Cash Balance Pension Plans
There are two general types of pension
plans — defined benefit plans and defined contribution plans. In general,
defined benefit plans provide a specific benefit at retirement for each
eligible employee, while defined contribution plans specify the amount of
contributions to be made by the employer toward an employee's retirement
account. In a defined contribution plan, the actual amount of retirement
benefits provided to an employee depends on the amount of the contributions as
well as the gains or losses of the account.
A cash balance plan is a defined
benefit plan that defines the benefit in terms that are more characteristic of
a defined contribution plan. In other words, a cash balance plan defines the
promised benefit in terms of a stated account balance.
How cash
balance plans work
In a typical cash balance plan, a
participant's account is credited each year with a "pay credit" (such
as 5 percent of compensation from his or her employer) and an "interest
credit" (either a fixed rate or a variable rate that is linked to an index
such as the one-year treasury bill rate). Increases and decreases in the value
of the plan's investments do not directly affect the benefit amounts promised
to participants. Thus, the investment risks are borne solely by the employer.
When a participant becomes entitled to
receive benefits under a cash balance plan, the benefits that are received are
defined in terms of an account balance. For example, assume that a participant
has an account balance of $100,000 when he or she reaches age 65. If the
participant decides to retire at that time, he or she would have the right to
an annuity based on that account balance. Such an annuity might be
approximately $8500 per year for life. In many cash balance plans, however, the
participant could instead choose (with consent from his or her spouse) to take
a lump sum benefit equal to the $100,000 account balance.
If a participant receives a lump sum
distribution, that distribution generally can be rolled over into an IRA or to
another employer's plan if that plan accepts rollovers. The benefits in most
cash balance plans, as in most traditional defined benefit plans, are
protected, within certain limitations, by federal insurance provided through
the Pension Benefit Guaranty Corporation.
How cash
balance plans differ from traditional pension plans
While both traditional defined benefit
plans and cash balance plans are required to offer payment of an employee's
benefit in the form of a series of payments for life, traditional defined
benefit plans define an employee's benefit as a series of monthly payments for
life to begin at retirement, but cash balance plans define the benefit in terms
of a stated account balance. These accounts are often referred to as
"hypothetical accounts" because they do not reflect actual
contributions to an account or actual gains and losses allocable to the
account.
Federal pension law governs cash
balance plans
Federal law, including the Employee
Retirement Income Security Act (ERISA), the Age Discrimination in Employment
Act (ADEA), and the Internal Revenue Code (IRC), provides certain protections
for the employee benefits of participants in private sector pension plans.
If an employer offers a pension plan,
the law sets standards for fiduciary responsibility, participation, vesting
(the minimum time a participant must generally be employed by the employer to
earn a legal right to benefits), benefit accrual and funding. The law also
requires plans to give basic information to workers and retirees. The IRC
establishes additional tax qualification requirements, including rules aimed at
ensuring that proportionate benefits are provided to a sufficiently broad-based
employee population.
The Department of Labor, the Equal
Employment Opportunity Commission (EEOC), and the IRS/Department of the
Treasury have responsibilities in overseeing and enforcing the provisions of
the law. Generally, the Department of Labor focuses on the fiduciary
responsibilities, employee rights, and reporting and disclosure requirements
under the law, while the EEOC concentrates on the portions of the law relating
to age discriminatory employment practices. The IRS/Department of the Treasury
generally focuses on the standards set by the law for plans to qualify for tax
preferences.