1. feature

arca_ex1

Please note: This item is from our archives and was published in 2000. It is provided for historical reference. The content may be out of date and links may no longer function.

Related

No Results

TOPICS

    Uncategorized Article
Exhibit 1: Converting to a Cash Balance Plan
The examples assume the following:

Defined benefit plan

  • Traditional defined benefit pension plan benefits are based on a final 5-year average pay formula.
  • Average annual salary increase: 4%.

Cash balance plan

  • Date of conversion to cash balance formula: January 1, 1999.
  • Cash balance plan benefits are based on interest credit of 6%, pay credit of 5% of salary and an average annual salary increase of 4%.

Amounts shown for both the traditional defined benefit plan and cash balance plan have been actuarially determined and amounts have been rounded for ease of presentation.

Example 1. Effect of conversion to a cash balance formula on participant A, age 30, vested in the plan with five years of service and earning $25,000 in the year of conversion. Assume a 4% discount rate is used to determine the hypothetical opening account balance:

Participant A  
Age at hire 25
Age at 1/1/99 30
Salary in 1998 $25,000
Service at 1/1/99 5 years
5-year average pay at 1/1/99 $23,000
XXXXXXXXXXXXXXXXXXX 1/1/99 1/1/00 1/1/01 1/1/02 1/1/03
Traditional defined benefit plan
Annual accrued benefit payable at age 65 		$1,200 $1,400 $1,700 $2,100 $2,400
Cash balance formula
Annual accrued benefit payable at age 65 		$1,200 $1,600 $2,200 $2,700 $3,200

By using a 4% discount rate to determine the hypothetical opening account balance, benefits accrued under the cash balance formula exceed benefits that would have accrued under the traditional defined benefit plan formula. In fact, if the employee leaves the company in year two, he or she would receive a windfall benefit because the annuity value under the cash balance formula ($1,600) exceeds the value of the annuity the employee would have earned under the traditional defined benefit plan ($1,400). Because the participant immediately accrues additional benefits under the cash balance formula, there is no wear-away of benefits in this example.

Example 2. Effect of conversion to a cash balance formula on participant B, who is age 60 and earning $50,000 in the year of conversion. Assume that a 6% interest rate is used to determine the opening account balance:

Participant B  
Age at hire 30
Age at 1/1/99 60
Salary in 1998 $50,000
Service at 1/1/99 30 years
5-year average pay at 1/1/99 $46,000
XXXXXXXXXXXXXXXXXXX 1/1/99 1/1/00 1/1/01 1/1/02 1/1/03
Traditional defined benefit plan
Annual accrued benefit payable at age 65 		$11,600 $12,500 $13,500 $14,600 $15,700
Cash balance formula
Annual accrued benefit payable at age 65 		$9,000 $9,400 $9,700 $10,100 $10,400

By using a 6% discount rate to determine the opening account balance, no new pension benefits accrue during the five years of service subsequent to the conversion. It should be noted that much of the negative publicity surrounding cash balance formulas is focused on “older” employees who typically lose future benefits upon conversion, as demonstrated in this example. However, some employers “grandfather” older employees under the old plan or provide transition credits upon converting to a cash balance formula to prevent this reduction in the accrual of future benefits.

Advertisement