• Retirement Plans
• Executive Compensation
• Health & Wellness
• Instant Insight
• Insight Subscription

A Primer On Cash Balance Plans

Oct 21, 1999

Cash balance plans are an increasingly popular defined benefit plan design. At the same time, cash balance plan conversions have generated much controversy, litigation and at least one major piece of legislation. Because of their importance to benefits design, financing and regulation, we have prepared the following Paper reviewing cash balance plans -- the fundamentals, the regulatory issues, issues presented by cash balance plan conversions, and cash balance plan-related litigation and legislation.

What Is A Cash Balance Plan?

A cash balance plan is a defined benefit plan that walks and talks like a defined contribution plan. It defines a participant's benefit in terms of a credit to a hypothetical account of a percentage of current pay (a "benefit credit") plus hypothetical earnings on that account at a rate specified in the plan (an "earnings credit"). Typically, distribution may, and is expected to be, taken as a lump sum equal to the balance in the participant's hypothetical account at termination of employment.

The earnings rate credited to the participant's hypothetical account in the plan, however, is not a function of the plan's actual earnings. Instead, as indicated, the earnings rate is defined in the plan. Thus, if the plan's actual earnings are less than the plan-specified rate of earnings, the employer/plan sponsor must make up the shortfall. Any excess of actual plan earnings over the plan-specified rate may be used by the employer, e.g., to reduce future contributions. It is this feature -- that the participant's benefit is not dependent on the actual performance of the plan's assets -- that makes a cash balance plan a defined benefit plan.

For example, a traditional defined benefit plan might provide a benefit of 1% of final average pay (typically defined as the average annual pay for the highest 5 consecutive years of pay) times years of service. A typical cash balance plan might provide a benefit of 5% of the current year's pay, with earnings credits of 6% per year, to the ultimate date of distribution.

The table below compares the key features of a cash balance plan with traditional defined benefit plans and defined contribution plans.

Why Do Employers Adopt Cash Balance Plans?

Part I -- DB vs. DC Design Issues

Because the benefits delivered under a cash balance plan are similar to those delivered under a DC plan, to understand why employers adopt cash balance plans we first must review the basic differences in the way defined contribution and defined benefit plans deliver benefits.

At its simplest, defined benefit plans point more benefits at older, longer service employees than at younger, shorter service employees. Fundamentally, that is because a traditional defined benefit plan defines its benefit in terms of a life annuity payable at normal retirement age. For any given year's accrual, the closer a participant is to normal retirement age, i.e., the closer he or she is to the commencement of payment, the more valuable the benefit. For example, if you are going to pay a participant $1,000 per year for life beginning at age 65, it costs me more to fund that benefit if the participant is 65 -- because you are going to have to start paying it right away -- than if he or she is 35. That's because, for the 35-year old, you will, for the next 30 years, be investing the money you set aside now to fund that benefit.

In contrast, defined contribution plans generally provide for a benefit of a fixed percentage of each year's pay over an employee's career. Thus, it costs you the same, as a percentage of pay, to fund any given year's benefit regardless of the participant's age.

The chart below graphs the rate of accrual of benefits under a defined contribution plan providing a benefit of 5% of pay and a traditional defined benefit plan. In the example illustrated by the chart, the cross-over occurs in the mid-forties. An individual participant, hired at age 20, does better under the defined contribution plan for the first 24 years (from 20 to 44); after that he or she does better under the defined benefit plan.

Like DC plans, cash balance plans may provide the same benefit value regardless of the participant's age -- like the flat line in the graph above. Thus, cash balance plans can be used to achieve the same benefit design objectives for which employers use defined contribution plans -- e.g., attracting new, younger employees who do not expect to spend a 35 or 45 year career with one employer, and changing the culture of their business from one of "guaranteed employment for life" to one of pay for current performance. That's the first reason employers adopt cash balance plans. We should note, however, that many employers blunt the impact of this change in benefit styles, for example by providing for higher cash balance plan benefit crediting rates at older ages.

