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Chapter 15: cash balance pension plan.


A cash balance pension plan is a qualified defined benefit plan that provides for annual employer contributions at a specified rate to hypothetical individual accounts that are set up for each plan participant. The employer guarantees not only the contribution level but also a minimum rate of return on each participant's account. A cash balance plan works somewhat like a money purchase pension plan discussed in Chapter 16, but money purchase plans do not involve employer guarantees of the rate of return.


1. When the employees are relatively young and have substantial time to accumulate retirement savings.

2. When employees are concerned with security of retirement income.

3. When the work force is large and the bulk of the employees are middle-income. (Banks and similar financial institutions find this type of plan particularly appealing.)

4. When the employer is able to spread administrative costs over a relatively large group of plan participants.

5. When the employer has an existing defined benefit plan and wishes to convert to a plan that provides a more attractive benefit for younger employees and may lower costs for older employees.


1. As with all qualified plans, the cash balance plan provides a tax-deferred savings medium for employees.

2. The employer guarantee removes investment risk from the employee.

3. Plan benefits are guaranteed (within limits) by the federal Pension Benefit Guaranty Corporation (PBGC).

4. The benefits of the plan are easily communicated to and appreciated by employees.


1. The retirement benefit may be inadequate for older plan entrants--see Figures 15.1 and 15.2.

2. Because of the need for actuarial services, the minimum funding requirements, and the PBGC guarantee, the plan is more complex administratively than qualified defined contribution plans.

3. The shift of investment risk to the employer increases employer costs.


A cash balance plan provides a hypothetical individual account for each participant. These hypothetical accounts are credited by the employer at least once a year with two types of credit--the "pay credit" and the "interest credit."

The pay credit uses a formula based on compensation. (1) For example, the plan might require the employer to credit each employee's account annually with a pay credit of 6% of compensation. The pay credit formula may also be "integrated" with Social Security. With Social Security integration, compensation below a level specified in the plan--the "integration level"--receives a lesser credit than compensation above the integration level. This reflects the fact that the employer pays Social Security taxes to provide retirement benefits through Social Security. Social Security integration for qualified plans is discussed in Chapter 7 of this book.

The interest credit is an amount of employer-guaranteed investment earnings that is credited annually to each employee's account. The interest credit must follow a formula in the plan and cannot merely be discretionary on the employer's part. For example, the interest credit formula in the plan might provide for each employee's account to be credited annually with a rate of earnings defined as the lesser of (a) the increase in the Consumer Price Index over the preceding year or (b) the one-year rate for U.S. Treasury securities. The plan can allow the employer to credit accounts with actual plan earnings, if these are higher.

In a cash balance plan there are no actual individual accounts, as there are in defined contribution plans. All amounts are pooled in a single fund. Any plan participant has a legal claim on the entire fund to satisfy his or her claim to plan benefits.

The employer's annual cost for the plan is determined on an actuarial basis because of the employer guarantee feature. Investment risk lies with the employer; if actual plan earnings fall below total interest credits for the year, the employer must make up the difference. Employer costs can be controlled primarily by choosing the right kind of formula for the interest credit, one that does not risk uncontrollable and unforeseeable employer obligations. However, the interest credit formula should not be excessively conservative--if actual plan earnings year after year are more than interest credits, plan participants may resent the employer's enrichment and the positive employee relations value of the plan may be lost.

Investment designation by participants (earmarking) is not available in a cash balance plan, because the plan is not technically an individual account plan under ERISA section 404(c). Loans from the plan can be made available, but most employers will not want a loan provision because of the administrative problems resulting from the plan's status as a defined benefit plan without separate participant accounts. Life insurance can be purchased by the plan as an incidental benefit to participants or as a plan investment, under the limitations discussed in Chapter 13.

Modification of Existing Defined Benefit Formula. Some employers that have a traditional defined benefit plan (see Chapter 14) become dissatisfied with the plan because it does not provide an attractive benefit for younger employees, but imposes substantial costs for employees nearing retirement. Termination of the defined benefit plan and substitution of a defined contribution plan would require that most or all existing plan assets would have to be immediately credited to vested participants. However, a less costly alternative might be to revise the existing plan's formula into a cash balance formula.

Generally, the Internal Revenue Code requires that after a conversion of existing defined benefit plan to a cash balance formula, each participant's benefit must be no less than the sum of the actuarial value of the participant's benefit under the old formula at the time of the conversion plus the participant's benefit earned for post-conversion service under the new formula. (2)

If an employer amends a defined benefit plan (or any other plan subject to the minimum funding standards) to adopt a cash balance formula, or makes any other change resulting in a reduction in the rate of future benefit accrual, the plan administrator must provide a prescribed written notice to affected plan participants and beneficiaries. Failure to provide the notice results in a $100/day penalty. (3) The provision allows for regulations exempting certain plans with fewer than 100 participants under certain circumstances.


