GAO

United States General Accounting Office

Report to the Chairman, Special

Committee on Aging, United States

Senate

September 2000 CASH BALANCE

PLANS

Implications for

Retirement Income

GAO/HEHS-00-207

Page 1 GAO/HEHS-00-207 Cash Balance Plans

Contents

Letter 3

Appendixes Appendix I: Scope and Methodology 42

Appendix II: Comments From the Department of Labor 44

Tables Table 1: Selected Differences Between Defined Benefit and Defined

Contribution Plans 9

Table 2: Comparison of Effect of Changing Jobs on Annual Pension

Benefit Under a Traditional Final Average Pay Plan and a Cash

Balance Plan 27

Figures Figure 1: Example of Traditional Final Average Pay Formula Used to

Calculate an Annual Pension Benefit 8

Figure 2: Example of Annual Increase in Pension Benefit Under a

401(k) Defined Contribution Plan 9

Figure 3: Example of Annual Increase in a Hypothetical Account

Balance Under a Cash Balance Formula 11

Figure 4: Percentage of Fortune 1000 Firms’ Cash Balance Plans, by

Number of Participants 14

Figure 5: Numbers of Firms Adopting Cash Balance Formulas Since

the 1980s 15

Figure 6: Comparison of a Cash Balance Accrued Benefit With the

Hypothetical Account Balance 22

Figure 7: Comparison of Annual Changes in Accrued Benefits for a

Cash Balance Plan and a Final Average Pay Plan 24

Figure 8: Comparison of Annual Change in Benefit Accruals for Cash

Balance Plans With Differing Age-Weighted Formulas 25

Figure 9: Percentage of Fortune 1000 Firms Maintaining a 5-Year

Vesting Requirement After Conversion 30

Figure 10: Annual Accrued Benefit With Mid-Career Change From

Traditional Final Average Pay Plan to Cash Balance Plan 34

Figure 11: Percentage of Participants With Expected Benefits

Protected by Transition Provisions 35
Contents

Page 2 GAO/HEHS-00-207 Cash Balance Plans

Abbreviations

ADEA Age Discrimination in Employment Act

BLS Bureau of Labor Statistics

ERISA Employee Retirement Income Security Act of 1974

FAP final average pay

IRS Internal Revenue Service

PBGC Pension Benefit Guaranty Corporation

PEP pension equity plans

PWBA Pension and Welfare Benefits Administration

SPD summary plan description
Page 3 GAO/HEHS-00-207 Cash Balance Plans

United States General Accounting Office

Washington, D.C. 20548

Health, Education, and

Human Services Division

B-286323 Letr

September 29, 2000

The Honorable Charles E. Grassley

Chairman

Special Committee on Aging

United States Senate

Recognizing that pensions are an important source of income for many

retirees, the Congress provides preferential tax treatment under the

Internal Revenue Code (the Code) for pension plans that meet certain

qualification requirements. Congress estimates that in fiscal year 2000 the

Treasury will forgo about $76 billion due to the tax treatment of qualified

employer-sponsored pension plans. Pensions are the largest of such “tax

expenditures” in the federal budget, exceeding those for home mortgages

and/or health benefits.1 In exchange for preferential tax treatment, an

employer is required to design the pension plan within legal limits that are

intended to improve the equitable distribution and security of pension

benefits. Recently, firms that sponsor plans and plan participants have

expressed concern about the application of these qualification

requirements to newly emerging plan designs, particularly “cash balance”

formulas.2

In response to such concerns, you asked us to describe (1) the prevalence

and features of cash balance plans and (2) the factors employers

1

Fiscal year 2000 estimate, from the Joint Committee on Taxation, Estimates of Federal Tax

Expenditures for Fiscal Years 2000-2004, prepared for the Committee on Ways and Means

and the Committee on Finance, JCS-13-99, Dec. 22, 1999, p. 23. “Tax expenditures” are

revenue losses attributable to provisions of federal tax laws and include any reductions in

income tax liabilities that result from special tax provisions or regulations that provide tax

benefits to particular taxpayers. Pension contributions and investments earnings on pension

assets are not taxed until benefits are paid to plan participants. As a result, these tax

preferences largely represent timing versus permanent differences in tax revenue

generation.

