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A cash balance plan is a defined benefit
retirement plan A pension (, from Latin ''pensiō'', "payment") is a fund into which a sum of money is added during an employee's employment years and from which payments are drawn to support the person's retirement from work in the form of periodic payments ...
that maintains
hypothetical A hypothesis (plural hypotheses) is a proposed explanation for a phenomenon. For a hypothesis to be a scientific hypothesis, the scientific method requires that one can test it. Scientists generally base scientific hypotheses on previous obser ...
individual employee accounts like a
defined contribution plan A defined contribution (DC) plan is a type of retirement plan in which the employer, employee or both make contributions on a regular basis. Individual accounts are set up for participants and benefits are based on the amounts credited to these a ...
. The hypothetical nature of the individual accounts was crucial in the early adoption of such plans because it enabled conversion of traditional plans without declaring a plan termination.


Basics

The employees' accounts earn a fixed rate of return that can change over a period of time from year to year. Although it works much like a defined-contribution plan, it is actually a defined-benefit plan for legal purposes. In 2003, over 20% of US workers with defined benefit plans were in cash balance plans, according to
Bureau of Labor Statistics The Bureau of Labor Statistics (BLS) is a unit of the United States Department of Labor. It is the principal fact-finding agency for the U.S. government in the broad field of labor economics and statistics and serves as a principal agency of t ...
data. Most of these plans resulted from conversions from traditional defined-benefit plans. The status of such plans was in legal limbo (see below), and the number of conversions slowed. However, legislation was recently passed that cleared the way for plan sponsors to adopt cash balance plans.


Conversion controversy

Cash balance conversions have been controversial and have raised the ire of workers and their advocates. In 2005 the
Government Accountability Office The U.S. Government Accountability Office (GAO) is a legislative branch government agency that provides auditing, evaluative, and investigative services for the United States Congress. It is the supreme audit institution of the federal govern ...
(GAO) released a report analyzing the effects of cash balance conversions on worker benefits. They found that in a typical conversion the cash balance plan would provide lower benefits for most workers than if the defined-benefit plan had remained unchanged and the worker had stayed in their job until retirement age. This decline in benefits tends to be largest for older workers. This is because in a traditional plan, where benefits are based on final average pay, the "value" of the benefits accrues much faster for older workers than for younger workers. In contrast, in a DC or cash balance plan, contributions are made at the same rate (by workers in the DC plans and by the employer in the cash balance plan), and a dollar contributed to a younger worker's account is actually more valuable because it has more time to compound before retirement. Thus some argue that cash balance plans hurt older workers. On the other hand, this may not be the relevant comparison. If the alternative to cash balance conversion is that the plan is frozen or terminated (with the vested balance going to the worker), all workers would be much worse off than in a cash balance conversion. This is a realistic possibility; tens of thousands of defined benefit plans have been frozen and/or terminated in the last two decades, far more than have been converted to cash balance plans. Likewise, for the many employees who leave their job before retirement (whether voluntarily or not), many would be better off under the cash balance conversion than under the original defined-benefit plan. In addition, about half of cash balance conversions have grandfathered in some or all of the existing participants in the defined-benefit plan.


