Pointers For Planners On Cash Balance Plan Conversions

By April Caudill

One of the questions planners are hearing on a regular basis from some of their clients is how to choose the best of several options when the clients employer decides to convert a defined benefit plan to a cash balance plan.

This choice is particularly critical for participants between the ages of 40 and 55. Less frequently, but just as important, employers need advice on whether to convert from a defined benefit plan to a cash balance plan, or which to implement from the start.

Planners offering advice in either of these situations should have at least a basic working knowledge of how cash balance plans and conversions operate.

Cash balance plans are essentially defined benefit plans that account for benefits like a defined contribution plan. The biggest difference is that with a cash balance plan, benefits typically accrue evenly over the employees working career instead of being backloaded in the final years before retirement.

In spite of a recent Internal Revenue Service announcement that it was withdrawing a section of its controversial proposed regulations for cash balance plans, it appears the plans are here to stay. The offending provision caused a technical conflict with some other nondiscrimination rules, and it appears likely the IRS will correct it and reissue the proposed regulations shortly.

Despite strong (and sometimes misinformed) objections by much of the press, cash balance plans by themselves are not necessarily unfair. Over a typical employees working life, they offer considerably more security than, for example, a 401(k) or other defined contribution plan, especially in a down market. The cost over time is only a little lower than that of a defined benefit plan, but benefits are more evenly spread over the employee population. Both plans involve required contributions, meaning that they are ill-suited to employers who do not have a stable cash flow.

The problem that has generated so much publicity for cash balance plans is that depending on how the employer chooses to handle the transition, converting from a traditional defined benefit plan to a cash balance plan can be anything from a no-lose proposition to a devastating blow to employees between the ages of about 40 and 55.

Most employers making such a conversion handle the reduction of older employees accruals in one of two ways: a so-called “A + B” approach or a total conversion approach. The more generous of these is the A + B approach, under which the defined benefit plan is frozen, and the participants cash balance plan account is started at zero. This allows employees to qualify for any early retirement subsidies to which they were entitled on their frozen DB plan benefit, yet accumulate benefits under the cash balance plan going forward.

Under the second (total conversion) approach, the existing defined benefit plan benefit is converted to an opening account balance, and the cash balance “hypothetical account” is determined taking it into account.

One of the approaches employers take to try to ease the transition and protect people close to retirement is to offer employees a choice of continuing in either plan. (In this case, the determination of which is more advantageous will depend on the employees age, his expected years until retirement and the actual plan provisions.)

A second method is to offer “the greater of” the A + B method or the benefit under the old plan.

A third common transition approach is to provide additional cash balance credits to a select group of participants (e.g., those whose age plus service equal 60) who would be most impacted by the transition.

A conversion from a defined benefit plan to a cash balance plan does not have to be bad news for older employees, nor does it have to result in costly litigation. Employers who make it a priority to handle the conversion fairly can make the change a win-win proposition for all involved. (The source material for this update is Announcement 2003-22, 2003-17 IRB 846.)

April K. Caudill, J.D., CLU, ChFC, is managing editor of Tax Facts and ASRS, National Underwriter Company publications.


Reproduced from National Underwriter Edition, May 12, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.