Cash Balance Plans

In recent years, a method of calculating retirement benefits has emerged that combines the characteristics of both defined-benefit and defined-contribution plans. Known as cash balance plans, those arrangements feature a formula, that serves as a basis for employers' contributions, which is typical of defined-contribution plans. But cash balance plans are classified as defined-benefit plans because once the contribution is made, the employer promises a certain overall level of benefit that does not depend directly on the fund's actual investment performance. The aggregate benefit is determined by a fixed interest rate that is applied to the contributions.

The use of cash balance plans grew rapidly in the late 1990s. Much of that growth occurred as employers converted traditional defined-benefit plans to cash balance plans, a trend that proved controversial.⁽¹⁾ In response to the controversy, the IRS placed a moratorium on new conversions in 1999, effectively halting the growth of cash balance plans.

In 1997, the percentage of employees of medium-sized and large establishments whose defined-benefit plan used a cash balance formula was only 6 percent. Among employees of small establishments in 1996, such formulas were virtually unknown. By 2000, the percentage had increased to 23 percent for full-time employees of private businesses of all sizes. By 2002, however, that figure had dropped to 18 percent.

Both employers and their critics have suggested several reasons for the increased use of cash balance plans in the late 1990s. Among the rationales that employers cite are:

• Eliminating incentives for early retirement;
  
  
• Providing employees with portable benefits;
  
  
• Permitting new retirees to take lump-sum distributions; and
  
  
• Making the accrual of benefits more transparent to participants.

Critics maintain that employers are actually motivated by the prospect of cost savings. Under traditional benefit formulas, most employees accrue a disproportionate share of their benefits late in their careers, when their earnings are highest. Under a typical cash balance plan, benefits accrue much more evenly. Baby boomers have recently reached the point where their traditional benefits are beginning to accrue very rapidly, resulting in greater-than-usual funding needs. Those new funding needs represent an unwelcome jump in costs for employers, which may encourage them to switch to a cash balance plan in which benefits accrue more slowly.

One argument raised against conversions to cash balance plans is that they work to the disadvantage of older workers but not to younger ones. For example, when a traditional defined-benefit plan is converted to a cash balance plan, a beginning balance must be calculated for each participant by using an actuarial formula. If that balance is greater than what would have accrued had the cash balance plan been in place all along, some plans halt all further accruals until the difference has been made up--a process known as wearaway that affects mostly older workers. One court decision--still under appeal--found a cash balance plan to be age discriminatory.

Furthermore, critics maintain that the actuarial formula used to calculate beginning balances frequently understates the fair market value of the benefits accrued under the traditional plan. Because employees have given up cash wages over the course of their careers in favor of the promise of future pension benefits, their advocates argue, beginning balances should reflect the full present value of the forgone wages. Determining that value is extraordinarily difficult, however, and no party has yet plausibly claimed to have done so. Some companies have offered "transition benefits" that may approximate the difference, but that approach has not succeeded in containing the controversy. Most cases in which cash balance plans have met with disapproval in the courts have not focused on the transition, but rather on how to calculate the lump-sum distributions for workers who leave prior to retirement.

Not all cash balance plans provoke disputes; some such arrangements that have not met with resistance are those offered by new businesses, those that are the first plan offered by older businesses, and those that replace or supplement defined-contribution plans. Such employers are motivated by different concerns than are employers converting from traditional defined-benefit plans. For firms with relatively young workers or in industries that experience a high turnover of their workforce, cash balance plans can be a feature to attract new employees. When begun at an early age, cash balance plans can help generate large retirement benefits--but with neither the risks nor the rewards associated with defined-contribution plans.