2

Cash balance plans express benefits as an “account balance” based on hypothetical pay

credits (percent of salary or compensation) and hypothetical interest credits to employee

accounts. As with other defined benefit plans, benefits are paid from commingled funds

invested in a pension trust on behalf of all participants, and plan trustees have a fiduciary

responsibility for all assets in the pension trust. Hypothetical account balances need not be

related to investment returns on assets in the plan’s pension trust, nor are hypothetical

accounts credited with investment gains or losses. Employees do not own these “accounts”

or make investment decisions.
B-286323

Page 4 GAO/HEHS-00-207 Cash Balance Plans

considered in making a decision about whether or not to use a cash balance

formula and to discuss (3) the effects of using cash balance formulas on the

adequacy of individual workers’ retirement income.

We also discuss the effects of current disclosure practices on plan

participants’ ability to address issues regarding the adequacy of their

retirement funds.

To address your questions, we surveyed a random sample of 420 firms on

the 1999 Fortune 1000 list and asked these firms about the types of pension

plans they sponsor. To examine the characteristics of cash balance plans,

we reviewed summary plan descriptions and other plan documents from

cash balance plan sponsors identified among the Fortune 1000 firms. We

selected Fortune 1000 firms for two reasons. First, they are a wellrecognized group of some of the largest publicly traded firms in the

country. Second, pension experts advised us that these firms would be

among the most likely to sponsor cash balance plans. Because the Fortune

1000 list is selected solely on the basis of revenues and does not include

nonprofit firms, the results cannot be generalized to all firms or even to all

large firms. We also conducted indepth interviews with officials from 14

firms, including two nonprofit firms, with cash balance or similar plans. We

discussed reasons why they adopted such plans and obtained information

about how firms communicated pension plan changes to plan participants.

To examine the effect of cash balance plans on the adequacy of retirement

income, we interviewed pension consultants and actuaries, performed a

review of the relevant literature, and created simplified simulations of plan

formulas to illustrate certain design features associated with these plans.

We conducted our work between November 1999 and August 2000 in

accordance with generally accepted government auditing standards. A

more detailed description of our scope and methodology appears in

appendix I. In conjunction with this report, we are also issuing a report that

provides additional information on cash balance plans, particularly on the

implications of converting traditional defined benefit plans to cash balance

plans.3

3

Private Pensions: Implications of Conversions to Cash Balance Plans (GAO/HEHS-00-185,

Sept. 29, 2000).
B-286323

Page 5 GAO/HEHS-00-207 Cash Balance Plans

Results in Brief Our survey of firms from the 1999 Fortune 1000 list indicated that about 19

percent of these firms sponsor cash balance plans covering an estimated

2.1 million active participants; more than half of these plans have been

established within the last 5 years. Firms in many sectors of the economy

sponsor these plans, but greater concentrations are found in the financial

services, health care, and manufacturing industries. Of the firms we

surveyed that sponsor such plans, about 90 percent previously covered

their workers under a traditional defined benefit plan. As with traditional

defined benefit plans, there is significant variation in the design and

operation of cash balance plans. For example, some plans provide the same

annual hypothetical pay and interest credits for all participants while most

select from a wide variety of options to provide extra benefits for

participants who are older or who have been with the firm for a long period

of time.

Cash balance plans have had such visibility in recent years that most firms

we surveyed had at least considered adopting such a plan. These firms

reported that their decisions to adopt or not to adopt a cash balance plan

were based on many factors, including corporate philosophy, the need to

remain competitive, and the potential impact on workers. Key reasons

firms gave for adopting a cash balance plan included lowering total pension

costs, increasing the portability of pension benefits, and the ease of

communicating the value of plan benefits. Key reasons firms gave for not

adopting a cash balance plan included possible adverse effects on workers

who are older, longer-tenured, and less mobile; uncertainty about possible

changes in the regulation of cash balance plans; the impact of adverse

employee and public reactions to cash balance plan conversions; and

increased costs.

Cash balance plans offer both opportunities and challenges to workers

seeking to ensure adequate retirement income. Cash balance plans

generally are structured such that workers accrue benefits earlier in their

careers than they would under most traditional defined benefit plans. This

feature, combined with the lump sum payouts also common to such plans,

provides opportunity for more mobile workers to secure and retain higher

benefits, even when they change jobs, than they would under most

traditional defined benefit plans. The extent to which such workers realize

this opportunity can depend on their career and investment choices.

