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Cash Balance Plan Basics

This outline is a publication of Rothgerber Johnson & Lyons LLP and Jan A. Steinhour, and should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only, and you are urged to consult with a lawyer concerning your own situation and any specific legal questions you may have.

Originally Published in Cash Balance Plans Seminar Course Materials
By Glasser LegalWorks

  1. Are Cash Balance Plans New? Cash balance plans were first introduced in 1985, when BankAmerica Corporation converted its traditional defined benefit plan into a cash balance plan. Since that time, an estimated 400 to 600 large and mid-sized employers have implemented cash balance plans covering an estimated 7 million people. Colleen T. Congel, Cash Balance Pension Plans Draw Both Praise, Criticism,Daily Tax Rep. (BNA) Mar. 3, 1999, at J-1. The cash balance plan is one of several trendy hybrid plans which have been created, or revived, to address changes in the American work force. Due to recent controversies, cash balance plans have become the most notorious of the chic pension plans.

  2. What Is A Cash Balance Plan? A cash balance plan is a defined benefit plan that looks like a defined contribution plan.

  3. How Does A Cash Balance Plan Work? Typically, each cash balance plan participant has a hypothetical, or nominal, account. (There is not any one cash balance plan design. The account-based defined benefit plan is, however, the cash balance plan design most commonly recognized as a cash balance plan. E.g., Treas. Reg. § 1.401(a)(4)-8(c)(3); Notice 96-8, 1996-1 C.B. 359. An indexed career pay plan is also a cash balance plan, but does not provide hypothetical accounts. For a comparison of an indexed career pay plan and an account-based cash balance plan, see Strella, 352-2nd T.M., Specialized Qualified Plans--Cash Balance, Target, Age-Weighted and Hybrids A-33.)

    1. A participant's hypothetical account balance is determined by the plan's benefit formula consisting of two components (1) a hypothetical contribution credit and (2) a hypothetical interest credit.

    2. The hypothetical contribution is credited at least annually, if not more frequently, to the nominal account of each eligible participant. This contribution is usually a hypothetical employer contribution determined as a percentage of pay. In the context of hourly or collectively bargained participant groups, the credit may be a stated flat dollar amount. In some cases, this contribution will include an actual participant contribution to the plan. Such a contributory benefit formula may provide, for example, a base hypothetical contribution credit for any eligible participant with an additional hypothetical employer contribution credit with respect to any participant contribution.

    3. Although it can be annually, the hypothetical interest is commonly credited on a monthly or daily basis.

      1. Generally, the interest credit is made both during and subsequent to the participant's employment. So that if a participant terminates his employment with the plan sponsor and does not elect a distribution of his cash balance plan benefit, his hypothetical account will continue to be credited with interest until it is distributed to him.

      2. The rate for this interest credit can be fixed, or nonvariable, but is usually based on an external index such as the Consumer Price Index or Treasury bill rates. If it is variable, the interest rate may also contain a maximum or a minimum rate. In every event, the interest rate must be "fixed" or stated in the cash balance plan terms to comply with the qualification requirements of the federal tax laws. I.R.C. § 401(a)(25); Treas. Reg. § 1.401-1(b)(1)(i).

      3. Some cash balance plan benefit formulas provide a lower interest rate for terminated vested participants than the rate provided for participants who are active employees.

      4. Other benefit formulas have a guaranteed minimum interest rate which is amended by the plan sponsor on a year-by-year basis to provide additional interest credits. Once a pattern of these repeated amendments is established, however, the ad hoc interest arguably becomes guaranteed as part of the accrued benefit subject to the anti-cutback provisions of the tax laws and the Employee Retirement Income Security Act ("ERISA"). Treas. Reg. § 1.411(d)-4, Q&A-1(c)(1); see, I.R.C. 411(d)(6); ERISA § 204(g)(1). In this case, the higher interest credit established by the amendments would be protected so that the existing hypothetical account could only be credited with this higher interest rate.

  4. What Does A Cash Balance Plan Formula Look Like? A simple cash balance plan benefit formula might provide an annual employer contribution credit to a participant's hypothetical account of 10% of his salary for that year and a 7% credit interest on the hypothetical account balance.

  5. How Is The Cash Balance Plan Like A Defined Contribution Plan? The cash balance plan benefit formula appears very similar to a profit sharing plan formula that provides a fixed employer contribution rate. As a defined contribution plan, the profit sharing plan provides each participant with an account reflecting his pro-rata share of the value of the plan assets. Treas. Reg. § 1.401-1(b)(1)(ii). The profit sharing plan benefit formula might provide that each eligible participant's account will be annually credited with an employer contribution of 10% of his salary for that year and with a pro-rata portion of the increase or decrease of the value in the plan assets for the year.

