Cash balance plans: 2015 update

Many sponsors maintain cash balance plans, either as (1) their main retirement benefits program, (2) a program for a specific group of employees (e.g., employees ‘grandfathered’ in connection with a ‘soft freeze’), or (3) a legacy benefit for certain employees (in connection, e.g., with a ‘hard freeze’). In 2014, IRS finalized cash balance plan regulations, reflecting changes made by the Pension Protection Act of 2006 (PPA), and we now have a clear set of rules for the operation of these plans.

In this article we review the evolution of the cash balance plan design and summarize where we are now. We then consider the relative merits of this design vs. a defined contribution plan.


In 1980, defined benefit (DB) plans were the predominant vehicle for private sector retirement wealth accumulation, holding more than twice as much in assets as defined contribution (DC) plans. Today, the situation is roughly reversed, with DC plans holding close to two-thirds of retirement plan assets. What happened?

Perhaps the biggest driver has been a changing corporate culture. During this time, many companies embarked on an effort to reform their employee culture, moving from a ‘long-term relationship’ culture where employee retention (and employee loyalty) was highly valued to a more transactional culture where an employee’s ‘current value’ was rewarded by explicit compensation. In retirement benefits policy, that translated into (more or less) a shift from a DB to a DC contribution culture.

A contributing factor was a growing preference for ‘cafeteria’ style benefits, which allowed employees to direct their benefit dollars to programs most meaningful to them. In the retirement space, the emergence of 401(k) plans filled this need, allowing employees to choose their own savings rate and asset allocation. And there was a generational shift at play: DB plans are generally more valuable for older employees. DC benefits are much ‘flatter’ with respect to age.

Implementing this DB-to-DC benefits policy shift in the context of significant DB surpluses presented a challenge to many sponsors. Congress had made it nearly impossible to recapture DB funding surpluses. So, if a sponsor of a DB plan with a significant funding surplus froze that plan and implemented a DC plan, it was, in effect, abandoning a significant corporate asset.

Enter the cash balance plan: a DB plan that provided a very DC-like benefit. If the ‘traditional’ DB plan were converted to a cash balance plan, participants could receive a lump sum benefit based on annual contributions (‘pay credits’) and earnings (‘interest credits’), just like in a DC plan. And because this was still technically a DB plan, those benefits could be financed out of the DB plan surplus.

This retirement benefits policy innovation provoked a lot of controversy, more than a little litigation, and eventually Congressional action. One way to see that controversy was as, essentially, a fight over ‘who owns the surplus.’ And, indeed, there were anti-cash balance advocates who argued that, as in some cases in the past, surpluses should be used to increase benefits, e.g., for retirees.

Challenges to cash balance plans

Anti-cash balance advocates raised several issues with respect to cash balance plans, but two in particular made adopting or converting to a cash balance plan particularly problematic:

Age discrimination: Some suggested that, simply because under a cash balance plan every year older a participant gets she will earn one less year of interest credits, a cash balance plan provides for a benefit that decreases with age in violation of ERISA. Perhaps a bigger problem was that in some conversions, wearaway was used to prevent ongoing accruals for older employees for significant periods of time.

Whipsaw: In a cash balance plan, a participant’s benefit is generally thought of as the balance in his or her hypothetical account. According to IRS (at that time), however, because a cash balance plan is a DB plan, the participant’s benefit was equal to the account balance projected to normal retirement age (typically, age 65) at the plan’s interest crediting rate and then discounted back to the current age at the 30-year Treasury Bond rate. For some plans, when you go through that exercise (dubbed ‘whipsaw’), the participant gets a bigger benefit than his account balance. IRS provided a limited exception to this rule for certain fixed and fixed income interest crediting rates.

PPA reforms

PPA settled these and a number of other issues. Under PPA:

The accrued benefit in a cash balance could be expressed as the balance of a participant’s hypothetical account.

A cash balance plan was generally allowed to use any interest crediting rate (1) that was not in excess of a ‘market rate of return’ so long as it (2) met a ‘preservation of capital’ requirement. PPA clearly contemplated that plans would be allowed to use a variable rate of return, based, e.g., on the performance of an equity index.

The wearaway of frozen benefits in cash balance plan conversions was generally prohibited.

Probably the two most significant accomplishments of PPA were (1) settling the various disputes over the legitimacy of the cash balance plan design as such and (2) clearly authorizing the crediting of market-based rates of return. At this point, (1) is largely of only historical significance. (2) – market-based rates of return – however, significantly increased the utility of cash balance plans.

Market-return cash balance plans

In 2010, IRS proposed regulations providing that a cash balance plan could use an interest crediting rate equal to the actual return on plan assets. In 2014 it finalized that proposal, adding the nuance that a cash balance plan could, for different participant groups, provide different rates of return based on different subsets of plan assets. (One regulatory issue with respect to cash balance plans that remains outstanding is how some plans with interest crediting rates that do not comply with the 2014 final regulations are to transition to compliant rates.)

Market-return cash balance plans represent an improvement in cash balance design in two respects. First, from the participant’s point of view, they allow sponsors to provide equity based rates of return. Prior to this innovation, cash balance plan interest crediting rates were generally limited to a fixed rate (e.g., 5%) or a rate based on a fixed income yield (e.g., the yield on 30-year Treasury bonds). Market-based returns are more like what a participant could earn in a DC plan.

Second, from the sponsor’s point of view, they eliminate one of the risks ‘traditional’ cash balance plans present: a mismatch between asset performance and the interest crediting rate. We discussed this in our 2012 article Plain talk about cash balance plans.

