16 April 2021

Converting A Traditional DB Plan Into A Cash Balance Plan

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Converting a traditional DB Plan into a Cash Balance Plan  

Employers are not required to establish pension plans for their employees because the private pension system is voluntary. Employers are also allowed substantial flexibility in deciding whether to terminate or amend their existing plans. Therefore, employers generally may change by plan amendment their traditional pension plans and the benefit formulas they use.

Federal law does place restrictions on plan changes generally. For example, advance notification to plan participants is required if, as a result of the amendment, the rate that plan participants may earn benefits in the future is significantly reduced. Additionally, there are other legal requirements that have to be satisfied, including prohibitions against age discrimination. In addition, while employers may amend their plans to cease future benefits or reduce the rate at which future benefits are earned, they generally are prohibited from reducing the benefits that participants have already earned. In other words, an employee generally may not receive less than his or her accrued benefit under the plan formula at the effective date of the amendment. For example, assume that a plan's benefit formula provides a monthly pension at age 65 equal to 1.5 percent for each year of service multiplied by the monthly average of a participant's highest three years of compensation, and that the plan is amended to change the benefit formula. If a participant has completed 10 years of service at the time of the amendment, the participant will have the right to receive a monthly pension at age 65 equal to 15 percent of the monthly average of the participant's highest three years of compensation when the plan amendment is effective. This pre-amendment benefit (including related early retirement benefits) is protected by law and cannot be reduced.

In addition, there are additional restrictions that apply specifically in the case of an amendment that converts a plan formula to a cash balance plan formula. Specifically, participants must receive the sum of the pre-amendment benefit plus benefits under the new cash balance formula (as a result, there cannot be a "wear away" period during which the participant does not accrue additional benefits, as could occur if participants were merely entitled to the greater benefit). Furthermore, all benefits under a cash balance plan (including benefits accrued prior to a conversion) must be fully vested after 3 years of service.  

Changing Formulas 

When an employer amends its plan to convert the plan's traditional defined benefit plan formula to a cash balance plan formula, the plan's assets remain intact and continue to back all of the pension benefits under the plan. Employers cannot remove funds from the plan, unless the plan has been terminated and has assets remaining after payment of all of the benefits under the plan. 

If a participant has worked long enough to be vested under the plan, the participant should receive the sum of (1) the accrued benefit under the formula in effect before the amendment, and (2) the additional benefits you earned under the plan formula in effect after the amendment. However, the participant may have to wait until a retirement age under the plan to receive your benefit.

Neither ERISA nor the IRC requires employers to give employees the choice of remaining in the old formula. Employers have several options, including:

  • Providing no choice, replacing the old formula and applying the new formula to all participants.
  • Allowing employees to remain under the old formula, while restricting new hires to the new formula.
  • Stipulating that certain employees who have reached a specific length of service or who have reached a certain age may choose to stay with the old formula.
  • The law permits employers to have such flexibility, but whatever option applies has to satisfy legal requirements.

Under each of these options, benefits already earned by the participants, as of the effective date of the amendment that converts the old formula to a cash balance formula, may not be reduced.

Employee Notices 

Many employers voluntarily provide helpful information about these conversions in advance of the change becoming effective. If a participant is not sure if they have enough information to understand the plan change, they have a right to contact the plan administrator and ask for more information or help in understanding the change and any choices in conjunction with the change.

Plan administrators are generally required to give at least 45 days advance notice of plan amendments that significantly reduce the rate at which plan participants earn benefits in the future.

After the plan is amended, the plan administrator is required to provide all plan participants with a Summary of Material Modifications to the plan or a revised Summary Plan Description. This document will summarize the changes to your plan.

In addition, under the Age Discrimination in Employment Act (ADEA), an employer requiring an employee to sign a waiver of rights and claims when choosing between plans is required to provide enough information to enable the employee to make a knowing and voluntary decision to waive ADEA rights. In most cases, an employee must be given at least 21 days to sign the waiver and at least 7 days to revoke the agreement.

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