    1. The cash balance plan also resembles a defined contribution, profit sharing plan in other respects.

      1. Accruals under a cash balance plan are relatively frontloaded, similar to accruals under a profit sharing plan. In other words, a larger portion of a participant's ultimate retirement benefit accumulates faster, or earlier, than under a traditional defined benefit plan, which is relatively backloaded. Consequently, in a cash balance plan a younger participant with shorter service will accrue a larger benefit than he would under a traditional defined benefit plan. Furthermore, if this participant terminates his employment with the cash balance plan sponsor prior to attaining retirement age under the plan, he will have a larger benefit than he would have under a traditional defined benefit plan.

      2. The cash balance plan may have a vesting schedule characteristic of a defined contribution plan, which is more rapid than that of traditional defined benefit plans. If the cash balance plan defines the accrued benefit as the hypothetical account balance, the vesting schedule may apply to this account as it does in a defined contribution plan. E.g., I.R.C. §§ 411(a)(7)(A)(i), 411(c)(3); Treas. Reg. §§ 1.411(a)-7(a)(1), 1.411(c)-1(e). Whereas in a traditional defined benefit plan, the vesting schedule applies to the annual benefit commencing at normal retirement age. Id.

      3. The primary benefit payment form in the cash balance plan is the qualified joint and survivor annuity, or qualified preretirement survivor annuity in the event of the participant's early death, with a lump sum optional payment form. I.R.C. §§ 401(a)(11)(A)(i), 401(a)(11)(A)(ii); ERISA §§ 205(a)(1), 205(a)(2). These payment forms are not uncommon in a profit sharing plan.

      4. Like a profit sharing plan, the cash balance plan usually provides an immediate distribution for a participant who terminates from employment with the plan sponsor prior to retirement age.

      5. In typical a cash balance plan, which has a variable interest rate credit, the dollar amount of a participant's benefit cannot be determined until the time when the benefit is paid from the plan. For example, if a participant terminates employment with the plan sponsor and does not then elect a plan distribution, the dollar amount of his benefit when distributed will depend on future interest credits, which depend on a currently unknown index. The same is true of a the benefit provided under a profit sharing plan.

    2. The cash balance plan can even mimic the self-directed investment feature of the profit sharing plan. For example, the cash balance plan recently implemented by World Bank Group permits each participant to choose from a menu of indexes provided under the plan terms those indexes for the interest credit to his hypothetical account.

  6. How Is The Cash Balance Plan Different From A Defined Contribution Plan? Despite the similarities in appearance, the cash balance plan is actually very different from a defined contribution plan.

    1. Because it is a defined benefit plan, all the rules governing this type of plan apply to a cash balance plan. As a result, a cash balance plan is generally more difficult, and more costly, to administer than a defined contribution plan.

      1. With several exceptions, the defined benefit plan rules do not specifically contain provisions for cash balance plans and only readily apply to traditional defined benefit plans. Application of these rules to a hybrid of a defined benefit plan, such as a cash balance plan, is frequently problematic.

        1. For the two instances in which guidance has been provided specifically with respect to cash balance plans, see Treas. Reg. 1.401(a)(4)-8(c)(3) and Notice 96-8, 1996-1 C.B. 359. A very general discussion of cash balance plans is provided by Todd Newman, James Holland and Ken Black in the 1997 I.R.S. Employee Plans CPE Technical Topics, Employee Plans and Exempt Organizations manual which is available on LEXIS in the Fedtax Library, I.R.S. CPE Materials File.

        2. Although the Internal Revenue Service and the Treasury have informally suggested that further cash balance plan guidance may be required, no such guidance is indicated on the 1999 business plan for either. IRS Previews 1999 Employee Benefit Guidance Priorities, Pension Plan Guide (CCH) No. 1257 (Mar. 8, 1999).

      2. Cash balance plan administration requires actuarial valuations and compliance with FASB statements for plan costs, which are required for any defined benefit plan. Because the plan is subject to ERISA's plan termination insurance requirements, annual premiums must be paid to the Pension Benefit Guaranty Corporation for each participant. ERISA §§ 4006(a)(3), 4021(a). Additionally, cash balance plan administration requires participant recordkeeping similar to that for a defined contribution plan.

      3. Furthermore, the cost of administering a cash balance plan is always borne by the plan sponsor. Even if the costs are paid from the plan assets, the plan sponsor is ultimately liable for the value of these assets for benefit payments. Whereas, many of the costs to administer a defined contribution plan can be charged against trust earnings, without any additional contribution from the plan sponsor.

