How Does A Cash Balance Plan Work?
A cash balance plan is a hybrid plan in the sense that the plan combines features of both defined contribution and defined benefit plans. Similar to most defined benefit plans, there are no participant contributions. The employer determines benefit levels and bears responsibility for providing the specified level of benefits at retirement. Like a traditional defined benefit plan, funds are not segregated into individual accounts, but rather, are pooled and managed as a single trust fund.
The plan expresses benefits in terms of hypothetical account balances for each participant; in this sense, benefits are communicated to employees in much the same way as a defined contribution plan. Account balances are “hypothetical” only in the sense that, like any other defined benefit plan, the benefit must always be convertible to the underlying annuity. Annual contribution credits may be constant or may increase based on advancing age and/or service. The contributions are credited with a rate of interest that is typically tied to an outside index, such as the one-year U.S. Treasury Bill rate.
On an annual basis, participants receive a statement illustrating their account balance, which equals the lump sum value of their benefits under the plan. Statements include a beginning-of-year account balance, earnings for the year, the employer provided allocation and an end-of-year balance.
Like a traditional defined contribution plan, cash balance benefits are payable as a lump sum payout upon termination at any age. This gives the cash balance plan the advantage of having completely portable benefits.
WHY OFFER A CASH BALANCE PLAN?
SIMPLICITY – Benefits are structured in a way that is easily communicated to employees. Employees are better able to appreciate the value of the plan since benefits are communicated in the form of a lump sum account balance including employer provided allocations and investment earnings.
PORTABILITY – Portability reinforces participant appreciation as benefits may be distributed at any age as a lump sum payment, benefits are also available as an annuity.
COST CONTROL – Cash balance plans tend to reduce pension costs because benefit targets are based on current salary rather than projected final average salary. In this sense, cash balance plans are similar in design to career average traditional defined benefit plans. Employers typically find they can get “more for less” by providing a more easily understood and appreciated benefit at a lower cost.
FLEXIBILITY – Plan features afford the employer maximum flexibility and can be designed to meet both cost and benefit objectives. Employers often find they can achieve a greater degree of equity through a cash balance plan. Equity can be achieved through either an age-based or service-based plan design which provides higher allocation rates to older or longer-service plan participants.
BENEFIT SECURITY – The main advantage of maintaining the Cash Balance plan as your Defined Benefit program is the security provided by defined benefit plans. Benefits at retirement are definitely determinable at any point in time and are guaranteed under the plan provisions. Also, the protections afforded by the Employee Retirement Income Security Act (ERISA) are more stringent with regard to defined benefit programs.
PBGC INSURED – Since a cash balance plan is a defined benefit plan, plan benefits are insured by the Pension Benefit Guaranty Corporation.
TAX IMPLICATIONS – As is the case with all qualified pension plans, contributions are fully tax-deductible to the organization and benefits accrue on a tax-deferred basis.
WHAT TYPES OF BENEFIT FORMULAS CAN BE USED WITH A CASH BALANCE PLAN?
The plan’s benefit formula is a fundamental plan design issue. The benefit formula affects both the level of retirement income that the plan will provide and the plan’s cost. Cash balance plans provide annual salary-related credits in accordance with the plan’s benefit formula.
Various types of formulas that can be used include:
UNIFORM PERCENTAGE FORMULAS
An employer may elect to provide employees with a uniform annual contribution of between 5% and 15% of plan salary. Contributions are posted to each participant’s account. Account balances earn a guaranteed rate of interest each year.
Rather than providing a single allocation rate for all employees, rates can increase with length of service or age.
SERVICE GRADED FORMULAS – A service graded formula provides an annual credit which increases as a percentage of salary every five or ten years of service.
AGE-GRADED FORMULAS – Alternatively, annual salary-related credits may vary based on the participant’s age. An Age Graded formula provides an annual credit which increases as a percentage of plan salary once the employee reaches certain ages.
CAN AGE/SERVICE FORMULAS BE COMBINED IN A CASH BALANCE PLAN?
Yes, a cash balance plan formula can be designed to provide credits based on both age and service. Under this type of arrangement, the percentage of plan salary which the participant receives as an annual credit is based on the sum of the employee’s age and years of service.
WHAT IS A PENSION EQUITY PLAN?
A pension equity plan is a type of Cash Balance Plan. Under a Pension Equity Plan, employees accrue a percentage of final average pay for each year worked. The percentage accrued each year may increase with age.
The advantage inherent in a Pension Equity Plan is that the benefit at retirement is reflective of final salary. As with other cash balance arrangements, the benefit is expressed in the form of a lump sum.
WHAT ARE THE FUNDING REQUIREMENTS FOR A CASH BALANCE PLAN?
Individual participant account balances and current year allocations are credited with a guaranteed rate of interest specified by the plan. The interest rate is usually based on a particular index, such as the Consumer Price Index or a U.S. Treasury rate. Employers select the interest rate to be credited under the plan within the guidelines issued by the IRS.