Whether they stay in the plan long enough to vest, for example, is crucial to

whether they will benefit from earlier pension accruals. Special challenges

exist for workers who accrue part of their retirement benefits under a
B-286323

Page 6 GAO/HEHS-00-207 Cash Balance Plans

traditional defined benefit plan, where they accrue few benefits until late in

their career, and accrue part of their benefits under a cash balance plan.

Older workers may be disadvantaged if their employer converts from a

traditional defined benefit plan to a cash balance plan or if they leave a firm

with a traditional plan for one with a cash balance plan. These workers may

have little time to make up for benefits expected under a traditional plan.

To mitigate the impact of conversion, many Fortune 1000 employers

provide transition provisions for workers previously covered under their

traditional defined benefit plans.

Because the decisions of individual participants play a more significant role

in maximizing retirement income under cash balance plans than under

traditional defined benefit plans, cash balance plan participants have a

particular need for clear and timely information about their plans. We

found a wide variation in the quality of information that firms provided to

participants in cash balance plans. However, most plans provided

insufficient information to allow a participant to make informed careerand retirement-related decisions. For example, more than half of the

Fortune 1000 firms we surveyed did not inform participants that the

individual cash balance account was hypothetical in nature. Documents we

reviewed that Fortune 1000 firms provided to plan participants did not

provide an explanation of the difference between the accrued benefit and

the hypothetical account balance. Participants would need such

information to assess accurately the impact of career decisions on their

pension benefits.

We are making recommendations to the Secretary of Labor concerning the

improvement of disclosure requirements to help provide plan participants

with the information they need to make informed decisions affecting their

retirement income.

Background With respect to private pensions, the Congress has used the Code to

encourage employers to sponsor pensions to help workers achieve

adequate income for retirement. In exchange for providing preferential tax

treatment, Congress has imposed requirements that plans must meet for

tax qualification through the Code and the Employee Retirement Income

Security Act of 1974, as amended (ERISA). The administration of ERISA for

new and ongoing plans is divided between the Department of Labor’s

Pension and Welfare Benefits Administration (PWBA) and the Internal

Revenue Service (IRS). IRS is tasked with ensuring that plans meet the

qualification requirements for receiving tax preferences. PWBA is
B-286323

Page 7 GAO/HEHS-00-207 Cash Balance Plans

responsible for ensuring that plans are operated in the best interest of their

participants. The Pension Benefit Guaranty Corporation (PBGC) insures

most private defined benefit plans, including cash balance plans, within

certain limits.

Types of Tax-Qualified

Pension Plans

The Internal Revenue Code defines pension plans as either defined benefit

or defined contribution plans and has established separate requirements

for the two types of plans. In a defined benefit plan, the retirement benefit

is expressed as an annual payment that would begin at the normal

retirement age specified in the plan.4 The retirement benefit is determined

by a formula based on a worker’s years of employment, earnings, or both.

The employer is responsible for funding the plan at a level sufficient to pay

the promised benefit and to insure a portion of that benefit through PBGC.

According to the Bureau of Labor Statistics,5 most participants in large- and

medium-sized firms’ defined benefit plans are covered by a formula

referred to as “final average pay” because the formula uses only the

earnings in the most recent yearsthose closest to the employee’s

retirement dateto calculate benefits.6 As shown in figure 1, under a

defined benefit plan with a final average pay formula, the retirement

benefit is a percentage of the participant’s final years of pay multiplied by

his or her length of service.

4

ERISA requires that tax-qualified plans allow participants to retire with full benefits at no

later than age 65 with 10 years of service. Many plans allow normal retirement sooner than

these limits.

5

Based on the 1997 Employee Benefits in Medium and Large Private Establishments, Bureau

of Labor Statistics, Sept. 1999.

