A new type of pension plan is being instituted by many of America’s largest businesses. This pension plan commonly referred to as "Cash – balance plan" has both benefits and costs. The benefits generally accrue to the younger workers, those in their 20’s and 30’s. Employees with fewer years of service may reap benefits; however, the losers are employees with many years of service. A major benefit to the younger workers is the fact that the pension is portable and can be taken from one job to another job when the workers switch employment. However, if you are in your 40’s or older the cash balance plan can eliminate any new benefits earned in the near term.

Employers choose cash balance plans when it benefits them, however a plan change must be approved by The Department of Labor. The Department of Labor which oversees pension plan administration has been so overwhelmed with a dollar volume and number of conversions to the new cash balance pension plans that they have not had time to keep up on the complexities of these plans.

Plan description

The cash balance plan is a defined benefit plan. With the cash balance plan, each participant has his or her own individual account into which employer contribution is credited. The contribution is generally based on a percentage of pay. Each participant’s individual account also is credited with interest. Upon withdrawal, by law, cash balance plans must provide an annuity option. A lump sum option also may be provided, however this is at the discretion of the employer. (Note: After a bull market the lump sum can be very high.)

The cash balance plan is different from a defined contribution plan and most other types of defined benefit plans. The cash balance plan does not define employer’s contributions but instead defines the future pension benefits that will accrue in each individual account. Because the cash balance plan stresses the current lump sum of an individual participant’s benefit, the plan’s assets have no direct relationship to the individual account accruals.

The employer’s contributions are based on actuarial valuations. Because the actuarial valuations are not present value valuations, the employer contributions may be less than the sum of the additions to participant’s account. The interest-rate by which a cash balance plan account is promised to grow generally is some specified rate related to an index [e.g., CPI] or a bond index rate or treasury bill fund rate.

The employer and/or sponsor of the plan determines how the assets from the plan will be invested. The employer and/or sponsor therefore (legally), assumes all the risks. However, they can definitely garner all near-term rewards and the potential of getting all future rewards. The cash balance plan can be very rewarding to the employer/sponsor if there is a large positive difference between the rate of return promised to the employee and a rate at which the assets earn when invested. The investment gains and losses also will affect the employer’s future contributions to fully fund the pension plan. If the employer can earn a high enough differential between the promised rate of return and the actual rate of return the plan can become self-funded. Management of a cash balance plans portfolio would seek the highest long-term consistent with the appropriate risk levels. Although management may not achieve the required (or set) interest-rate in one-year, over time management is likely to earn a return on the investment portfolio that is greater than or equal to the set rate (particularly if the management selected interest rate is low.)

The cash balance plans are subject to the same ERISA regulations as other defined benefit plans. The vesting is required to meet the minimum vesting requirements under both cliff (5 years) and graded vesting (three to seven years). The funding rules for the plan are the same as for other defined benefit plans. However, unlike defined contribution plans, cash balance plans must be insured by the Pension Benefit Guarantee Corporation. By definition, a defined contribution plan is always fully funded and therefore plan termination insurance is not needed. However, because it is possible, under the cash balance plan, for participants to lose part of their accrued benefits, insurance is required.

Under a typical defined benefit plan, two employees with equal pay but differing years of service will earn the same amount of retirement income for each new year of service. But note, because the money invested for an older employee [who is closer to retirement], the employer’s cost of funding the pension obligation for younger employee is less than that for the older employee. Also note, the combination of a defined benefit, a low promised interest-rate, and a bull market may be a fully funded plan running years into the future solely on self-funding; and thus eliminating the employer’s obligation for any current contributions. For employees who terminate employment at younger ages, both the accrued employee’s benefits and the employer’s costs are low. No doubt this is one of the reasons why younger employees place low value on non-portable defined benefit plans.

Traditional pension plan benefit formulas are oriented toward the total retirement benefit, taking into account the retirement age and the length of service. In stark contrast, cash balance plans emphasize annual accumulations and therefore may not be as flexible as traditional plans in providing specific levels of retirement income.

The Problems with Cash Balance Pension Plans

The main problem with the cash balance pension plan appears to be when long-standing employees are involuntarily switched or are encouraged with insufficient information to switch to the cash balance plans. Many of the individual employee’s benefits that have been built up over long years of service under either a defined contribution plan or a traditional defined benefits plan can be lost in the switch, and will be needed to be earned again. The pension benefits that accrue under a traditional defined contribution plan are generally calculated through a formula that considers the number of years of service, the average of an individual’s final few years salary and a multiplier [generally some where in the fifty percentage range]. The reason that the problem "grows" for older or long-standing employees is, in general, the majority of the salary growth that occurs in the final years of their employment. As a result the defined benefits that you receive upon retiring might be fifty percent or more attributable to the last five or ten years of employment. The dual pressures of the escalating years of service times escalating wage base explode the defined benefits owed by the employer to employees with many years of service.

