Somewhere in the Middle: Cash Balance Plans
The information contained in this article is not intended as legal advice and may no longer be accurate due to changes in the law. Consult NHMA's legal services or your municipal attorney.
EDITOR'S NOTE: The following is an excerpt from an article originally published in the April 2013 issue of Government Finance Review. It is reprinted here with permission.
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The recent financial downturn and resulting economic decline have put substantial fiscal pressures on state and local governments. As a result, many states have made significant changes to their retirement plans. Most of the changes were made within the existing defined benefit framework. Generally, the changes involved: 1) increasing employee contributions; 2) lowering benefit formulas for newly hired employees; and 3) reducing postretirement cost-of-living adjustments. However, some states made more fundamental changes. While only a few established new defined contribution plans, several introduced plans that combine elements of DB and DC plans, including two states that recently established cash balance plans.
Cash balance plans are not new to state and local governments. The Texas Municipal Retirement System is a cash balance plan that has been operating since 1947, and the Texas County and District Retirement System is a cash balance plan that has been operating since 1967. In 2002, Nebraska established a cash balance plan to replace its DC plans for state and county employees. More recently, in 2012, Kansas and Louisiana also established cash balance plans. However, while cash balance plans are not new, their benefit design is fundamentally different from traditional DB plans. The goal of this article is to provide readers with a better understanding of how cash balance plans work and their key advantages and disadvantages.
Comparing Plan Designs
Although cash balance plans are legally considered to be defined benefit plans, they combine elements from both defined benefit and define contribution plan designs. To better understand how they work, it is helpful to compare them to DB and DC plans. The following discussion is summarized in Exhibit 1.
Defined Benefit Plans. DB plan benefits are typically determined using a formula based on an employee’s years of service, final average salary, and a benefit multiplier representing the portion of final average salary earned each year. For example, given a 2 percent benefit multiplier, an employee retiring after 30 years of service with a final average salary of $50,000 would earn an annual benefit of $30,000 (i.e., 2 percent x 30 years x $50,000). Generally, the benefit is paid as a guaranteed lifetime annuity, and it often includes a postemployment COLA to protect retirees from inflation. In addition, most state and local DB plans also provide disability and survivor benefits that are based on service and salary. In a typical DB plan, the plan sponsor bears most of the risk.
Defined Contribution Plans. DC plans benefits are based on accumulated employer and employee contributions made to an employee’s individual account, combined with actual investment earnings. Members usually have a significant control over how their accounts are invested. The benefit depends largely on investment returns and is not guaranteed over an employee’s lifetime. Generally, the benefit is paid as a lump sum, which can be rolled over into other retirement accounts. DC plans do not provide disability and survivor benefits, other than for the distribution of the employee’s account balance. In a typical DC plan, the plan participant bears most of the risk.
Cash Balance Plans. Cash balance plans are similar to DC plans in that the benefit is based on an employee’s account balance. Under cash balance plans, employees contribute a fixed percentage of pay and employers also provide contributions (referred to as “pay credits”). However, unlike DC plans, the account is a hypothetical “nominal” account that keeps track of the benefit accrual, but the related contributions and investment earnings are held and invested by the cash balance plan. Members typically have no say at all in how their nominal accounts are invested.
Interest is credited on an employee’s nominal account at a fixed rate (or may be based on an index rate or other variable rate). For example, a cash balance plan could promise to credit interest to a member’s account at an annual rate of 5 percent, regardless of the plan’s actual investment returns. Consequently, the interest credited to an employee’s cash balance account is generally less volatile than the interest earned by employees in DC plans.
Cash balance plans are similar to DB plans in that the plan sponsor bears most of the risk. Also, cash balance plans commonly provide retirees with the option of converting their account balances into lifetime annuities. Unlike most DB plans, cash balance plans usually allow lump-sum distributions. Similar to DC plans, cash balance plans do not usually provide disability or survivor benefits, other than for the distribution of the employee’s account balance. For this reason, they may be less suitable for public safety employees whose jobs are more hazardous and, consequently, warrant more substantial disability and survivor benefits. However, some public-sector cash balance plans have been structured to provide disability and survivor benefits to plan members.
