Magazine article The National Public Accountant

Cash Balance Pension Plans: Do They Discriminate against Older Employees?

Magazine article The National Public Accountant

Cash Balance Pension Plans: Do They Discriminate against Older Employees?

Article excerpt

One of the most important issues facing the pension world today involves companies replacing their traditional, defined-benefit pension plans with cash-balance plans. Although cash-balance plans have been around since 1985, they went virtually unnoticed until IBM wanted to establish a cash-balance plan in 1999 and some employees sued. According to the Pension Benefit Guaranty Corporation's (PBGC) annual report for 2000, the number of PBGC insured defined-benefit plans has declined from about 114,000 in 1985 to about 38,000 in 2000.

Advantages and disadvantages of cash-balance plans are being debated from legal, economic, and behavioral points. Cash-balance plans are said to be less costly to the companies providing them, in terms of both future liability and administration and maintenance. The portability feature offered by many cash-balance plans is attractive to many of today's younger corporate employees.

What Is a Cash-Balance Plan?

A cash-balance plan is a hybrid pension plan with features of both a defined-benefit plan and a defined-contribution plan. In substance, it is a defined-benefit plan in that an employer promises to pay a certain sum of benefit to employees at retirement. In a cash-balance plan, the cash balance is the current lump-sum accrued pension benefit. An employee's cash balance comes from periodic "pay-related credits" linked to salary and wages, at a rate that usually depends on age and seniority, and from "interest-related credits" at an annually adjusted rate linked to a market rate (usually a constant-maturity bond yield or discount) or the U.S. Consumer Price Index (CPI).

For example, an employer may promise that employees will receive a lump-sum retirement payment composed of, say, four percent of each year's salary plus one percent interest (may be fixed or variable) on each year's balance owed. Under this arrangement, all the risks and rewards of the pension plan investments are borne by the employer, as in a traditional defined-benefit plan. What is promised is the final balance in an employee's virtual account, regardless of the investment performance. It is a virtual account in that no amount is invested in any specific employee's name. The pension plan trustee still invests all pension assets for all employees. Because it is a defined-benefit pension plan, the employee can choose to receive a lump-sum payment (preferred by most employees) or an annuity. Note that the employee is not promised monthly benefits like a traditional plan--only the option to receive the lump-sum benefit in the form of an annuity.

A cash-balance plan also mimics a defined-contribution plan in that vested benefits can be received upon termination of employment and are therefore portable, unlike defined-benefit plans. Unlike 401(k)-type defined-contribution plans, cash-balance plans do not require employee contributions. Some also think that "pay credit" or percent of employee salary contributed by the employer behaves like a defined-contribution plan.

What Is the Controversy?

Part of the controversy concerning cash-balance plans arises because of the complexity of the issue. Proponents and opponents of the cash-balance plans are able to tout the features that support their position. The most appealing part of a cash-balance plan for an employee is its portability. Most U.S. employees can expect to switch jobs about four or five times during their careers. The ability to look at your account on the Web and see that you have earned a certain sum of dollars further enhances the plan's attractiveness. Thus, a very simple and easy to understand account statement looks very appealing compared to the complex, traditional, defined-benefit plan statements that are full of assumptions.

Cash-balance plans appeal to employers because they save money, due to the nature of the benefits promised. They also save in administrative costs; when retired or terminated vested employees carry their benefits with them, the employer is relieved from bookkeeping burdens. …

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