1. Employer contributions to the plan are deductible when made. (4)

2. Internal Revenue Code section 415(b) limits the benefits provided under the plan to the lesser of $195,000 annually (in 2009, as indexed (5)) or 100% of the participant's high 3-year average compensation. (6) For a given employee, this is the defined benefit plan limit. This limit may be more or less favorable than the defined contribution limit applicable to a comparable money purchase plan.

3. Taxation of the employee on employer contributions is deferred.7 Both contributions and earnings on plan assets are nontaxable to plan participants until withdrawn, assuming the plan remains "qualified." A plan is qualified if it meets the eligibility, vesting, funding and other requirements explained in Chapter 7.

4. Distributions from the plan must follow the rules for qualified plan distributions. Certain premature distributions are subject to penalties. These distribution rules are discussed in Chapter 7.

5. Lump sum distributions may be eligible for the special 10-year averaging (for certain employees born before 1936) tax computation available for qualified plans. Not all distributions are eligible; see Chapter 8 for coverage of these rules.

6. The plan is subject to the minimum funding rules of the Internal Revenue Code.8 This requires minimum contributions, subject to a penalty if less than the minimum amount is contributed in any year. If the plan is not fully funded, the subsequent year's contributions must be made on at least an estimated quarterly basis. (9)

7. Since a cash balance plan is a type of defined benefit plan, it is subject to mandatory insurance coverage by the Pension Benefit Guaranty Corporation (PBGC). The PBGC is a government corporation funded through a mandatory premium paid by employer-sponsors of covered plans. The premium is a flat rate is $30 annually per participant; (10) however, an additional annual premium may be required, depending on the amount of the plan's unfunded vested benefit. (11) If the plan is terminated by the employer, PBGC termination procedures must be followed.

8. Certain employers adopting a plan may be eligible for a business tax credit of up to $500 for "qualified startup costs." See Chapter 10 for details.

9. A plan may permit employees to make voluntary contributions to a "deemed IRA" established under the plan. Amounts so contributed reduce the limit for other traditional or Roth IRA contributions. See Chapter 13 for details.

10. The plan is subject to the additional ERISA reporting and disclosure rules outlined in Chapter 12.


1. Money purchase pension plans and profit sharing plans build up similar qualified retirement accounts for employees, but without the employer guaranteed minimum investment return. (See the comparison chart in Figure 15.3.)

2. Traditional defined benefit plans provide guaranteed benefits for employees, but are more complex in design and administration. (See the comparison chart in Figure 15.3.)

3. Individual retirement saving is always an alternative or supplement to any qualified plan, but there is no tax deferral except in the case of certain IRAs.


A cash balance plan follows the qualified plan installation procedure discussed in Chapter 10 of this book.


Graduate course: Qualified Retirement Planning (GS 814), The American College, Bryn Mawr, PA.


(1.) See also Prop. Treas. Reg. [section]1.411(b)-2(b)(2)(iii)(D), (E).

(2.) IRC Sec. 411(b)(5)(B) (effective for conversions after June 29, 2005).

(3.) IRC Section 4980F.

(4.) IRC Section 404(a).

(5.) Notice 2008-102, 2008-45 IRB 1106.

(6.) IRC Section 415(b). This limit is indexed for inflation, in increments of $5,000. IRC Section 415(d)(4)(A).

(7.) IRC Section 402(a).

(8.) Actuaries differ as to the correct approach in applying the minimum funding rules. For discussion, see Grubbs, "The Cash Balance Plan--A Closer Look," Journal of Pension Planning and Compliance, Vol. 15, No. 3 (1989).

(9.) IRC Section 412(m).

(10.) ERISA Section 4006(a)(3)(A)(i).

(11.) ERISA Section 4006(a)(3)(E). This extra premium was formerly "capped" at a maximum of $53 per participant, but after June 30, 1996 there is no cap. URAA '94, Section 774(a).
Figure 15.1


Pay credit: 10 percent of compensation
Interest credit: 7 percent annually guaranteed rate

Age at plan        Annual        Account balance
entry           compensation        at age 65

25                $30,000           $640,827
30                 30,000            443,739
40                 30,000            203,028
50                 30,000             80,664
55                 30,000             44,349
60                 30,000             18,459

Figure 15.3


                                    Typical Defined
                  Cash Balance      Contribution      Typical Defined
                  Plan              Plan              Benefit Plan

Contribution      percentage of     percentage of     actuarially
rate              salary (with      salary            determined

Investment risk   employer          employee          employer

Investment        not available     available         not available

Social Security   available         available         available

PBGC coat/        yes               no                yes

401(k) feature    not available     available in      not available
                                    profit sharing

Adequate          no                except for        yes
benefit for                         age-weighted
older entrants                      plan

Administrative    higher            lower (unless     higher
cost                                401(k) or
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Title Annotation:Defined Benefit Plans
Publication:Tools & Techniques of Employee Benefit and Retirement Planning, 11th ed.
Date:Jan 1, 2009
Previous Article:Chapter 14: defined benefit pension plan.
Next Article:Chapter 16: money purchase pension plan.

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