    2. Unlike the benefit provided by a defined contribution plan, the cash balance plan benefit is guaranteed, regardless of the investment performance of the plan assets. A participant's defined contribution plan benefit is based solely on the value of his individual account under the plan. I.R.C. § 3(34). Consequently, the defined contribution plan participant bears the investment risk for the plan assets which fund his plan benefit. By contrast, the sponsor of a cash balance plan bears the investment risk for the plan assets which fund the benefits under this plan. I.R.C. § 414(j); ERISA § 3(35). In other words, a cash balance plan is like a defined contribution plan in which a participant's account value from fixed employer contributions is guaranteed and the rate of investment return on this value is also guaranteed.

    3. As a defined benefit plan, a cash balance plan is subject to various other requirements which do not apply to a defined contribution plan.

      1. Benefit accruals must meet the minimum accrual methods which are designed to prevent backloading of benefits. I.R.C. § 204(b). If the hypothetical interest credit is not conditioned on future service, the benefit accruals under a cash balance plan easily satisfy the minimum accrual requirements.

      2. Benefits must be distributed in the form of a qualified joint and survivor annuity for a married participant and a life annuity for an unmarried participant. I.R.C.§ 401(a)(11)(A)(i); ERISA § 205(a)(1); Treas. Reg. § 1.401(a)-20, Q&A-25. (Generally, this requirement only applies to a defined contribution which is also a pension plan. Id.) Consequently, the plan terms must provide the assumptions for converting a participant's hypothetical cash balance account to an annuity benefit. See I.R.C. § 401(a)(25).

        1. Since these assumptions are part of the cash balance plan benefit formula (as compared with assumptions to determine actuarially equivalent forms), there are no requirements for these conversion factors.

        2. As a practical matter, however, there a several considerations, if not constraints, governing the selection of factors for converting the hypothetical cash balance account.

          1. If the assumptions do not provide reasonable annuity values, participants will be discouraged from this benefit payment form.

          2. Additionally, as described below, the conversion factors for determining lump sum actuarial equivalents are commonly used to avoid lump sum whipsaw issues. I.R.C. § 417(e)(3); ERISA § 205(g)(3).

            1. Because its benefits are defined in terms of an account, a cash balance plan typically provides a lump sum distribution option for all participants.

            2. Proposed cash balance guidance recently proffered by the I.R.S. echoes the Treasury position in the nondiscrimination safe-harbor provisions for cash balance plans; i.e., the lump sum always must be the present value of the normal retirement benefit stated as an annuity. Notice 96-8, 1998-1 C.B. 359. (Some cash balance plans deem a participant's lump sum benefit to be equal to his hypothetical cash balance account.)

            3. Thus, to avoid paying a lump sum that exceeds the value of the hypothetical cash balance account (dubbed a "lump-sum whipsaw"), the assumptions for determining the annuity payable at normal retirement age under the plan are the same as those required for determining the present value of the annuity--the prescribed lump sum rates. I.R.C. § 417(e)(3); ERISA § 205(g)(3).

      3. Although many do not, a cash balance plan, as a defined benefit plan, can provide a subsidized early retirement benefit on either a temporary incentive basis or an ongoing basis. The value of any such subsidy may be reflected in the lump sum distribution option. Treas. Reg. § 1.411(d)-4, Q&A-2.

      4. The preretirement survivor annuity rules determine death benefits in the event of the participant's early death. I.R.C. § 411(a)(11)(A)(ii); ERISA § 205(a)(2).

      5. Forfeited benefits cannot be used to increase the benefits payable to other participants. I.R.C. § 401(a)(8); Treas. Reg. § 1.401-1(b)(1)(i).

      6. In-service distributions are not permitted before normal retirement age under the plan terms. Treas. Reg. § 1.401-1(b)(1)(i); Prop. Treas. Reg. § 1.411(b)-(2)(b)(4)(iv), Ex. 3; see Rev. Rul. 78-120, 1978-1 C.B. 117.

      7. Although permitted, participant loans are generally not provided due to complexities in administering such loans.

      8. The total value of the cash balance plan assets may be more or less than the total value of accrued benefits under the plan. The minimum funding rules establish the plan sponsor's ongoing funding or contribution liability to provide the cash balance plan benefit. I.R.C. § 412; ERISA § 302. A contribution must be actuarially determined with realistic assumptions, permitting considerable flexibility to determine the amount of the required contribution. Thus, with actuarially-based funding, the plan sponsor can choose the amount of its cash balance plan contribution within the deductible contribution limits prescribed by the federal tax laws. I.R.C. § 404(a)(1). In contrast, a defined contribution plan with a fixed contribution rate does not provide this flexibility.

  7. Can A Traditional Defined Benefit Plan Be Converted Into A Cash Balance Plan? A traditional defined benefit plan can be amended, or converted, into a cash balance plan.

    1. This course of action is particularly attractive if the existing plan is overfunded. By amending this plan into a cash balance plan, the excess assets can be used to fund the future cost of the cash balance plan benefits. If the existing plan were terminated instead, any excess assets that reverted to the plan sponsor could be subject to a federal excise tax of up to 50% in some instances. I.R.C. § 4980.