Another way in which cash balance plans are similar to DB plans is that both require actuarial valuations to determine the employer contributions needed to fund the promised benefits. Like DB plans, cash balance plans are subject to a variety of risks, including those related to investment returns, mortality, and inflation. While cash balance plans may help to mitigate some of these risks, they cannot eliminate them. The plan sponsor still bears the risk that terminations will be less than assumed, that salary increases will be more than assumed, and that investment returns will be less than assumed. If so, additional employer contributions will be required to make up the difference.
Advantages and Disadvantages
In considering the advantages and disadvantages of plan designs, the overall goals of both employers and employees need to be considered. For state and local government employers, key goals in providing retirement benefits include: 1) attracting and retaining qualified employees; and 2) providing sufficient and sustainable benefits. As discussed below, these goals are also important for state and local government employees, since they relate to the overall sufficiency of the benefits. The following discussion is summarized in Exhibit 2.
Attracting and Retaining Qualified Employees. Defined benefit plans are useful in attracting and retaining qualified employees. This is due to the rewards they provide for long-term service and their provision of guaranteed retirement, disability, survivor, and in-service death benefits. However, DB plans are generally less portable than DC plans and may not appeal as much to younger and more mobile employees. Although DC plans may appeal to such employees, they are not as effective for retaining them.
Cash balance plans are somewhere in the middle. Because the benefits accumulate as an account balance, they are more portable and may be appealing to more mobile employees. In addition, the account balance can be converted to an annuity upon retirement and, therefore, reward service with a guaranteed lifetime benefit. However, in themselves, cash balance plans may not provide attractive disability or survivor benefits. Also, since cash balance plans are more portable, they may be less effective than DB plans in retaining employees.
Providing Sufficient and Sustainable Benefits. Because DB plans provide benefits based on an employee’s service and final average salary, the accumulated benefit is clear and directly related to replacing an employees’ pre-retirement income. Moreover, because the benefit is provided as a guaranteed lifetime annuity, retired employees can count on the benefit over their lifetimes. However, since DB plans shift the risks of funding the benefit to the employer, the employer’s contributions may be more volatile which could jeopardize sustainability. While DC plans limit the employer’s contribution volatility by shifting these risks to employees, the benefits they provide are much less certain and may prove insufficient throughout retirement.
Cash balance plans may help mitigate the investment risks by managing the interest rate credited to the employee’s accounts. If the interest is credited to employee accounts at a rate that reflects the plan’s long-term rate of return, but also allows for adverse experience, the employer’s contribution rates may be somewhat more stable. However, employers in cash balance plans are still subject to investment risks, since the interest credits promised to employees must be honored, even when the plan earns negative investment returns.
Longevity risk is the risk that employees may outlive their savings. The amount of longevity risk borne by the employer and employees can vary in a cash balance plan depending on how much of the benefit is paid as a lump sum, how much is annuitized, and how much of a subsidy or surcharge is applied to annuities.
However, because the benefit provided by a cash balance plan is expressed as an account balance rather than an annual benefit, it may be difficult for employees to judge whether it will be sufficient throughout retirement. In addition, the benefits provided by a cash balance plan for career employees may be substantially less than those provided by a final average salary DB plan of a similar contribution level, all else being equal. This is because the benefits provided by a cash balance plan are based on the employees’ earnings over their full careers, rather than the earnings near the end of their careers.
Conclusions
The financial downturn and resulting economic decline have put many governments under fiscal stress. As a result, numerous state and local governments have recently made significant changes to their retirement plans in order to manage their costs including, in two very recent cases, establishing cash balance plans. However, if these new designs are used, care should be taken that the implications are fully understood and that they are effective in attracting and retaining qualified employees and providing sufficient and sustainable retirement benefits.
Paul Zorn is director of governmental research at the benefit consulting and actuarial firm of Gabriel, Roeder, Smith & Company.