Pension Issues: Cash-Balance Plans

Publication Date: January 2005

Publisher: Library of Congress. Congressional Research Service

Author(s):

Research Area: Labor

Type:

Abstract:

In recent years, hundreds of employers have converted their traditional defined benefit pension plans into what are called a cash-balance plans. In these plans, the employer regularly sets aside pay and interest credits into "hypothetical" employee accounts. The accounts are hypothetical because, while the employee receives periodic statements of the amount of pay and interest credits that have accumulated in his or her "account," all of the funds in the plan are commingled and the employer makes all the investment decisions. The employer also determines the percentage of pay and the interest rate (or index of rates) that will be credited to employee accounts. Employees covered by cash-balance plans usually are given the option of receiving a lump-sum distribution from the plan when they leave their employer, a practice that is not typical of traditional defined benefit pensions.

Cash-balance plans have become popular with employers both because they can reduce pension expenses and because they may be better appreciated by younger employees than traditional pension plans. Cash-balance plans provide the employer with the control over pension assets characteristic of traditional defined benefit plans while potentially reducing the employer's financial liability. In a traditional defined benefit pension, the retirement benefit usually is based on years of service and average income in the years immediately prior to retirement. In a cash-balance plan, the employer contributes a percentage of pay to the plan and pays interest at a rate that the employer may determine in advance. Funding is easier to estimate, and any excess growth in pension assets can be used to fund future pay and interest credits.

As more employers have converted their traditional pensions to cash-balance plans, two issues of particular concern to many pension plan participants have been (1) employer practices in disclosing the impact of the pension conversions on employees' pensions and (2) the effect of conversions on older and long-service employees. Employees who are informed about the future value of their benefits can better decide how to prepare for retirement, such as by saving more on their own. Employees who expect to change jobs several times over the course of their careers sometimes can accumulate larger retirement assets under a cash-balance plan than under a traditional plan, provided that they re-invest the lump-sum distributions they receive when they leave an employer. Employees who have worked for many years under a traditional pension, however, can experience substantial reductions in future benefit accruals as the result of a conversion to a cash-balance plan.

Section 659 of the Economic Growth and Tax Relief Reconciliation Act of 2001 (P.L. 107-16) amended ?4980(f) of the Internal Revenue Code to impose an excise tax of $100 per participant per day on any employer that fails to notify to plan participants of an amendment that would significantly reduce future benefit accruals. The Secretary of the Treasury may issue a simplified notice requirement for plans with fewer than 100 participants or that allow participants to choose between the old plans and the new plan. The President's budget for FY2005 proposed legislation that would have clarified the legal status of cash balance plans, provided protections for workers in future cash balance conversions, and repealed regulations that effectively limit interest credits to cash balance plans. Congress took no action on the proposals.