Cash balance plans. They're defined benefit pension plans. But they don't look like them. They're not 401(k) plans. But they sure look like them.
Employees receive individual accounts, and although these accounts exist only on paper, they let workers see how their retirement benefits are growing. These theoretical accounts include annual credits based on pay, as well as an assumed rate of return, frequently linked to that on long-term Treasury bills.
The individual accounts represent the present value of their future benefits at retirement age.
When they quit or retire, workers may take their "cash balances" with them or keep the money in the company's pension plan and opt for an annuity or monthly pension in retirement.
Because workers covered by cash balance plans steadily earn benefits over time, the sizes of their accounts are a simple matter of compounding -- the longer they stay in their jobs, the greater their account balances will be. Like 401(k) plans, cash balance plans fit the definition of "career average" pension plans, where workers earn benefits linked to their current pay, averaged over their careers.
In traditional defined benefit pension plans, by contrast, employees usually earn large chunks of their retirement benefits in their last few years before retirement. That's because the benefits in such "final average pay" plans usually are calculated based on a percentage of an employee's annual salary in the last three or five years on the job, multiplied by years of service. Workers who quit after a few years usually get just a token retirement benefit. Some traditional pension plans also let workers who quit early take their earned benefits in lump sums.
At the same time, cash balance plans still are defined benefit pension plans (although they limit employers' pension liabilities to the amounts of the account balances). As such:
* Employers continue to manage the underlying plan assets and can keep the difference between the amounts they credit to employees' accounts and the returns they earn on the money.
* They are insured by the Pension Benefit Guaranty Corp., and employers must pay an insurance premium for each participant. To date, the PBGC has taken over cash balance pension plans from: American Industries and Resources Corp., Wintersville, Ohio; Sewell Manufacturing Co., Bremen, Ga.; Quadrex Corp., St. Louis; Golden Valley Health Center, Golden Valley, Minn.; and Dill Products Inc., Norristown, Pa. The PBGC intends to begin collecting information on these plans from employers next year.
* The same accounting rules apply, and companies must show their pension liabilities in their annual financial statements.
Under IRS rules, workers at a company with a 401(k) plan that converts its defined benefit plan to cash balance get a bigger benefit than if the employer had shuttered the defined benefit plan and set up a second defined contribution plan.
Such companies also gain from flexible funding rules.
In a 401(k) plan, an employer has to make a specified cash contribution to employees' accounts each year. But because the individual accounts in a cash balance plan exist only on paper, the employer doesn't have to worry about ponying up cash each year. Instead, the company uses actuarial statistics to help determine a funding schedule over, say, 30 years.
One problem with cash balance plans -- from an employee's perspective -- is the annuity a participant receives upon leaving the job depends on the account balance and interest rates at that time, so employees are not entirely insulated from interest rate risk.
When interest rates fall, annuities become more expensive, so the account balance buys a smaller pension, and when interest rates rise, annuities become cheaper, so the account balance buys a bigger pension, said Ron Gebhardtsbauer, senior pension fellow at the American Academy of Actuaries, Washington.
"Employers can reduce this problem by keeping the price of annuities in their plan constant," he said.