6

Another formula, called “career average,” operates in the same way but bases benefits on

the employee’s pay averaged over all years of service with an employer rather than the final

years.
B-286323

Page 8 GAO/HEHS-00-207 Cash Balance Plans

Figure 1: Example of Traditional Final Average Pay Formula Used to Calculate an

Annual Pension Benefit

In a defined contribution plan, the retirement benefit is expressed as the

account balance of an individual participant. This balance results from

contributions that the employer, the worker, or both make and subsequent

investment returns on the assets in the account. Retirement benefits are

not guaranteed, and employees bear the risk of poor investment

performance. The best known of these defined contribution plans is the

401(k) plan, named for the section of the Code that sets out rules for

providing tax preferences to such plans. The 401(k) plan generally provides

that a specific percentage of pay be contributed to an individual account,

by either the employer, the employee, or both (see fig. 2). The principal in

the account is typically invested based on options specified in the plan. The

sum of principal and investment earnings or losses minus administrative

expensesthe individual account balancedetermines the pension

benefit.
B-286323

Page 9 GAO/HEHS-00-207 Cash Balance Plans

Figure 2: Example of Annual Increase in Pension Benefit Under a 401(k) Defined

Contribution Plan

Federal pension law defines any pension plan that does not provide actual

individual accounts as a defined benefit plan.7 Furthermore, while firms

sponsoring defined benefit and those sponsoring defined contribution

plans may pay pension benefits in a lump sum amount, ERISA requires that

defined benefit plans provide participants with the option of receiving

benefits as an annuity, specifically, a series of payments for life beginning at

the plan’s normal retirement age.

For a summary of selected key differences between defined benefit and

defined contribution plans, see table 1.

Table 1: Selected Differences Between Defined Benefit and Defined Contribution Plans

7

26 U.S.C. 414(j).

Characteristic Defined benefit plan Defined contribution plan

Benefit formula Determines pension due at normal retirement

age.

Determines amount regularly contributed to

individual account.

Form of benefit expressed by

formula

An annuity—a series of payments beginning at

the plan’s normal retirement age for the life of

the participant.

A single lump sum distribution at any time.
B-286323

Page 10 GAO/HEHS-00-207 Cash Balance Plans

Cash Balance Plans

Combine Features of Both

Plan Types

Innovation in plan designs has resulted in “hybrid” plans that have the

characteristics of both types of plans. The most well known of the hybrid

plans is the cash balance plan. A defined benefit plan under the law, the

cash balance plan contains features that resemble a defined contribution

plan. Cash balance plans are not specifically identified in the law, but IRS

guidance describes a cash balance plan as “a defined benefit plan that

defines benefits for each employee by reference to the amount of the

employee’s hypothetical account balance.”8 The cash balance formula, like

all defined benefit plan formulas, determines the amount of pension

benefits to be paid rather than the amount to be contributed. The cash

balance plan resembles a defined contribution plan in that the formula

expresses pension benefits as a lump sum rather than a series of payments.

It also bases the lump sum amount on periodic pay and interest credit

contributions to employee “accounts,” as shown in figure 3. Pay credits are

specified as a percentage of salary, such as 5 percent, and interest credits

are often fixed to the yield on a particular Treasury security, such as the

yield on 30-year Treasury bonds.

Funding Annual funding is based on an actuarial formula

subject to strict limits set by the Code and is not

equivalent to annual increases in pension

benefits.

Annual contributions and investment earnings

are held in an individual account.

Investment risk/profit Employee is guaranteed benefits regardless of

investment returns on trust. Employer is

responsible for ensuring sufficient funding to pay

promised benefit.

Employee bears the investment risk, which can

result in higher investment returns or the loss of

previously accumulated pension benefits.

Insured benefit Generally insured by PBGC. Depends on insurance provided by individual

investment vehicle, if any.

(Continued From Previous Page)

Characteristic Defined benefit plan Defined contribution plan

8

26 CFR §1.401(a)(4) − 8 (c)(3)(i). Section 414(k) of the Code addresses the requirements

for a combination of defined benefit and defined contribution arrangements, which some

have referred to as a form of hybrid plan. However, section 414(k) does not address cash

balance and similar hybrid arrangements where one formula has components of both.
B-286323

Page 11 GAO/HEHS-00-207 Cash Balance Plans

Figure 3: Example of Annual Increase in a Hypothetical Account Balance Under a

Cash Balance Formula

Note: For purposes of illustration, we assume an annual salary of $20,000.

