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Frequently Asked Questions: CBP

Cash Balance Plan - What is it?


The purpose of this article is to answer the following questions in a simple-to-understand manner:
  • What is a cash balance plan?
  • Why is it becoming popular?
  • What does a plan participant need to know?


What is a cash balance plan?
Most retirement plans belong to one of two types: defined benefit (DB) and defined contribution (DC).

The main characteristics of a DB plan are:
  • the benefit for a participant is defined by a benefit formula that depends on factors such as salary and years of service
  • the contributions required to fund the plan benefits are not defined, but are calculated by an enrolled actuary based on actuarial liability, plan assets, and funding method adopted by the plan sponsor
  • sponsor (typically your employer) of the plan is responsible for the investment of the plan assets - higher returns will reduce future employer contributions, lower returns will increase future contributions
  • the plan assets are not separated for individual participants
  • the Pension Benefit Guarantee Corporation (PBGC), a governmental agency, provides a guarantee of the accrued benefits up to a certain amount - the sponsor has to pay a PBGC premium each year for this protection.
  • the DB plan has a better delivery efficiency - i.e. a dollar contributed to a DB plan by a plan sponsor delivers more value to an employee than a DC plan
  • the plans are mostly funded by employers

The main characteristics of a DC plan are:
  • the contribution formula is defined
  • the benefit is not defined - the benefit at retirement is based on contributions plus investment earnings
  • the participant is responsible for the investment risk
  • the plan assets are the sum of individual accounts
  • the PBGC does not guarantee benefits under a DC plan
  • the plan usually requires employee contributions such as in a 401(k) arrangement
A cash balance plan is a type of DB plan. It’s benefit is defined as a cash balance account. Because it is a DB plan, it has an accrued benefit at any time. The accrued benefit is calculated from the cash balance account. The plan will define how to convert the cash balance account to the accrued benefit.

An account is set up for each participant in a cash balance plan. This account will increase each year based on new credit (a percent of pay) and a theoretical investment return rate such as a fixed percent or a percent tied to a known market rate such a the US 30 year treasury rate.

At termination or retirement, a participant is typically allowed to choose a monthly annuity or a lump sum distribution. The number of options available depends on your company’s plan document. The lump sum value is the greater of the cash balance account or the lump sum value of the accrued benefit.

A traditional DB plan does not offer a cash balance account. The benefit calculated under a traditional DB plan is an accrued benefit. All other benefits such as various forms of payment including lump sum distribution are calculated from this accrued benefit.

Why Is It Becoming Popular?
Many sponsors of traditional DB plans feel that their employees do not appreciate the value of their traditional DB plans. One of the reasons is because the benefit under a traditional DB plan is expressed as an annuity instead of an account balance such as that of a 401(k) plan.

However, a DB plan has better delivery efficiency than a DC plan. Studies indicate that on the average, each dollar contributed by a plan sponsor under a DB plan delivers more value to the employee than under a DC plan. One of the main reasons for higher delivery efficiency under a DB plan is because the sponsor takes care of the investment of the plan assets.

Cash balance plans were created to improve on employee appreciation while maintaining the delivery efficiency of a DB plan. In addition, accrual pattern is more level, so you accrue retirement benefits faster and more evenly throughout your career than under a traditional DB plan.

Some employers are switching to a cash balance plan because it saves them money.

What does a plan participant need to know?
It is important that you understand how your plan works so that you get what you are entitled to and you can properly plan for your retirement. You need to understand (1) how the opening cash balance is calculated, (2) how it grows from one accounting period to the next, and (3) what your options are at termination or retirement.

(1) Opening Cash Balance
If your company starts a new cash balance plan (and did not have a traditional DB plan before), your opening cash balance is $0, unless the plan allows for retroactive service. This is also true for a new employee where there is a cash balance plan in existence.

For many employees, there is an opening cash balance because your employer decided to convert your traditional DB plan to a cash balance plan. This is typically calculated by multiplying the accrued benefit earned under the traditional DB plan by the appropriate lump sum factor. The conversion method is stated in your company’s plan document and you can ask for a copy.

It is important that your opening cash balance is calculated accurately because it is used to accumulate your retirement benefits until termination or retirement. It is very hard to recalculate this number many years from now. To prevent any careless mistakes, you should check the calculations yourself, or have your HR department or an independent enrolled actuary assist you in verifying the opening cash balance.

(2) How does it grow from one accounting period to the next?
Once the opening cash balance is calculated, you need to understand how it grows from one accounting period to the next. There are two components that are added to your cash balance account from one period to the next. First, there is the new credit that your earned for your service in that period and second the investment credit for that period. Both credits are defined in your company’s plan document. Again, you need to check these numbers to prevent any mistakes.

(3) What are your options at termination or retirement?
Understanding your options at termination or retirement allows you to do proper retirement planning. Your need to be able to project your cash balance account to your projected retirement age so that you can properly plan for your retirement. You also need to understand what payment forms (such as lump sum distribution, life-only annuity, deferred annuity, joint and survivor annuity) are available to you at termination or retirement. Again, these are all stated in your company’s plan document or Summary Plan Description (SPD).

Final Analysis
Many large employers are converting from a traditional DB plan to a cash balance plan to improve on employee appreciation.

Cash balance plan has created some controversy lately. It is mainly due to poor communication by the employers. Even though a cash balance plan is a DB plan, the way benefit is accumulated is quite different from a traditional DB plan. In general, it is less favorable to older employees than to younger employees. To mimic the benefit accrual pattern of a traditional DB plan, some employers adopted an age-weighted formula that will give more credits to older employees or included grandfather provisions to phase in the new plan formula while protecting anticipated benefits of employees who are close to retirement age.

There are a few employers who are adopting a cash balance plan to reduce costs but did not communicate properly to their employees. It is important for you to take the time to understand how the change affects your individual situation and to understand why your company is making this change.

We hope this article provides you with a better understanding of a cash balance plan.

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