Types of pensions

The
ubiquitous Omnipresence or ubiquity is the property of being present anywhere and everywhere. The term omnipresence is most often used in a religious context as an attribute of a deity or supreme being, while the term ubiquity is generally used to describ ...
401(k) plan is an example of a
defined contribution plan A defined contribution (DC) plan is a type of retirement plan in which the employer, employee or both make contributions on a regular basis. Individual accounts are set up for participants and benefits are based on the amounts credited to these a ...
because the Internal Revenue Code §414(i) states at the term defined-contribution plan means any plan that provides
retirement Retirement is the withdrawal from one's position or occupation or from one's active working life. A person may also semi-retire by reducing work hours or workload. Many people choose to retire when they are elderly or incapable of doing their j ...
benefits to a worker based solely on the amount contributed to the (worker's individual) account and any (investment) income, gains net of any
expenses An expense is an item requiring an outflow of money, or any form of fortune in general, to another person or group as payment for an item, service, or other category of costs. For a tenant, rent is an expense. For students or parents, tuition is a ...
and losses. Under the
definition A definition is a statement of the meaning of a term (a word, phrase, or other set of symbols). Definitions can be classified into two large categories: intensional definitions (which try to give the sense of a term), and extensional definitio ...
of accrued benefit under Code §411(a)(7)(A)(ii) in the case of a plan that is not a
defined benefit plan Defined benefit (DB) pension plan is a type of pension plan in which an employer/sponsor promises a specified pension payment, lump-sum, or combination thereof on retirement that depends on an employee's earnings history, tenure of service and age ...
, he term accrued benefitmeans the balance nthe employee's ndividualaccount. On the other hand, for defined-benefit plans, Section §411(a)(7)(A)(i) states that "accrued benefit" means "the employee’s [] annual benefit" as it is "determined under the plan … expressed in the form of an … [annuity] … commencing at normal retirement age." Finally, the Code's definition for defined benefit plans are all plans that are not
defined contribution A defined contribution (DC) plan is a type of retirement plan in which the employer, employee or both make contributions on a regular basis. Individual accounts are set up for participants and benefits are based on the amounts credited to these a ...
plans. Cash balance plans are defined-benefit plans that look like defined-contribution plans. A worker's right to a
pension A pension (, from Latin ''pensiō'', "payment") is a fund into which a sum of money is added during an employee's employment years and from which payments are drawn to support the person's retirement from work in the form of periodic payments ...
in a defined-benefit plan represents a
contingent liability In accounting, contingent liabilities are liabilities that may be incurred by an entity depending on the outcome of an uncertain future event such as the outcome of a pending lawsuit. These liabilities are not recorded in a company's accounts ...
, and hence an uncertain financial obligation to the
employer Employment is a relationship between two parties regulating the provision of paid labour services. Usually based on a contract, one party, the employer, which might be a corporation, a not-for-profit organization, a co-operative, or any othe ...
sponsoring the plan. Section 412 of the Code requires the employer to make annual contributions to the plan to ensure that the plan assets will be sufficient to pay the promised benefits later at retirement. As part of this process the plan is required to have an
actuary An actuary is a business professional who deals with the measurement and management of risk and uncertainty. The name of the corresponding field is actuarial science. These risks can affect both sides of the balance sheet and require asset man ...
perform annual "actuarial valuations" in which the present value of each worker's "accrued benefit" is
estimated Estimation (or estimating) is the process of finding an estimate or approximation, which is a value that is usable for some purpose even if input data may be incomplete, uncertain, or unstable. The value is nonetheless usable because it is der ...
and then each present value for each worker covered by the plan is added up so that the
minimum In mathematical analysis, the maxima and minima (the respective plurals of maximum and minimum) of a function, known collectively as extrema (the plural of extremum), are the largest and smallest value of the function, either within a given ran ...
annual contribution can be determined. The "actuarial present values" for the "accrued benefit" for each worker is the lump sum
dollar Dollar is the name of more than 20 currencies. They include the Australian dollar, Brunei dollar, Canadian dollar, Hong Kong dollar, Jamaican dollar, Liberian dollar, Namibian dollar, New Taiwan dollar, New Zealand dollar, Singapore dollar, U ...
amount that represents the
financial Finance is the study and discipline of money, currency and capital assets. It is related to, but not synonymous with economics, the study of production, distribution, and consumption of money, assets, goods and services (the discipline of fina ...
value of the employer's liability on the date of the valuation. It does not include the future
accrual Accrual (''accumulation'') of something is, in finance, the adding together of interest or different investments over a period of time. Accruals in accounting For example, a company delivers a product to a customer who will pay for it 30 days l ...
of pension benefits nor does it include the effect of projected future salary increases. Thus the lump sum value for each worker is not based on that worker's projected final salary at retirement, but only the worker's salary on the date of valuation.


Design of plans

Some cash balance plans
communicate Communication (from la, communicare, meaning "to share" or "to be in relation with") is usually defined as the transmission of information. The term may also refer to the message communicated through such transmissions or the field of inquir ...
to workers that these "actuarial present values" are "hypothetical accounts" because upon termination of service, the employer will give the former worker the option to take "all his money" from the pension plan out. In
reality Reality is the sum or aggregate of all that is real or existent within a system, as opposed to that which is only imaginary. The term is also used to refer to the ontological status of things, indicating their existence. In physical terms, r ...
, if both the worker and employer agree, even in a normal defined-benefit plan a former worker may take away "all his money" from the pension plan. There are no legal differences in this "portability" aspect between a
traditional A tradition is a belief or behavior (folk custom) passed down within a group or society with symbolic meaning or special significance with origins in the past. A component of cultural expressions and folklore, common examples include holidays or ...
defined- benefit plan and a ''cash balance plan''. A typical "design" for a cash balance plan would provide each worker a "hypothetical account" and pay credits in the current year of say 5% of current salary. In addition, the cash balance plan would provide an interest credit of say 6% of the prior year's balance in each worker's "hypothetical account" so that the current year's balance would be the sum of the prior year's balance and the current year's pay credit and an interest credit on prior year's balance. For a worker who starts at age 25 with a $2000 a month starting salary, he would start with a zero account balance and the first year's pay credit would be $1200 leaving him with an end of first year balance of $1200 in his "hypothetical" account. Because his beginning of first year balance was zero, his interest
credit Credit (from Latin verb ''credit'', meaning "one believes") is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately (thereby generating a debt) ...
for the first year is also zero. In his second year, with a 3.5% salary increase his monthly salary would be $2070 on his 26th birthday. The 5% pay credit for this second year would be $1242. Because his second year "hypothetical account" starts the year with a $1200 balance, the interest credit at 6% would be $72. Adding the beginning balance of $1200 to the $1242 pay credit and $72 interest credit would give an ending balance in the "hypothetical" account of $2514 ($2514 = $1200 + $1242 + $72) for the second year. Repeat this process for each ensuing year until termination. This creates a hypothetical account balance from which the legally required benefit -- ''an annuity payable for the life of the participant or beneficiary who elects to commence payment at normal retirement age''—can be calculated. This is due to requirement that benefits be ''definitely determinable'' found in the IRS Regulations Section 1.401.


