Defined Benefit Insights Plan design - Cash balance plans

Defined Benefit Insights Plan design—Cash balance plans Vanguard Strategic Retirement Consulting Fall 2009 What is a cash balance plan? Cash balance plans are one of several types of "hybrid" pension plans, which have characteristics of both defined benefit (DB) and defined contribution (DC) plans. Cash balance plans are technically DB plans because they provide a guaranteed level of benefit—there's little or no investment risk for the participant. The benefit payable to a participant is expressed as a lump-sum amount—a cash balance in an account. That's different from a traditional pension plan, which expresses its benefit as an annuity payable for the participant's lifetime. Here's how a typical cash balance account would increase during a plan year. Account balance at beginning

of year $5,000 Pay credit (e.g. 5% of $50,000 compensation) $2,500 Interest credit (e.g. 3% x $5,000 balance) $150 Account balance at end of year $7,650 The plan sponsor won't usually contribute the pay credit amount for every employee to the pension trust. Because the pension assets are usually assumed to earn more than the interest credit rate, contributions are usually expected to be less than the total pay credits. What are typical interest crediting rates? Most cash balance plans credit a market rate of interest, which is changed each year. The most common interest crediting rate is the 30-year treasury rate. This is a common rate because it's the same rate used for calculating lump-sum values in pension plans prior to the Pension Protection Act of 2006 (PPA), and it was convenient to have the rate for both purposes. Some plans use a 10-year treasury rate or a 1-year treasury rate. Some plans use a fixed rate (that doesn't change each year), usually in the 3% to 5% range. Why have some plan sponsors converted their pension plans to cash balance plans? Many employees seem to understand the account balance concept and appreciate the value of an account balance more than the value of an annuity promise. Younger participants also may appreciate that the value of their benefit increases faster than in a traditional pension plan where much of the value accrues after age 45. Cash balance plans are likely to have more predictable costs than traditional pension plans using traditional investment strategies. One reason for this is that the liability for most cash balance plans doesn't change significantly if interest rates go up or down. The cost of traditional pension plans can be difficult to predict because of final average salary provisions and early retirement subsidies (e.g. an unreduced benefit paid after 30 years of service), which are not part of cash balance plans. What are the disadvantages of cash balance plans? Most cash balance benefits are paid out as lump sums so that participants don't get the benefit of guaranteed lifetime income. Participants may view the low rate of interest unfavorably. Also, for most cash balance designs, it's more difficult to invest in assets that match the cash balance liability than it is to invest in assets that match a traditional pension liability. Evan Inglis, chief actuary © 2009 The Vanguard Group, Inc. All rights reserved. DBICBP...

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