and the employees do not have real account balances. Rather, they have a promised benefit equal to their hypothetical account balance. The employer, through its contributions, must ensure that the plan has sufficient assets to pay benefits as they come due. Thus, the employer bears the risk of poor investment return and reaps the benefit of good investment return. In addition, the Pension Benefit Guaranty Corporation guarantees the benefit in the case of plan insolvency.
Why are cash balance plans controversial?
Cash balance plans are controversial because they are less favorable to older employees than traditional defined benefit plans. Thus, when a business converts a traditional plan to a cash balance plan, older employees will earn smaller future benefits. In some cases, a conversion will reduce an older employee’s expected retirement benefits by more than half.
Why are cash balance benefits not as good for older employees?
There are actually two reasons. The first reason is that benefits in a traditional defined benefit plan are frequently based on final pay, which means that every pay raise affects all prior benefits. The second reason is that a traditional defined benefit plan promises a benefit payable at retirement age. The value of a dollar’s worth of benefit payable at retirement age is worth more for an older employee since the benefit’s payment is closer in time to when the employee earns it. For example, if an employer promises to pay a 25 year old and a 64 year-old one dollar at age 65, the promise is much more valuable to the 64-year old.
In a cash balance plan, the employee’s new benefit is basically the pay credit, which is the same for all employees earning the same salary that year. In other words, the cash balance plan’s format does not favor the older employee. In practice, this means that a conversion of a traditional defined benefit plan into a cash balance plan will reduce future benefits for older employees.
Do conversions have to harm older employees?
No. A firm that converts a traditional plan into a cash balance plan can take steps to protect the older employee’s benefit expectations if it wishes, but of course this increases the business’s future benefit costs. One way of protecting benefits is to give older employees the option of continuing to earn benefits under the traditional defined benefit formula. Another way is to give older employees larger pay credits.
What do the proposed regulations say?
The proposed regulations address two issues. First, they refute an argument made by some plaintiffs’ lawyers that cash balance plans violate certain technical age-discrimination requirements of the Internal Revenue Code. Second, they establish some rules dealing with the transition between a traditional defined benefit formula and a cash balance formula. In general, the regulations provide a green light to new cash balance plans.
Who should consider adopting a cash balance plan?
Firms that have traditional defined benefit plans.
An employer with a traditional defined benefit plan may in certain circumstances want to consider switching to a cash balance plan. There are at least two situations in which a conversion might be attractive:
The employer needs to recruit younger employees, who do not value or understand a traditional defined benefit plan. For younger employees, a cash balance plan provides more valuable and easier-to-understand benefits.
The employer has an aging workforce and wishes to reduce the cost of their future benefits.
Firms that do not have defined benefit plans.
Although to date most cash balance plans have resulted from conversions of traditional defined contribution plans, some businesses may want to consider adopting a cash balance plan from scratch. Although such plans look like defined contribution plans, they can, in some cases, provide more flexibility and other advantages over a defined contribution plan. Among these are the following:
An employer has more funding flexibility in a cash balance plan than a defined contribution plan (i.e., the annual contributions can be larger or smaller than the year’s benefit growth in the plan).
A cash balance plan can, in some cases, give benefits for years someone worked before the plan was adopted. Thus, for example, a business can sometimes use a cash balance plan to provide a very large initial benefit to the business’s owner, much larger than would be possible in a true defined contribution plan.
The employer benefits from good investment performance.
Some plan benefits are guaranteed by the Pension Benefit Guaranty Corporation, which can be appealing to employees who have watched their 401(k) account balances decline in value.
There are financial reporting benefits to a cash balance plan in certain circumstances.
Moreover, a business that has a regular defined contribution plan, such as a 401(k) plan, an ESOP, or profit-sharing plan, can adopt a cash balance plan as well, thereby increasing the amount that can be contributed and deducted for key employees.
Are there any disadvantages to cash balance plans over defined contribution plans?
Cash-balance plans do have some disadvantages over true defined contribution plans. They tend to have higher annual operational costs, require payment of premiums to the Pension Benefit Guaranty Corporation, and impose the risk of poor financial performance on the employer.
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