Lump sum calculation cases

In 1993, the Third Circuit decided in ''Goldman v. First National Bank of Boston'' that the terminated worker did not demonstrate that the adoption of the cash balance plan violated age
discrimination Discrimination is the act of making unjustified distinctions between people based on the groups, classes, or other categories to which they belong or are perceived to belong. People may be discriminated on the basis of race, gender, age, relig ...
rules. In 2000, the Eleventh Circuit in ''Lyons v. Georgia Pacific'' and the Second Circuit in ''Esden v. Bank of Boston'' decided that the employer violated rules for calculating lump sums, and a district court in Eaton vs. Onan Corp. decided that
adopting Adoption is a process whereby a person assumes the parenting of another, usually a child, from that person's biological or legal parent or parents. Legal adoptions permanently transfer all rights and responsibilities, along with filiation, from ...
the cash balance plan did not violate age discrimination rules. In early 2003, the First Circuit in ''Campbell v. BankBoston'' did not decide that the employer violated the age discrimination rules against a former worker because the former worker made a procedural error and brought the issue up late. Then in summer of 2003, the Seventh Circuit in ''Berger v. Xerox Corp. Retirement Plan'', decided that the lump sum calculation for workers terminating service prior to retirement who were covered by the
defendant In court proceedings, a defendant is a person or object who is the party either accused of committing a crime in criminal prosecution or against whom some type of civil relief is being sought in a civil case. Terminology varies from one jurisdic ...
cash balance pension plan cannot violate the rules for defined-benefit plans and in a district court in Illinois in ''Cooper vs. IBM Personal Pension Plan'', decided that the very design of the cash balance plan – the issue that the ''Campbell'' court only reached in dicta – had indeed violated the age discrimination rules because the "rate of benefit accruals" did "decrease" on account the "attainment of any age." The Lump Sum cases all held that because cash balance plans were defined-benefit plans, they had to abide by the rules for defined benefit plans when the employer calculates the lump sum actuarial present value by first accruing the account balance to normal retirement age and then converting the account balance at retirement age into a life annuity before then discounting back to the current date at a statutorily required discount rate. Because these cash balance plans were designed to "look like" defined-contribution plans, the defendants asserted that these cash balance pension plans were not true defined-benefit plans but were "hybrid" plans instead. Therefore, because, they were "hybrids" and looked like defined-contribution plans and because workers are only entitled to the actual balance in defined-contribution plans, the
plaintiffs A plaintiff ( Π in legal shorthand) is the party who initiates a lawsuit (also known as an ''action'') before a court. By doing so, the plaintiff seeks a legal remedy. If this search is successful, the court will issue judgment in favor of the ...
should get lump sums equal only to their "hypothetical" account balances. In ''Berger v. Xerox'', Judge
Richard Posner Richard Allen Posner (; born January 11, 1939) is an American jurist and legal scholar who served as a federal appellate judge on the U.S. Court of Appeals for the Seventh Circuit from 1981 to 2017. A senior lecturer at the University of Chica ...
noted in the case – "for hybrid read unlawful" – held that the lump sum amounts should have been larger. So the cash balance plan is not an exotic "hybrid" plan in the eyes of the law but remained in the defined-benefit part of the pension taxonomy. This process of taking the account balance forward from the terminated worker's current age up to the worker's normal retirement age, before discounting back to the current age is sometimes called the "''whipsaw''." If the interest rate used for discounting back is lower than the rate used for interest credits on the hypothetical account balances, then the legally required lump sum values would be higher than the worker's account balance in his hypothetical account.