By switching all employees to a defined benefits cash balance plans employers can simultaneously achieve many of the employer’s desired objectives.

1. Stop exploding obligations under traditional defined benefit pension plans if employer has an aging workforce [with or without pay escalating with age].
2. Slash current obligations necessary to satisfy actuarial requirements for a fully funded defined benefit plan.
3. Create the possibility of the employer reaping benefits from pension fund management’s ability to generate income in excess of the promised interest-rate, that rate selected by the management [but, since these are defined benefit plans, cash balance plans also create a new risk of employer loss.]
4. Create portability of pension benefits, a feature particularly attractive to younger, lower wage employees.
5. Extinguish a significant portion of the real income from high wage older workers, which may prod their departure from that employer’s workforce. In addition to lowering average wages by prompting older workers to depart, an added benefit would be predictable reductions in expenses related to medical insurance. Of particular legal note is that this stimulus is not explicitly age based and will work most on those older workers who no longer are job focused (e.g., retired in place).
6. Transfer from employees to the employer the current high values produced by the bull market.

When a plan is switched, some of the accrued benefits under the old plan may be "lost in time", or "plateaued" under the new plan’s assumptions.

Example: Assume an existing, traditional defined benefits annual retirement plan with a multiplier of 2.5% times the length of service, times the average high five. (i.e., the average of the five highest years of earnings).

Assume a new cash balance retirement plan with an employer match of up to $3,000 at a 5% annual guaranteed rate.

The table below shows the ordinary progression in benefits under the assumed existing, traditional defined benefits pension plan.

EXISTING PENSION PLAN: At 20 years employing the existing pension plan the employee has accumulated $22,948 per year pension benefit. Given an
8% annual return (over a 30 year expected retirement life), this pension has a present value of $258,645.

NEW PENSION PLAN: With an up to $3,000 match (i.e., both the employee and the employer contribute $3,000), yields a per year total of $6,000 each year for 20 years at the company guaranteed rate of 5% (over a 30 year expected retirement life). Over 20 years this pension has a
future value of $198,396. At the (note that it is lower) guaranteed rate of 5%, the compounded annual rate and a contribution of $6,000 per year the new pension plan would not equal the existing pension plan's 20 year present value of $258,645 until 23.55 years. Therefore, the long term employee would be "plateaued" (read: working for no pension benefits) for 3.55 years.

Below is a graphical representation of such a plateau.

Additional Readings:

_____. Work Week Section: "THE CHECKOFF: Both baby boomers and Gen-Xers consider retirement benefits more important than salary, says a survey by Transamerica Life Cos." Wall Street Journal, December 22, 1998, Page A-1.

Eisenberg, Daniel. "The Big Pension Swap: Accounts that yield benefits sooner are replacing traditional plans, but older workers are crying foul." Business Section, TIME, April 19, 1999, page 36.

Schultz, Ellen E. "Actuaries Become Red-Faced Over Recorded Pension Talk" Wall Street Journal, May 5, 1999, Page C-1; C-19. (Actuaries recorded discussing how cash balance plans are really designed to target older workers and prompt their exit.)

Schultz, Ellen E. and Auerbach, Jon G. "IBM Pension-Plan Changes Spark Ire-Filled Web Site." Wall Street Journal, June 14, 1999, Page C-1; C-13.

Schultz, Ellen E. "Older Workers Fight 'Cash Balance' Plans", FUND TRACK Section, Wall Street Journal, February 11, 1999, Page C-1; C-27.

Schultz, Ellen E. "Some Pension Funds Look Like 401(k)'s, But They Sure Don't Behave Like Them." FUND TRACK Section, Wall Street Journal, December 31, 1998, Page C1; C19.

Schultz, Ellen E. "Some Workers Facing Pension Hit: Longtime Employees May Find Themselves on Long 'Plateau' As Companies Make Switch." FUND TRACK Section, Wall Street Journal, December 18, 1999, Page C-1; C-21.

Schultz, Ellen E. "Your Pension Plan May be Changing: Go Figure How . . . If You Can", YOUR MONEY MATTERS Section, Wall Street Journal, March 3, 1999, Page C-1; C-15. (Notes how Kodak does it correctly.)