Looked at one way, the switch from a traditional DB design to a DC (or cash balance design) represents a wealth transfer from the older generation to the younger. The plan may be costing the same, but the benefits that were formerly going to older, longer service employees are now going to younger, shorter service participants who used to get next to nothing under the old system.

Part II -- DB vs. DC Financing Issues

Another difference between traditional defined benefit plans and defined contribution plans is control and predictability of costs. Defined benefit plan liabilities are notoriously hard to control or predict.

That is because traditional DB liabilities can fluctuate wildly with interest rate changes. For instance, in the mid-90's, during a period of record stock market performance, many employers saw their net DB liabilities go up, because of interest rate reductions, notwithstanding significant growth in asset value.

Defined contribution plans provide a much more predictable cost, generally a fixed percent of payroll each year. And the participant bears the risk of investment performance. Changes in interest rates have no direct effect on these costs.

Cash balance plans, because they generally provide for a benefit equal to a fixed percent of current payroll and a specified interest rate, generate liabilities that, like defined contribution plan liabilities, are more controllable and predictable than those under traditional defined benefit plans. While, under a cash balance plan and in contrast to a defined contribution plan, the employer remains on the hook for investment performance, the liability with respect to that performance is generally much more manageable than under a traditional defined benefit plan. That is because the amount of earnings credits that must be funded under a cash balance plan are generally quite predictable -- in our example above, 6% per year.

Thus, greater control over and predictability of costs is the second reason why employers adopt cash balance plans.

Part III -- DB Funding Surpluses

So far, the purposes to be achieved by adopting a cash balance plan that we have discussed could be as easily, indeed more easily, achieved with a defined contribution plan. So why do employers go to the trouble of adopting a cash balance plan, which is admittedly more complicated? There are two reasons, and the first has to do with DB funding surpluses.

Many employers who have maintained defined benefit plans for a long period of time have built up significant funding surpluses in those plans. Under federal tax laws, it is prohibitively expensive to get those surpluses out. So employers look for other ways to use the surplus to defray business costs. One way to use the surplus is to finance a defined contribution-like benefit with it; doing so may permit you to reduce or eliminate contributions you are currently making to any defined contribution plan you maintain.

For instance, assume you maintain, as many companies traditionally did and continue to do, a defined benefit plan and a defined contribution plan. Assume that you have built up a significant funding surplus in your defined benefit plan and that you contribute 10% of pay each year to your defined contribution plan. You could introduce a cash balance feature into your defined benefit plan, providing for an annual credit to each participant's hypothetical account of 5% of pay per year, funded out of the funding surplus. Then you could reduce your defined contribution plan contributions, and your annual out-of-pocket costs, by 5%.

Funding surpluses can also be used to "grandfather" special benefits for a group of older employees, i.e., cushion the impact on them of a switch to a defined contribution benefit design. As discussed above, switching to a DC or cash balance design can have a significant negative impact on older employees. Often, when employers convert from a traditional defined benefit plan to a cash balance plan, they will provide additional benefits to some group of older employees, to "cushion the blow". A funding surplus makes it easier to finance that cushion.

Neither of these objectives -- reducing out-of-pocket defined contribution costs and cushioning the impact of a switch from a traditional defined benefit to a defined contribution or cash balance plan design -- can be easily accommodated with a defined contribution plan. They can be with a cash balance plan. So, making use of DB surpluses is the third reason employers adopt cash balance plans.

Part IV -- Reduction of Cost -- Earnings Arbitrage

With an aging workforce, switching from a traditional defined benefit plan to a defined contribution or cash balance plan can reduce costs, simply because you will not have to pay for those higher traditional DB benefits for your increasingly older workforce. But there is another cost reduction that is unique to cash balance plans.