Age discrimination cases

Proponents of cash balance plans advocate that these plans do not violate the
age discrimination Ageism, also spelled agism, is discrimination against individuals or groups on the basis of their age. The term was coined in 1969 by Robert Neil Butler to describe discrimination against seniors, and patterned on sexism and racism. Butler def ...
statutes applicable to defined benefit-pension plans. The statutes forbid – in virtually the same words – any plan from reducing "the rate of benefit accrual" for any worker on account "of the attainment of any age". Although the Code defines the "accrued benefit" for any worker covered by defined-benefit plans as "expressed in the form of an annual benefit commencing at normal retirement age" and defines "normal retirement benefit" as the "greater of the early retirement benefit under the plan, or the benefit under the plan commencing at normal retirement age", the supporters of such cash balance plans still argue that the terms "accrued benefit" and "rate of benefit accrual" are ambiguous or undefined. In ''Onan Corp.'', District Court Judge Hamilton agreed with the supporters of cash balance plans and held that the cash balance plan design did not violate age discrimination because the terms "rate of benefit accrual" and "accrued benefit" were not defined in the relevant statutes. But the terms "accrued benefit" and "rate of benefit accrual" have long been very familiar and unambiguous to pension actuaries. It was because the terms were so unambiguous to actuaries that they could construct the initial balances in each worker's "hypothetical" account for these new cash balance pension plans. Also, §411(a)(1)(7) of the Code defines "accrued benefit". Thus pension actuaries are very familiar with changes in accrual rate factors used in a traditional defined-benefit pension plan's formula. In ''Kathi Cooper v. IBM Personal Pension Plan'', District Court Judge Murphy in 2003 came to the opposite conclusion because the terms accrued benefit and rate of benefit accrual were not ambiguous. According to Murphy benefits accrued at a decreasing rate solely based on increases in age, the plan design of the cash balance plan violated the age discrimination statutes. If this rule is upheld, then all "flat rate pay credit" design cash balance plans would violate age discrimination. A plan sponsor could avoid these problems by setting up a cash balance plan with steadily increasing – or age graded – rates for pay credits. This has the same
economic An economy is an area of the Production (economics), production, Distribution (economics), distribution and trade, as well as Consumption (economics), consumption of Goods (economics), goods and Service (economics), services. In general, it is ...
effect as adopting a "career average salary" traditional defined-benefit plan. The ruling was reversed on appeal in 2006.United States Court of Appeals, Seventh Circuit
- No. 05-3588


Legislative developments

Because of the troublesome age discrimination suits and misunderstanding and frustration by older workers covered by such plans, Congress, notably Senator Charles Grassley (R) of Iowa, has a proposal to statutorily fix the problem. It involves outlawing "wearaway". The
Pension Protection Act of 2006 The Pension Protection Act of 2006 (), 120 Stat. 780, was signed into law by U.S. President George W. Bush on August 17, 2006. Pension reform This legislation requires companies who have underfunded their pension plans to pay higher premiums to ...
was signed into law in August 2006 and prospectively made the flat salary credit type plans immune from age discrimination. Also, the use of a higher interest rate for calculation of lump sums is now allowed as the new law eliminates the whipsaw. The law fixes age discrimination only prospectively.


See also

*
Pension A pension (, from Latin ''pensiō'', "payment") is a fund into which a sum of money is added during an employee's employment years and from which payments are drawn to support the person's retirement from work in the form of periodic payments ...
*
PBGC The Pension Benefit Guaranty Corporation (PBGC) is a United States federally chartered corporation created by the Employee Retirement Income Security Act of 1974 (ERISA) to encourage the continuation and maintenance of voluntary private defined b ...
*
ERISA The Employee Retirement Income Security Act of 1974 (ERISA) (, codified in part at ) is a U.S. federal tax and labor law that establishes minimum standards for pension plans in private industry. It contains rules on the federal income tax eff ...
*
Defined benefit pension plan Defined benefit (DB) pension plan is a type of pension plan in which an employer/sponsor promises a specified pension payment, lump-sum, or combination thereof on retirement that depends on an employee's earnings history, tenure of service and age ...


References


GAO report on cash balance conversions
* Berger v. Xerox, 338 F.3d 755 (7th Cir., 2003) Judge
Richard Posner Richard Allen Posner (; born January 11, 1939) is an American jurist and legal scholar who served as a federal appellate judge on the U.S. Court of Appeals for the Seventh Circuit from 1981 to 2017. A senior lecturer at the University of Chica ...
* Cooper v. IBM, 274 F.Supp.2d 1010 (S.D. Ill. 2003) Judge Murphy * Campbell v. Bank of Boston, 274 F.3d 1 (1st Cir. 2003) Judge Lynch {{DEFAULTSORT:Cash Balance Plan Retirement