By Larry B. Wattenberg, EA, Geller & Wind, Ltd.
Cash balance plans are rapidly replacing the traditional defined benefit (DB) pension plans that were once the mainstay retirement vehicles of larger companies. As the number of larger companies converting DB plans to cash balance plans has increased, smaller companies have begun to show interest as well.
Cash balance plans are, in fact, defined benefit plans, with the benefit defined so as to mimic an account balance as in a defined contribution (DC) plan. Although cash balance plans behave like DC plans, they are subject to all the complex regulatory provisions for DB plans under the Employee Retirement Income Security Act of 1974 (ERISA) and all subsequent Federal pension legislation.
One reason that cash balance plans have become popular with plan sponsors (employers) is that it is easy to show employees what they are getting under an account balancetype of plan. Other reasons are that cash balance accruals tend to favor younger workers and may save the employer money. Savings can occur because the employer usually reserves the legal right to amend its DB plan to reduce, or even eliminate, the future accrual of benefits. It is easy to see how some characteristics of cash balance plans may be viewed as undesirable.
The cash balance concept has been around since the early 1980's, but has only caught fire recently, in part because regulatory guidance has been lacking. The IRS has long been delegated the task of formulating most of the rules and regulations governing all pension plans. While many employers had received determinations from the IRS that the specific terms of their cash balance plans allowed for continued favorable tax treatment, there was always the possibility that future IRS guidance would effectively prohibit such actions. In 1996, however, the IRS issued guidance resolving some fundamental technical issues, and, as a result, more employers now view cash balance plans as being appropriate retirement vehicles.
The cash balance plan must grant interest credits to participants, akin to the investment gains and losses of a DC plan. However, the interest credits are independent of actual investment results of plan assets held in trust. It is the employer, rather than the employee, that bears the investment risk. The interest credits are usually tied to a standard index, such as the yield on one-year Treasury securities. The cash balance plan also credits participants with a share of the employer's contribution, usually expressed as a percentage of each participant's compensation. Because individual accounts are maintained, cash balance benefits are usually paid as a lump sum rather than as the more traditional retirement annuity. In general, cash balance plans also offer more design flexibility than DC plans (although, notably, 401(k)-type features are not allowed in cash balance plans).
While designs vary, cash balance plans tend to favor younger workers because they have a greater future working lifetime in which their share of the employer contributions can accumulate interest credits. Older, long-service employees near retirement can suffer if the employer is converting a traditional defined benefit retirement plan, where most of the benefit value accrues during the last few years of employment. However, transition benefits can usually be offered to older employees without running afoul of nondiscrimination rules.
Proposed legislation now before Congress would require larger pension plans undergoing cash balance conversion to disclose more detailed information to each employee, comparing expected retirement benefits under the existing pension plan with proposed retirement benefits under the cash balance plan. This proposed legislation, introduced as the Pension Right to Know Act in both the Senate and House, is primarily in response to increased concern by employees over possible loss of benefits. *
Sheldon M. Geller, Esq.
Geller & Wind, Ltd.
Michael D. Schulman, CPA
Schulman & Company
Steven Pennacchio, CPA
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