Remember, in a cash balance plan you credit a specified percent of pay to the participant's account and then credit earnings at a specified rate -- in our example, the earnings rate was 6%. However, when you, the employer, go to invest plan assets, your objective is not to make 6%. It is to maximize returns at an acceptable level of risk given your liabilities. Generally, you will aim to make more than 6%. So when your actuary sits down to figure out how much money you must put in to fund a credit of, in our example, 5% of payroll, the answer he or she comes up with will be less than 5%. Think of it like a bond. If you own a bond with a face value of $100 bearing interest at 1% below the market rate, the bond is worth less than $100. Similarly, if you promise a benefit of 5% of this year's pay plus earnings at 6% until distribution, and you reasonably expect to earn 7%, then you don't have to fund that liability at 5% of this year's pay. Maybe you can fund it at only 4%. This is sometimes called the cash balance plan "earnings arbitrage"

Because of the earnings arbitrage, cash balance plans allow you to promise a nominal annual benefit that is greater than your actual cost. In effect, the higher earnings and concomitant reduced cost may simply be compensation for the risk that you as the employer are taking. If your investments underperform the earnings crediting rate, you must make up the difference. Thus, in a cash balance plan, you are getting the benefit that, for instance, your GIC provider is getting in your DC plan. And indeed, your savings may be returned to your employees in the form of a higher benefit crediting rate.

Regulatory Issues

Cash balance plans are considered to raise several very technical regulatory issues, most of which cannot be covered in a discussion of this scope. There are, however, a set of issues that arise out of IRS's interpretation of Code sections 411(a)(11) and 417(e) which have such a significant impact on cash balance plan design that they cannot be ignored.

The provisions of Code sections 411(a)(11) and 417(e) purport to address a fairly modest issue -- how you determine when you can cash a participant out of a defined benefit plan without his or her permission. The regulations under the Code, however, go further. We have to begin this analysis with the rule under the Code that the normal form of benefit under a defined benefit plan must be an annuity. Starting with that premise, the regulations under Code sections 411(a)(11) and 417(e) require that any lump sum payment of that annuity (such as a payment of a participant's cash balance account) must be the actuarial equivalent of that annuity. And, in calculating that lump sum present value, the plan must use the rate on 30-year Treasury securities.

The first issue that these rules present for cash balance plans is known as the "whipsaw" problem. Here's how it works:

In a cash balance plan, a participant's current accrued benefit is expressed as the balance in his or her hypothetical account. If a participant terminates at, for instance, age 45, and elects to take a lump sum distribution, you would think that you would simply pay him or her the amount credited to his or her account, just as you would in a defined contribution plan. Not according to IRS. Instead, because a cash balance plan is a defined benefit plan, to comply with the regulations discussed above you must go through the following exercise:

Step 1 -- Project the current accrued benefit to normal retirement date (typically age 65);

Step 2 -- Discount that normal retirement benefit back to the date of payment at the 30-year Treasury rate.

For cash balance plans, it is not clear what rate you should use in Step 1, to project the participant's benefit -- that is, his or her current account balance -- to normal retirement age. IRS has (sort of) taken the position that you must project the participant's benefit using the earnings crediting rate under the plan. If you project the participant's benefit at a higher rate than the 30-year Treasury rate, then discount back at the 30-year Treasury rate, you will wind up paying the participant a lump sum that is greater than his or her current account balance. In other words, the plan will get "whipsawed," and the participant will get a windfall, or at least a benefit that is greater than his or her account balance.

Thus, the regulations under Code sections 411(a)(11) and 417(e) have created a significant problem for cash balance plan design. In 1996 the IRS issued a notice (Notice 96-8) saying that it was considering proposing a regulation that would allow plan sponsors to pay participants the amount in their account -- and skip the convoluted projecting and discounting exercise described above -- where the earnings credit under the plan was one of a specified group of fixed income indices. While such a regulation would provide some relief, it would inhibit the use of non-fixed income indices, e.g., the S&P 500, that would, in fact, provide returns to participants closer to those available under defined contribution plans.

