Since 1995, a fifth of large companies in the US have converted their defined benefit (DB) plans to cash balance plans (CBP). A CBP is a DB plan that determines benefits for each participant by the amount of the participant’s hypothetical account balance. The hypothetical account balances are credited with allocations (generally referred to as ‘pay credits’ or ‘service credits’) and earnings (generally referred to as ‘interest credits’) determined under a formula in the plan. These credits are designed to simulate the allocations of actual contributions and actual earnings to an employee’s account under a DB plan.
Why is this controversial? Regulators, participants and plaintiffs’ attorneys raise three main issues in regard to CBPs. Firstly, they discriminate on the basis of age; secondly, accrued benefits ‘wear away’ during conversion and, thirdly, the present value of lump sum distributions for participants who have not yet attained normal retirement age are not calculated correctly.
How do CBPs allegedly discriminate on the basis of age? Even though CBPs look like DB plans, they really are DB plans. As such, they cannot reduce the rate of benefit accrual because of the attainment of any age. All other things being equal, the pay credit for a younger employee adds more to the value of an annuity payable at normal retirement age.
How do accrued benefits wear away in converting DB plans to CBPs? Because the law prohibits any cutback in accrued benefits, participants’ ‘account balances’ in new CBPs cannot be less than the present value of their accrued benefits in their old DB plans. However,some CBPs are structured so that participants do not accrue benefits under the new plan until their initial hypothetical account balance and subsequent allocations exceed their accrued benefits under the old plan. Because this wear-away feature most often affects older workers, it is characterised as age discrimination.
What is allegedly wrong with the way lump sums are calculated? As a DB plan, a CBP must follow three statutory steps in calculating lump sum present values for participants who have not yet attained normal retirement age. Firstly, the participant’s cash balance account must be increased by interest credits between the date of calculation and the date the participant attains normal retirement age; secondly, the projected lump sum must be converted to an actuarially equivalent annuity and, thirdly, the annuity must be converted back to a lump sum value at the participant’s current age.
Upon completion of these steps, the calculation may result in a lump sum that is greater than the participant’s hypothetical account balance. Unless a plan pays the higher amount, the difference may be considered to be an impermissible forfeiture. This result has been labelled the ‘whipsaw effect’.
Against the backdrop of these three issues, there have been several recent critical legal, regulatory and legislative developments, including the cases against Xerox and IBM concerning CBPs.
Legislation proposed in 2003, coupled with the Treasury department’s announced intention to propose a solution and a potential ban in an appropriations bill during 2004, has roiled the legislative outlook. In short, there is no congressional help in sight.
In conclusion, most pension experts agree that CBPs do not discriminate on age. As the American Benefits Council noted, if these hybrid plans are undermined, employers will exit the DB system altogether, impairing the retirement security of many American families.
Raymond Slabaugh III is managing director and Janae Schaeffer is senior compliance attorney with Palmer & Cary Compensation, Benefits and Retirement group, based in Richmond, Va. The firm is a member of the International Benefit Network

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