Some have regarded this characteristic of traditional cash balance plans as a feature, not a bug: a plan could provide a fixed rate of return of, say, 5% and the trust could be invested using a strategy designed to beat that ‘bogey.’ The excess trust earnings (that is, in excess of 5%) could be used to reduce the cost of the plan. This strategy was sometimes mischaracterized as ‘arbitrage’ – unlike true arbitrage, however, the strategy is fraught with risk.

There was a time when such a strategy was appealing to many sponsors. But in recent years the trend has been for sponsors to seek ways to reduce risk.

The emergence of risk as a key driver of DB policy

The phenomenon we identified at the beginning of this article as one driver of the adoption of the cash balance plan design – the desire to use a DB plan surplus to fund a DC-like benefit – has long since faded into history. Beginning in the 2000s, as interest rates continued to decline and stocks suffered historic losses, corporate DB policy began to be dominated by concern with risk. The most significant risk in this regard is interest rate risk, and the tale of interest rates since the year 2000 is one of nearly consistent decline and a corresponding increase in the ‘value’ of DB plan liabilities. Asset performance risk – in the context of both the bubble (at the beginning of this period) and the 2008 financial crisis – has added fuel to the fire.

Because of the precipitous drop in interest rates, the problem of ‘how to recapture plan surplus’ – a problem for which cash balance plans were perhaps the solution – has gone away. Most plans no longer have surpluses. And most sponsors are primarily concerned with how to reduce, or at least manage in a predictable way, the impact of their DB plans on company financials and cash flow.

Cash balance plans and risk

In this context, cash balance plans also, generally, have virtues that ‘traditional’ DB plans do not. The accrual rate is an explicit percentage of current pay. In a ‘traditional’ cash balance plan, where the interest crediting rate is fixed or is tied to a fixed income yield, asset performance risk is, however, not ‘hedgeable’, unlike a ‘traditional’ defined benefit plan. In the current interest rate environment, it’s generally impossible to find a (risk-free) 5% fixed return. And while it’s possible to buy fixed income securities that match the return on a fixed income index, if interest rates go up, the interest crediting rate goes up, while the plan is stuck with a loss on the fixed income securities it holds.

Market-return cash balance plans – in which the interest crediting rate is based on returns on plan assets – avoid these problems: the interest crediting rate is directly tied to asset performance. Thus, from the point of view of a sponsor concerned with risk, these plans, in most respects, the same way DC plans do. Nearly. The following risks still remain:

Preservation of capital. This rule puts a ‘return of principle’ floor on a cash balance plan participant’s benefit. The risk with respect to it varies with, e.g., the volatility of returns on plan assets and with the length of the participant’s participation in the plan. As we discuss in our article The cash balance capital preservation guarantee: quantitative analysis, this risk is very small compared to what traditional DB plans (annuity or cash balance) face.

Accounting treatment. Some interpret Generally Accepted Accounting Principle rules as requiring the application of, in effect, a version of whipsaw to value cash balance plan benefits for pension accounting purposes. So, while ‘real life’ risk may be significantly reduced, there still may be issues with financial statement treatment, although we understand this is an ongoing dialogue.

Contribution rules. Again, while Tax Code operational rules use the PPA approach – that the participant’s benefit is defined by his account balance – funding rules still apply something like whipsaw; this rule may complicate cash management.

PBGC premiums

Another issue that has emerged in recent years is the increasing cost of PBGC premiums. Given the low level of risk in a market-return cash balance plan where assets generally equal liabilities, these function as a $64 (in 2016) per head per year ‘tax.’ This tax obviously does not apply to DC plans. At the margin, particularly where there are a lot of participants with small balances, the PBGC head count premium may discourage the adoption or continuation of cash balance plans.

Why not a defined contribution plan?

If the issue is no longer surplus but risk, why establish (or convert to) a cash balance plan at all? Why not simply freeze the DB plan and establish a DC plan? Good question. DC plans do not present the preservation of capital, accounting and funding issues that market-return cash balance plans do. And in some respects they are more flexible – unlike a 401(k) plan, participants in a cash balance plan cannot choose their contribution level or asset allocation. There are, however, still some reasons why some sponsors may prefer a cash balance plan solution (for a fuller treatment of this issue, see our article Why use a ReDefined Benefit strategy?):

It may be easier to take care of specific groups the sponsor wants to benefit – a ‘grandfathered’ population, longer service participants or mid-career recruits – with a DB plan.

An ongoing ‘traditional’ cash balance plan can, for active participants, eliminate the asset/liability mismatch produced by fixed or fixed income based interest crediting rates. This cannot be done if the cash balance plan is simply frozen, and ongoing benefits are provided in a DC plan.

DB plans generate better investment results than DC plans, producing larger retirement benefits for a given contribution.

Market-return cash balance plans provide more flexibility than DC plans, including opportunities for sharing risks, such as annuity forms of payment – a challenge that DC plans are still struggling to meet.

401(k) match designs are less inclusive. The 10%-20% of employees who decline to participate receive no employer benefit.

For some sponsors, the higher deduction/benefit limits available for DB plans may be a factor.

Not all sponsors will be persuaded by these arguments. But they may account for the fact that cash balance plans have not gone away and, indeed, are viewed by some as a possible middle way between traditional DB plans and a ‘DC only’ culture.

There are significant concerns about the DC retirement plan system, particularly about participants’ ability to bear the risks and responsibilities that DC plans impose on them and the fairness and cost of 401(k) plans. As a result, many have recently attempted to come up with alternative retirement plan designs.

It remains to be seen whether cash balance plans generally and market-return cash balance plans in particular will remain a ‘niche’ design – useful in the transition from DB to DC and for special sorts of sponsors – or will take their place besides DC plans as a viable ‘mainstream’ retirement benefits strategy.