    2. A conversion can also be a cost-effective alternative to the termination of a traditional defined benefit plan, if the sponsor wishes to continue providing a tax-qualified benefit for its employees. The immediate cost of converting a traditional defined benefit plan could be considerably less than the cost of terminating this plan, which will include vesting all accrued benefits and paying them in lump sums or with purchased annuities.

    3. The nondiscrimination rules permit three alternative, safe-harbor methods for changing from one defined benefit formula to another. Each method requires freezing the existing benefit formula and switching to the new formula as of a specified date, defined as the "fresh start date".

      1. Under the first method, a participant's benefit under the new formula is the sum of his frozen benefit under the old formula as of the fresh start date plus his benefit determined under the new formula with only his new service after the fresh start date. This method is called the "formula without wear-away." Treas. Reg. § 1.401(a)(4)-13(c)(i).

      2. Under the second method, dubbed the "formula with wear-away," a participant's benefit under the new formula is the greater of his frozen benefit under the old formula as of the fresh start date and his benefit determined under the new formula with all of his service, including any service under the old formula before the fresh start date. Treas. Reg. § 1.401(a)(4)-13(c)(ii).

      3. Under the "formula with extended wear-away," which is the third method, a participant's benefit determined under the new formula is the greater of his benefit under the formula without wear-away and under the formula with wear-away. Treas. Reg. § 1.401(a)(4)-13(c)(iii).

    4. A fourth alternative is provided by a special transition rule for cash balance plans. Under this method, a participant's benefit under the new formula is the greater of the participant's frozen benefit under the old formula as of the fresh start date or the participant's cash balance benefit under the new formula with his service after the fresh start date. An opening balance must be provided under the new formula by converting into a lump sum the participant's frozen benefit under the old formula as of the fresh start date. Treas. Reg. § 1.401(a)(4)-13(f).

  8. What Are The Advantages Of A Cash Balance Plan? In addition to the above-described features of a cash balance plan which can be attractive to plan sponsors, a cash balance plan provides other advantages.

    1. As compared to a traditional defined benefit plan, a cash balance plan is easy for a participant to understand. On the surface, a cash balance plan resembles a profit sharing plan. Due to the popularity of this type of defined contribution plan, which frequently includes a 401(k) feature, many participants are familiar with these plans and, for this reason, find cash balance plans easy to understand.

    2. Because a participant can understand a cash balance plan, he can more readily appreciate the value of this employer-provided benefit.

    3. Because the benefit delivery under the cash balance plan is relatively frontloaded, like that of a defined contribution plan, a the plan sponsor may be able to attract and retain ordinarily mobile workers.

    4. This same mobile work force is also attracted by the portability of the cash balance plan benefit; i.e., the lump sum payment option upon termination of employment that is typically provided by a cash balance plan and not by many traditional defined benefit plans.

  9. If They Are So Great, Why Are Cash Balance Plans So Controversial? Recently, a small number of cash balance plans have been involved in litigation. This litigation seems to have sparked a high-level debate about cash balance plans among federal regulators and lawmakers. This litigation and the related on-going controversy stem from the typical accrual pattern under a cash balance plan, which tends to favor younger participants, and in some instances the failure to disclose this characteristic when a traditional defined benefit plan is converted into a cash balance plan, and the determination of lump sum benefits. McAuley v. International Business Machines, Inc., 165 F.3d 1038 (6th Cir. 1999); Esden v. The Retirement Plan of the First Nat' l Bank of Boston, 182 F.R.D. (D. Vt. 1998); Corcoran v. Bell Atlantic Corp., 21 E.B.C. 2360 (E. Pa. 1997), aff'd, 22 E.B.C. 1489 (3rd Cir. 1998); Lyons v. Georgia-Pacific Corp. Salaried Employees Retirement Plan, No. 1:97-CV-0980-IOF (N.D. Ga. dismissed Mar. 22, 1999); Eaton v. Onan Corp., No. IP97-C-0814-H/G (S.D. Ind. filed May 19, 1997); Aull v. Cavalcade Pension Plan, No. 96-D-628 (D.Colo. filed Mar. 5, 1996).

  10. Can Any Employer Adopt A Cash Balance Plan? Technically, a cash balance plan can be adopted by any employer, including a tax-exempt or governmental employer. Nevertheless, a cash balance plan is not suitable for every employer. For example, the administrative and funding requirements for a cash balance plan may discourage an employer from this type of plan. The decision to adopt a cash balance plan should include a careful analysis of the employer's overall current and future benefit objectives, the demographics of the employer's workforce and anticipated or perceived future changes in this force, the other plans maintained by the employer, including non-qualified deferred compensation plans, and relative cost considerations.

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