Employer contributions are determined using an actuarial funding method as is the case for any defined benefit plan. The funding method is used to calculate the plan’s annual normal cost, which equals the value of benefits accruing under the plan during the year. The funding method takes into account expected investment earnings, projected benefit levels, employee turnover and assumptions regarding salary levels and life expectancy. It is important to note that employer contributions are not equal to the sum of the annual participant account allocations. For example, an overfunded plan may have no required employer contributions for a given year, despite the current year allocations.
Although allocations are credited to individual hypothetical accounts, actual plan assets are commingled for investment purposes. Since the plan is a defined benefit plan, participants may not direct the investment of their account. If the plan’s investment performance exceeds the stated rate of interest, the excess will be applied to reduce the employer’s cost to fund the plan. Conversely, if investments do not outperform the assumed rate, employee account balances will still receive the stated rate of return and future employer contribution requirements may increase. This is the mechanism that provides employees with benefit security by insulating them from the risk of investment losses.
WHY OFFER A CASH BALANCE PLAN INSTEAD OF A TRADITIONAL DEFINED BENEFIT PLAN?
Cash balance plans have proven to be an attractive alternative to traditional defined benefit plans for several key reasons.
By converting a defined benefit plan to a cash balance plan, the employer avoids the need to terminate the defined benefit plan. Plan termination typically involves extensive actuarial calculations, government filings, and the need to purchase annuities to settle plan liabilities. The process usually generates significant fees from the plan’s actuary, attorney and accountant.
In converting a defined benefit plan to a cash balance plan, the employer is often able to reduce plan costs. Typically, traditional plans are based on a participant’s final average pay for a period just prior to retirement. Since Cash Balance benefits are based on current year’s pay, plan funding requirements are generally lower. In many cases this restructuring of the benefits creates surplus assets or overfunding. This surplus can reduce or eliminate funding costs for a number of years.
Employees in today’s workforce are increasingly more mobile. Cash balance plans have proven to be more attractive to short-term employees. The plan is structured to allow employees who terminate for any reason at any age to access their retirement monies. This allows employees to rollover their account balance to an IRA or to a new employer’s plan. Traditional plans typically restrict access to retirement funds until employees reach retirement age. Depending on age at termination, these funds could experience significant erosion due to inflation.
Since Cash Balance benefits are expressed in the form of an account balance, employees may feel more appreciative of the contributions being made on their behalf. The manner in which cash balance benefits can be communicated is more straightforward and makes them easier to understand than in a traditional defined benefit plan. Beyond that, interest on an account balance is guaranteed, rather than dependent on the investment performance of an actual investment fund. The combination of these factors leads to greater employee understanding and appreciation of the retirement program with a lower employer cost. The conversion of a defined benefit plan is particularly advantageous where an employer maintains an overfunded defined benefit plan. The defined benefit plan can be converted to a cash balance plan, with the excess funds remaining in the plan, available to fund the cash balance benefits. The period during which the excess is expected to cover annual normal costs is extended twofold by increasing the amount of excess assets and reducing the cost of annual accruals. In underfunded plans, a more positive funded status is created with lower annual normal costs.
WHAT STEPS NEED TO BE TAKEN IF A CASH BALANCE PLAN IS ADOPTED IN PLACE OF A TRADITIONAL DEFINED BENEFIT PLAN?
In the event that the employer adopts a cash balance plan in place of a traditional defined benefit plan, the plan is amended and restated to reflect the new provisions.
HOW IS THE PLAN TRANSITIONED FROM A TRADITIONAL DEFINED BENEFIT PLAN TO A CASH BALANCE PLAN?
There are several ways to transition from a traditional defined benefit plan to a cash balance plan. All benefits accrued to the transition date are guaranteed under the prior plan provisions. Several of the transition approaches are described below.
In the simplest case, a lump sum equal to the present value of accrued benefits under the defined benefit plan are calculated for each employee. This present value is then credited to each participant’s account as the participant’s “opening balance” under the cash balance plan.
In converting from a traditional defined benefit plan to a cash balance plan, the employer can guarantee, for a select group of employees, that projected benefits under the new plan will not be less than they would have been under the prior plan. Using a grandfathered approach, the cash balance plan can incorporate the defined benefit formula as the minimum benefit. This essentially creates a “minimum benefit” based on the prior plan benefit formula. The group of employees that would benefit under such a provision would need to satisfy IRS nondiscrimination requirements.
Using a transition provision more commonly referred to as a “Salary Roll-Up” the employer can ensure that prior plan benefits increase as the employee’s salary increases. A salary roll-up may be used to ensure that the value of the transition benefit grows as the employee’s salary grows.
ADDITIONAL PERCENTAGE OF PAY
The employer may elect to provide additional credits to employees upon conversion of the plan.
Under this arrangement, the employer would allocate an additional one-time payment of a percentage of pay to each eligible employee’s account. This contribution is made in addition to the regular annual contribution that the employer credits on an annual basis.
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