Cash balance plan

A cash balance plan is a defined benefit retirement plan that maintains hypothetical individual employee accounts like a defined contribution plan. The hypothetical nature of the individual accounts was crucial in the early adoption of such plans because it enabled conversion of traditional plans without declaring a plan termination.

The employees' accounts earn a fixed rate of return that can change over a period of time from year to year. Although it works much like a defined-contribution plan, it is actually a defined-benefit plan for legal purposes. In 2003, over 20% of US workers with defined benefit plans were in cash balance plans, according to Bureau of Labor Statistics data. Most of these plans resulted from conversions from traditional defined-benefit plans. The status of such plans was in legal limbo (see below), and the number of conversions slowed. However, legislation was recently passed that cleared the way for plan sponsors to adopt cash balance plans.

Cash balance conversions have been controversial and have raised the ire of workers and their advocates. In 2005 the Government Accountability Office (GAO) released a report analyzing the effects of cash balance conversions on worker benefits. They found that in a typical conversion the cash balance plan would provide lower benefits for most workers than if the defined-benefit plan had remained unchanged and the worker had stayed in their job until retirement age. This decline in benefits tends to be largest for older workers. This is because in a traditional plan, where benefits are based on final average pay, the "value" of the benefits accrues much faster for older workers than for younger workers. In contrast, in a DC or cash balance plan, contributions are made at the same rate (by workers in the DC plans and by the employer in the cash balance plan), and a dollar contributed to a younger worker's account is actually more valuable because it has more time to compound before retirement. Thus some argue that cash balance plans hurt older workers.

On the other hand, this may not be the relevant comparison. If the alternative to cash balance conversion is that the plan is frozen or terminated (with the vested balance going to the worker), all workers would be much worse off than in a cash balance conversion. This is a realistic possibility; tens of thousands of defined benefit plans have been frozen and/or terminated in the last two decades, far more than have been converted to cash balance plans. Likewise, for the many employees who leave their job before retirement (whether voluntarily or not), many would be better off under the cash balance conversion than under the original defined-benefit plan. In addition, about half of cash balance conversions have grandfathered in some or all of the existing participants in the defined-benefit plan.

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