The second issue presented by the regulations under Code sections 411(a)(11) and 417(e) is the calculation of the participant's opening account balance when you convert your traditional defined benefit plan to a cash balance plan. That issue is more easily discussed in connection with the next topic, cash balance plan conversions.

Conversions

While some employers install a cash balance plan as a brand new plan, most create cash balance plans by modifying their current, traditional defined benefit plan. Cash balance plan "conversions" raise a number of technical and legal issues, some of them painfully arcane. We are going to review three of the big ones -- "grandfathering" benefits of older employees, calculating a participant's opening account balance and communicating the new program.

Issue 1 -- Grandfathered benefits

As we noted above, a cash balance plan conversion can significantly reduce the amount of benefits an older participant will accrue, relative to what he or she would have accrued under a traditional defined benefit plan. Many, although not all, employers "grandfather" a group of older employees, protecting them from some or all of the impact of the cash balance changes.

Employers can protect their older employees from the impact of the cash balance conversion in a variety of ways. At its most generous, a grandfather provision might provide that any employee over a certain age, with sufficient service, would receive the higher of his or her benefit under the cash balance program or the traditional defined benefit program -- in effect, the best of both worlds. Alternatively, the employer might provide higher ongoing benefit credits for employees over a certain age or an additional credit to the opening account balances of older employees. There are a wide variety of possibilities.

Grandfathering does, however, have a downside. Unless you protect all employees from any reduction in the old program's future benefits, some group of employees will be left out. For instance, assume you protect, or give special benefits to, all employees over age 55. Some employees under age 55 will be disadvantaged by the new program, and by creating a special grandfather group from which they have been excluded, you have given them another reason to be angry. Their future benefit has been cut, and they have been left out of the protected group. Understandably, where there have been lawsuits over cash balance plan conversions, they have come from this group.

Issue 2 -- "Wearing away" lump sum rights

When a traditional defined benefit plan is converted to a cash balance plan, benefits under the old plan that have accrued to the date of conversion are stated as a participant's "opening account balance". This is done by taking the annuity payable to the participant under the traditional program and translating it into a lump sum value, based on an actuarially determined interest rate and, in some cases, mortality assumptions. A critical question is, what interest rate are you going to use to calculate this amount? Remember, the higher the interest rate the lower the opening account balance value.

As we discussed above, the regulations under Code sections 411(a)(11) and 417(e) provide that if you pay the participant a lump sum, you are supposed to value it using the 30-year Treasury rate. Many believe, however, that the rate on 30-year Treasury securities is too low, i.e., that long term interest rates, and the actual rates the plan will earn, will in fact be higher. Thus, an employer converting a traditional defined benefit plan to a cash balance plan is faced with a dilemma. If it converts old plan benefits using the 30-year Treasury rate, it will overstate the real value of a participant's benefit. If the employer converts the old benefit at a higher interest rate, generating a lower opening account balance, however, the participant must (according to IRS) receive at termination of employment a benefit at least equal to the benefit accrued to the date of conversion using the 30-year Treasury rate.

To comply with these requirements, employers choosing to convert at an interest rate higher than the rate on 30-year Treasuries use what is called a "wearaway". The participant is credited at the date of conversion with the smaller account balance based on the higher interest rate and on an ongoing basis receives benefit and earnings credits to his or her cash balance account so determined. When the participant actually terminates employment, his or her benefit under the cash balance plan is compared to the benefit he or she would have had under the old program if accruals had ceased at the date of cash balance plan conversion, using the (lower) 30-year Treasury rate to determine the lump sum value of that benefit. If the latter benefit -- the old plan benefit accrued to the date of conversion and expressed as a lump sum using the 30-year Treasury rate -- is greater than the current benefit payable under the cash balance plan, then that is the benefit that is paid to the participant. In that case, the participant has earned no benefit since the cash balance plan conversion.

