Cash Balance Plan
Cash Balance Plans have been around since 1985. BankAmerica Corporation is credited with the adoption of the first cash balance plan.
A cash balance plan is a type of hybrid pension plan that has a benefit formula designed to mirror a defined contribution plan. The plan sponsor credits amounts on a notional basis to a hypothetical (bookkeeping) account for each participant to determine the participant's benefit under the plan. The amounts credited are generally based on pay, but the credits may also be based on age, service, flat dollar amounts, or other criteria. Whereas defined contribution (profit sharing) plan contributions can be based on profits, the amount credited to the Cash Balance Plan cannot be tied to company profits. [Treas. Reg. § 1.401-1(b)(1)(i)] Amounts are also credited to reflect an assumed rate of interest on the hypothetical account. The hypothetical credits are allocated to the notional account of a cash balance plan participant, and the benefits under the plan are based on the resulting hypothetical account balance. Because no contributions are actually allocated to an individual account and the hypothetical account balance is only used to define the benefit payable under the plan, cash balance plans are considered to be defined benefit plans.
Under a more traditional pension plan, the benefit is defined as a monthly benefit payable at normal retirement age. For younger employees, retirement may seem to be a long way off, and they often do not attribute much value to a retirement annuity, whereas they are more likely to see value in a cash balance account. Even for employees who are closer to retirement, a benefit defined as an annuity may not seem to be as valuable as a lump-sum account, even if the present value is the same. A lump-sum value is perceived as part of an individual's net worth, whereas an annuity may be seen as future income rather than something that adds to the current net worth. Some traditional defined benefit plans allow for lump-sum distributions and for that reason may be considered more like a cash balance plan in terms of value. However, the lump-sum value changes with interest rates, which adds complexity and confusion for participants. [IRC §417(e)(3)] In addition, a change in interest rates can significantly affect the lump-sum value of the annuity benefit.
Conversely, a Cash Balance Plan is described to plan participants as a lump-sum benefit (as a notional account), which is easily understood, so the value to participants is very transparent. Similar to a defined contribution plan, employees can see the value of an annual pay (or service) credit and they understand how their account grows over time through the application of interest credits. It is often very difficult for participants in a more traditional defined benefit plan to understand (and for the plan sponsor to communicate) their benefits, particularly how the benefit formula works as they accrue their benefits over time and the current value of a deferred benefit. The simplicity of the cash balance plan design means that employees can easily understand and recognize the value they have accumulated by simply looking at their notional account balance.