The relationship between the account balance and plan funding is a key

difference between cash balance plans and the defined contribution plans

they resemble. In a defined contribution plan, the account represents

actual funds held on behalf of the individual participant, whereas in a cash

balance plan the amounts are purely hypothetical. In a defined contribution

plan, the account balance is equivalent to actual assets held in trust for the

individual plan participant. Under cash balance plans, employers make

annual contributions to a pension trust fund on behalf of all participants.

These annual contributions are not equivalent to the annual increases in

hypothetical account balances but are determined based on complex

federal rules designed to ensure that the trust has sufficient assets to pay

expected benefits without allowing unwarranted tax expenditures. As a

result, the trust fund for a cash balance plan is not required toand often

will nothave assets equal to the sum of all individual account balances.

Furthermore, trustees rather than individual plan participants have

investment control over all assets in the cash balance pension trust.

Hypothetical account balances are related to the interest rates specified in

the plan rather than the actual investment returns on assets in the plan’s

pension trust; hypothetical accounts are not credited with actual

investment gains or losses.

Requirements Relating to

Reductions in Pension

Benefits

Federal law does not require that employers sponsor pension plans nor

does it mandate the value of the benefit provided by plans that the

employer voluntarily sponsors. The law does, however, set specific

requirements for tax-qualified plans relating to the accrual rate, or the rate

at which plan participants must earn the right to a retirement benefit. Firms
B-286323

Page 12 GAO/HEHS-00-207 Cash Balance Plans

are prohibited from amending a plan’s benefit formula to reduce benefits

that have already accrued. However, the law does not protect future benefit

accruals under the plan’s formula. Consequently, firms can change the

plan’s benefit formula to reduce or freeze the future rate of accrual. For

example, defined benefit plan formulas can be amended on a prospective

basis to reduce the percentage of final pay used to determine the annual

benefit or to limit the number of years over which benefits accrue. The Age

Discrimination in Employment Act (ADEA), the Code, and ERISA prohibit

a defined benefit plan from ceasing accruals or reducing the rate of accrual

because of the attainment of any age.

Firms can also terminate their pension plans altogether. Defined benefit

plan sponsors that terminate their plans are subject to a tax on any surplus

assets in their pension trusts. When defined benefit plans that are

overfunded terminate and surplus assets revert to the plan sponsor, these

assets are counted as income to the corporation. As such, the assets are

subject to corporate income tax. In addition, an asset reversion excise tax

of up to 50 percent can be levied on the same assets if certain conditions

are not met.

ERISA mandates the types of information that must be disclosed to plan

participants. The law requires firms to provide all plan participants with a

summary plan description describing the terms of the plan. Furthermore,

whenever there is a significant change to the plan (a plan amendment),

firms must provide participants with a summary of the changes, known as a

“summary of material modification,” no later than 210 days after the end of

the plan year in which the changes are adopted. Firms must notify

participants of amendments that will result in a significant reduction in the

rate of future benefit accrual at least 15 days before the effective date. This

notification can entail providing either a copy of the amendment to the plan

or a written summary of the change.
B-286323

Page 13 GAO/HEHS-00-207 Cash Balance Plans

Cash Balance Plans

Are Increasingly

Common, But Plan

Features Vary

The number of firms sponsoring cash balance plans has increased in the

last few years. While few firms sponsored such plans before the early

1990s, by the year 2000, 19 percent of Fortune 1000 firms sponsored one or

more cash balance plans. Although these plans can be found in many

sectors of the economy, greater concentrations are found in the financial

services, health care, and manufacturing industries. Although there is

continuing interest in cash balance plans, few firms we surveyed expected

to adopt such a plan in the near future. As with traditional defined benefit

plans, there is significant variation in plan design among cash balance

plans.9

About One in Five Fortune

1000 Firms Sponsor Cash

Balance Plans

About 19 percent of Fortune 1000 firms sponsor cash balance plans,

covering an estimated 2.1 million active participants. It is difficult,

however, to determine the total number of cash balance plans and affected

participants because pension plan data collected annually by the

government cannot be used to identify all plans that use cash balance

formulas. Determining the extent to which small plans use cash balance

formulas is particularly difficult because little is known about the structure

of small plans. Pension experts have generally described the use of cash

balance formulas as a large employer phenomenon, although pension

practitioners have provided anecdotal information about the recent

interest of small firms in such plans.10

9

We also identified one firm that provided a nonqualified cash balance plan exclusively for

executives.