Thus, the use of wearaways in a cash balance plan conversion can result in a participant earning no benefits for a some period of time after the conversion.

Issue 3 -- Explaining cash balance plan conversions

If the foregoing sounds confusing, think how it must sound to employees. Moreover, for some employees, a cash balance conversion can result in a reduction of benefits they expected to receive in the future. Consider an employee who is not in the grandfathered group, whose possibility of future accruals has been cut back merely by the conversion to a DC-like plan design, and who may not accrue benefits for some period of time because of a lump sum wearaway. Communicating a cash balance plan to a young, short-service employee is easy. Communicating it to an older, non-grandfathered employee is a daunting task that is likely to leave the employee scratching his or her head, or depressed, or both. The temptation to punt, i.e., not to bother explaining just what you're doing to these employees, is considerable.

There are no easy answers to this problem. Unless you provide full grandfathering for everybody -- which could defeat the purpose of the cash balance plan conversion by undermining the effect of providing level benefits regardless of age -- some employees are going to get hurt. Explaining clearly what you are doing is not going to be easy, nor will it make you popular with some employees who believe they are not getting adequate "grandfather" protection.

The inadequacy of cash balance plan conversion communications is a very controversial issue. There is likely to be legislation mandating some level of disclosure. Moreover, given the high profile that cash balance plan conversions have attained with employees generally, you should probably treat as a fundamental element of the design process that you are going to have to tell every employee everything. Your ability to "spin" the effect of the conversion on older employees will be limited.

Recent Developments -- Litigation And Legislation

There have been several recent developments in cash balance plan litigation and in legislation to address the problems presented by cash balance plans.

Litigation

Whipsaw litigation

Recently, two courts of appeals have upheld IRS's whipsaw analysis. Click here for a discussion of those cases.

Age Discrimination Issues

Probably the main weapon in the arsenal of plaintiff's lawyers attacking cash balance plans and cash balance conversions is age discrimination. This is easy to understand, as the conversion of a traditional defined benefit plan to a defined contribution plan does adversely affect older employees. On the other hand, arguments against cash balance plans based on age discrimination theory must overcome the counter-argument that cash balance plans are only providing a fair benefit to all employees. If, as a result, more senior employees lose a benefit (the traditional defined benefit plan) that was biased in their favor, that can hardly be characterized as discrimination.

The anti-cash balance advocates generally use one or more of the following three arguments:

First (and in our view least persuasive), cash balance plans are part of a conspiracy, or overall plan, to push older employees out of the employer's workforce. By taking away a benefit that is specifically targeted at older employees, you further this effort.

It is hard to take this argument seriously. We assume that identically situated employees are being paid (in cash compensation) in a way that does not violate the age discrimination laws -- if older employees were discriminated against in cash compensation a law suit on that basis would have been brought long ago. If that is true, how can shifting the employer's pension benefit pattern from one biased towards older employees to one without bias be considered discriminatory?

The only basis for this argument that we can come up with is the possibility that there are HR memoranda or other evidence of an anti-age animus that can be linked to the cash balance plan conversion. For instance, a memo saying, more or less, "we've got to get rid of our traditional defined benefit plan because it only encourages the dead wood to stick around". We assume that employers with strong EEO compliance operations do not speak in these terms.

Second, cash balance plans as such violate Code section 411(b)(1)(H). It is difficult to discuss this issue because it is ultra-technical, and totally counter-intuitive; nevertheless, it has wide-ranging design and, ultimately, financial consequences. Code section 411(b)(1)(H) provides that a participant's rate of accrual cannot decrease with age. Looked at from one point of view, a cash balance plan, as such, provides for a benefit that decreases with age. That's because, under a cash balance plan, every year older a participant gets he or she will earn one less year of earnings credits. Of course, every defined contribution plan would also violate this requirement -- but 411(b)(1)(H) contains a special provision for them. Cash balance plans, because they are defined benefit plans, cannot take advantage of that provision.

