The Cash Balance Conundrum

Recently the Government Accountability Office (GAO) advised Congress to among other things, eliminate the legal uncertainty surrounding cash balance pension plans in order to permit / promote the defined benefit pension system.

The uncertainty around cash balance plans arose in 2003 after a federal judge named Murphy ruled that IBM´s plan discriminated against older workers. This ruling has almost become as famous as Murphy´s Law itself - If anything can go wrong, it will.

But I believe Murphy´s ruling was wrong as in the famous saying, but maybe for not so obvious reasons.

A cash balance plan (referred to as a hybrid plan) is a Defined Benefit plan but with the characteristics of a Defined Contribution plan, including but not limited to:

• An account (albeit) notional is set up on behalf of each participant
• Interest is credited to that account at least each year
• There is a regular statement of such account (at least annually)
• There is almost always a lump sum payment option
• The benefits are more understandable to the participants
• The plan is generally more appealing to a mobile workforce

The controversy around the cash balance plans is not the plan design, but more so around how companies with existing pension plans and workforces have converted to the cash balance world. So if a new company with a new workforce were to start a brand new cash balance plan with just prospective benefit accruals, there would be no legal issues.

Yes it is true as the GAO report will vouch for, that in any comparison of a typical final average plan converted to a cash balance plan, more participants would have received greater benefits under the final average plan than the cash balance replacement. These so called conversions are affected by the grandfathering, the actual richness of the cash balance plans, the actual demographics of the plan participants, and the interest rate assumption used in the present value analysis. Because of the so-called greater benefits under the final average plan, many employers provide grandfathering and transition benefits, to lessen if not remove the potential shortfall in benefits. But even still, many plans have crossover points, whereby up until this crossover point is reached; some of your participants´ might not accrue any further benefit. 

What this has not stated up until now, is why companies are changing their typical final average plans to a cash balance design in the first place. The expense and uncertainty of operating a traditional final average plan, the fact that many of the plan participants still don´t understand or accept the design of their plans anyway, and the unduly burdensome requirements and fiduciary responsibilities, many employers might choose to terminate their traditional plan. And as noted in the GAO report, the cash balance plan is more preferable than one viable alternative - a terminated final average plan!

Please feel free to email me any comments to this or any other topic.