CASH BALANCE AND BEYOND

I. DEFINITION:

1. It's a DB (formula to define benefits, employer invests assets, covered by
PBGC/maybe, actuarial funding) that looks and feels like a DC. Benefits expressed as current lump sum value rather than deferred annuity. Benefits more age neutral (i.e. less back-loaded) than traditional DB

2. It has the following hypothetical components:
a. Benefit credits: *usually % of pay (contribution rate/allocation rate)
*sometimes integrated (step-up) with Social Security
*sometimes age/service weighted
*sometimes vary by rate of employee contributions
b. Interest credits: *usually based on variable outside index (e.g. yield on 1-year T-Bills)
*sometimes fixed or minimum/maximum credits
*sometimes based on outside fund returns (e.g. S&P 500)
*sometimes more than one basis - participant choice
*sometimes rate lowered after employment terminates
*sometimes higher rate provided for fixed period of time
c. Annuity conversion:
*usually account @ benefit commencement converted to immediate annuity
*usually based on 417(e) type assumptions but not directly required
*sometimes conversion basis is more liberal but 417(e) whipsaw issue is a concern

3. EXAMPLE:
Benefit credit = 6% of pay Pay= $40,000
Interest credit = 6.50%
NRA = 65 AA = 30
Coversion rate = $ 10
Calculations: $40,000 X 0.06 = $ 2,400
FV: I=6.50%, n=(NRA-1)-AA or n=34. FV by year before NRA=$20,422
Account Balance=$20,422 means $2,042 yearly life pension benefit.

II. ADVANTAGES OVER DB:

1. Focus on account balances: like 401k accounts, usually start out with 4-digit balance, not long before five, often end up with 6-digit balance. Participants usually don't understand the concept of FV, PV, they like to see what's in their accounts. In short, CB is understandable, portable, tangible and guaranteed by PBGC/maybe upon plan termination

2. Accruals favoring youngters. Look @ the accrual pattern for both CB (decreasing $ accrual with increasing age) and DB (increasing $ accrual with increasing age)/Chart.Also we need to compare the Cummualative Accrued Benefits (convex for CB; concave for DB)/Chart. Accelerated accruals appeal to:
a. Employees: no longer one life=one job, job security is now a thing of the past, the only real security is FREEDOM TO BE MOBILE
b. Employers: no longer care for long faithful service (old-timers), now it cares on latest technical know-how brought on by younger workers

3. Employers like CB because of employees' perception, less exposure to risk of actuarial assumptions @ odds with experience, can reduce pressure for retiree COLA's, can reduce administrative burden for former employees (annuity payments)

III. ADVANTAGES OVER DC:

1. Contribution flexibility (Can you vary year by year contributions w/o affecting benefits ?) DC= NO, DB=YES, since CB is a DC, so CB=YES. There is a range of contribution under a CD, usually small, but useful (history of making more than minimum will generate a contribution holiday)

2. Excess earnings used to reduced cost: suppose hypo interest credit = yield on T-Bill, while actual investment is entirely in growth stocks

3. Benefit settlement flexibilty (Can you pay income for life w/o buying annuities ?) DC=NO, DB=YES, since CB is a DB, so CB=YES. In a CB, you have a choice of either using the money to buy an annuity (usually expensive from insurers) or paying a lifetime income from the plan.

4. Separate DB 415(b) limits

IV. THE 417(e) WHIPSAW

1. Most cash balance payments are LUMP SUMS therefore they are subject to 417(e) regulations (minimum lump sum is PVAB using 417(e) assumptions)
a. Convert current account balance to normal benefit payable @NRA using plan rates
b. Convert normal benefit to lump sum payable currently using 417(e) rates
c. If plan rates > 417(e) rates then LUMP SUM BENEFIT > Account Balance
d. This is not what the participant expected and not what the sponsor intended
e. Irony: more liberal plan's investment credit provisions, the worse the problem
f. Defining accrued benefits: what are the rules:
* can be lump sum @ current age: whipsaw disappears
* can be lump sum but must be @ NRA: whipsaw exists
* must be annuity @ NRA: whipsaw exists, subsidized annuities mean trouble
g. Solution to whipsaw: be sure plan is NOT more generous than 417(e) rates

V. OTHER CASH BALANCE ATTRIBUTES:

1. Advantages for small employers: nowadays, small employers would give up on DB, their common program would include a cross-tested PS, a MP or a 401(k) plan. All these plans are still subject to $30,000 limit. So now, with the repeal of 415(e), why not adding a CB, so this means for older participants, allocation > 30,000

2. Less costly top-heavy benefits (DC=3% of pay as in contribution, DB 2% of pay as in benefit). One problem: reduced non-discrimination testing opportunities (X-tested DC: 8.50% interest OK, CB: hypo rate, if increasing hypo rate up to 8.50% then will be hit by whipsaw. Possible solution: don't permit lump sums until age 60

3. Most CB plans were converted from traditional DB plans, usually overfunded DB (to avoid taxable reversion of excess assets). Conversion from DB to CB usually not applicable to small plans. Upon conversion, opening balance calculations must be made (selectiong assumptions, protecting accrued benefits)

VI WHY CB ?

1. Enhance/improve employee communications (from a DB)

2. Work-out an over-funded problem

3. Equalize contribution levels for different aged partners

4. Handle/assist in a younger partner's buy-out of an older partner

III. MARKET TRENDS

1. What's IN: 401(k), CB

2. Want's OUT: DB

3. Hybrid plan called PEP (Pension equity Plan): lump sum value equals final average pay X sum of annual benefit credit. No account balance concept nor prescribed specific interest rate credit prior to retirement