The IRS, in the preamble to regulations under Code section 401(a)(4) issued in 1991, stated that this design feature of cash balance plans would not violate Code section 411(b)(1)(H). As reported elsewhere in this Update, IRS appears to be reconsidering this issue -- the Cincinnati District Office seems to think there is a problem, and IRS's Chief Counsel told Congress IRS is revisiting it.

There are provisions parallel to 411(b)(1)(H) in ERISA and the Age Discrimination in Employment Act. So, in one sense, it doesn't matter what IRS says. If a judge decides cash balance plans violate this provision, he or she can find for the plaintiffs under those non-Tax Code statutes.

However, this argument, that a benefit that is simply the same percentage of pay for everyone, plus interest to the date of distribution, is age discrimination is fantastically counter-intuitive, and it is hard to believe any court would buy it.

The United States District Court For The Southern District Of Indiana recently rejected this theory, hold that cash balance plan are not per se illegal. Click here for a discussion of that case.

Third, cash balance plan wearaways adversely impact older employees. Without reprising the technicalities of wearaways, this argument can be boiled down as follows. If two employees identical in all respects except that one is over 40 and the other is under 40 have different wearaway periods -- the older employee accrues no benefits for a longer period of time under the new program -- that's age discrimination. And in fact, that is what is happening in a number of cash balance plan conversions. Older employees, whose benefits under the old, traditional defined benefit plan, were more valuable, have a longer wearaway, i.e., a longer period during which they accrue no benefits.

The counter-argument is that this longer wearaway is strictly a function of the fact that those older employees got a larger benefit in the past than similarly situated younger employees. It might also be said that the wearaway is in fact merely the result of the use of IRS-mandated interest rates to calculate the participant's accrued benefit as of the date of conversion. Using more realistic rates, there is no wearaway at all.

While these counter-arguments may have some appeal, they are not easily grasped. That is why, it seems to us, this last argument may be the most effective weapon plaintiffs lawyers have.

The current cases involving age discrimination challenges to a cash balance plan conversion are Eaton v. Onan Corporation and Engers et al. v. AT&T and AT&T Management Pension Plan. Many of the issues discussed above are being argued in those cases, and we will continue to follow them.

Resources

We have prepared a brief paper on IRS Cash Balance Math for those interested in the theoretical underpinning of some of the arguments in current litigation.

Legislation

Pension Reform

The Pension Reform legislation. passed last year includes requirements for enhanced disclosure for cash balance plan conversions.

Conclusion

Cash balance plans, and the conversion of traditional defined benefit plans to cash balance plans, are the hottest,and most controversial pension benefit issues of 1999. They have produced a blizzard of technical issues, litigation, legislative proposals and negative publicity. Notwithstanding these problems, they seem to be the wave of the future, allowing employers to reinforce changes in culture, control costs, free up plan surplus and deliver a higher nominal benefit for a lower actual cost. We will be living with them, and the issues they raise, for some time to come.

This is a publication of JPMorgan Compensation and Benefit Strategies. JPMorgan Compensation and Benefit Strategies is a part of JPMorgan Chase & Co. If you have any comments or questions, please contact your JPMorgan Consultant or Insight Editorial.

The information, analyses and opinions set out herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Nothing herein constitutes or should be construed as a legal opinion or advice. You should consult your own attorney, accountant, financial or tax advisor or other planner or consultant with regard to your own situation or that of any entity which you represent or advise.

Information set out or referred to above has been obtained from sources believed to be reliable. However, neither JPMorgan nor any of its affiliates has verified the accuracy or completeness of any such information. Neither JPMorgan nor any of its affiliates shall have any liability for any use of the information set out or referred to herein. JPMorgan Compensation and Benefit Strategies is wholly owned by J.P. Morgan Retirement Plan Services LLC, an affiliate of JPMorgan Chase & Co.

IRS Circular 230 Disclosure: JPMorgan Chase & Co. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with JPMorgan Chase & Co. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.