Understanding the Cash Balance Plan

The Defined Benefit Cash Balance plan marries features of both traditional Defined Benefit and Defined Contribution plans.

A Defined Benefit plan is the traditional company pension that promises a regular payment to the participant (who was the employee) for the rest of his or her life. There are no individual accounts. A Defined Contribution plan, such as a 401(k), maintains individual account balances for the benefit of each plan participant. In recent years, more and more companies have begun to offer what is called a Cash Balance plan - a hybrid which the Department of Labor says defines the participant’s benefit “in terms that are more characteristic” of a Defined Contribution plan because the employee’s benefits are expressed in a stated account balance.

The individual accounts of a Cash Balance plan seem like a Defined Contribution 401(k), and participants may often (but not always) receive an immediate lump sum distribution when he or she leaves the company.

Under the Cash Balance regime, Tom the employee receives what are called “defined” pension credits for his Cash Balance plan at XYZ Widgets. Under the Cash Balance plan at XYZ Widgets, for example, an amount equal to 5 percent of Tom’s annual $35,000 wages or $1,750 goes to an account in his name. This 5 percent pension credit continues annually until Tom retires or leaves. In addition, Tom’s account grows by the addition of what are called “interest credits,” which are annual plan investment returns. These interest credits in the Cash Balance plan are predetermined by the plan, so if Tom receives say, 5 percent of his investment, the plan may be earning 12 percent investing Tom’s money.

Unlike a 401(k), where traditional interest and gains and losses fluctuate, interest credits in a Cash Balance plan are predetermined, which is why a Cash Balance plan is said to be a defined benefit pension. Moreover, like a Defined Benefit plan and unlike a 401(k), Tom has no say about his investments in the XYZ Widgets Cash Balance plan.

Some companies assert that they established Cash Balance plans as a way of making pensions more transparent and giving more money to younger workers. However, most Cash Balance plans started as traditional Defined Benefit company pension plans. Faced with soaring legacy costs, many companies converted their Defined Benefit plans to Cash Balance plans. Traditional Defined Benefit Plans (“old fashion company pensions”) cost more to operate because Tom’s retirement benefits at XYZ Widgets are usually based on his final average earnings, when his wages are highest. If Tom, who started with XYZ in his twenties, retires from XYZ with 40 years of years of service at 65, his retirement benefits are increased by all his years of service. Put simply, Tom’s pension becomes more expensive to fund for every year on the job. Under a Cash Balance plan, the pension credits are based on the actual salary. For example, if Tom were under a traditional Defined Benefit plan, his retirement benefit for the early years of his employment is not based on what he actually earned that year, but on “his annual compensation earned in the future” – during his final years at XYZ.

Cash Balance plans work to the advantage of the pension plan (which is to say, the company) because they make it cheaper to employ (and fund the pensions of) younger workers, and they work to the disadvantage of older workers who accumulate benefits significantly less than those they would have under a traditional Defined Benefit. Older workers argue that Cash Balance plans discriminate against them, particularly when their traditional Defined Benefit plans are converted to Cash Balance plans.

In order to save money, many companies have converted their traditional Defined Benefit plans to Cash Balance plans. Conversions make writing Cash Balance QDROs more complicated. In a conversion, the plan administrator must calculate the accrued benefits for employees covered by a traditional Defined Benefit plan, and then convert the accrued benefit into an opening balance for employees under the plan as of what is called the “establishment” date of the Cash Balance plan. This is very important in drafting a QDRO to divide a pension. It must be determined if the Cash Balance plan is a conversion from a traditional Defined Benefit in order to have the QDRO approved by the plan administrator.

Experienced practitioners take care of this when negotiating the division of a Cash Balance account because the stated value of a participant’s plan is “sometimes more of a hypothetical construct than a real number one would see on a 401(k) statement.” Because of this there has been at least three court of appeals cases in which the issue of what is termed “whipsaw” has been introduced. Whipsaw refers to the way the lump sum value is calculated, which can produce a value higher or lower than the stated account value.

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