10In addition to cash balance plans, about 4 percent of firms we surveyed sponsor pension

equity plans (PEP). Under these plans, employees earn a percentage of final average pay

expressed as a lump sum amount. PEPs are similar to cash balance plans in that higher

benefits accrue earlier in a career, and lower benefits accrue later in a career than under

traditional defined benefit plans.
B-286323

Page 14 GAO/HEHS-00-207 Cash Balance Plans

Similar to traditional pension plans, many cash balance plans that we

identified do not cover all workers at a firm. Instead, these plans cover

particular segments of a firm’s workforce, such as management, salaried

employees, or certain workers in a firm’s subsidiary. An estimated 69

percent of the cash balance plans we identified in our survey have fewer

than 10,000 active participants (see fig. 4). Eight percent of these plans

have no active participants because benefit accruals are frozen.11 The most

common reason for a frozen cash balance plan was that it was acquired as

part of a merger or acquisition, and the firm did not want to continue with a

cash balance plan.

Figure 4: Percentage of Fortune 1000 Firms’ Cash Balance Plans, by Number of

Participants

Cash balance plans have become more prominent since the early 1990s.12

As shown in figure 5, the earliest a firm in our survey had adopted a cash

balance plan was 1985; over 60 percent of the cash balance plans in our

11Frozen plans have stopped participants’ benefit accruals and allow no new entrants into

the plans. However, they cover the vested benefits of employees and retirees.

12During our indepth interviews, we identified one firm that had sponsored a cash balance

plan since 1925.

Active Participants

8%

0

31%

10,000 and Over

17%

1-999

44%

1,000-9,999

No Active Participants
B-286323

Page 15 GAO/HEHS-00-207 Cash Balance Plans

survey had been adopted in the last 5 years. Firms sponsoring these plans

exist in many sectors of the economy, but greater concentrations are found

in the financial services, health care, and manufacturing industries. Some

of these firms have undergone mergers or acquisitions and have adopted

cash balance plans to “harmonize” benefits, that is, to provide the same

pension plan for employees that had been covered by different plans.

Participants in about 90 percent of the cash balance plans had been

covered previously by a traditional defined benefit plan. Firms had either

frozen the benefits of the plan and begun a new plan or they had amended

an existing plan formula. Firms where participants had no previous defined

benefit plan started cash balance plans as their first pension plan,

supplemented existing defined contribution plans, or added a cash balance

component without changing the existing defined benefit plan.

Figure 5: Numbers of Firms Adopting Cash Balance Formulas Since the 1980s

0

25

50

75

100

125

150

1985-89 1990-94 1995-99 2000

Estimated Numbers of New or Converted Plans

42

23

127

16
B-286323

Page 16 GAO/HEHS-00-207 Cash Balance Plans

Although pension practitioners, employer associations, and agency

officials spoke to us of the continuing interest in cash balance or similar

hybrid plan designs, few firms we surveyed expected to adopt a cash

balance plan in the future. About 3 percent of firms we surveyed told us

that they were considering the adoption of a cash balance plan within the

next 5 years and about one-third of these, or 1 percent of Fortune 1000

firms, told us that they were considering or planning to adopt a cash

balance plan next year. All the firms considering the adoption of a cash

balance plan told us that continued uncertainty about whether such plans

violate pension and age discrimination laws might discourage them from

doing so.
B-286323

Page 17 GAO/HEHS-00-207 Cash Balance Plans

Variations in Plan Design

Features

As with traditional pension plans, significant variation exists in cash

balance plan designs, particularly the benefit formulas. Thirty-five percent

of cash balance plans in our survey provide level pay credits for all

participants, regardless of age or years of service. Most plans, however,

provide pay credits that increase based on participant age or service. For

example, one plan provides an annual pay credit of 3 percent of salary for

participants under age 30 that increases in increments up to 11 percent for

participants age 50 and older. Another plan provides annual pay credits of 3

percent for participants with 4 or fewer years of service, with incremental

increases up to 9 percent for participants with 25 or more years of service.

About 30 percent of the cash balance plans in our survey, because they are

integrated with Social Security, provide participants with higher pay credits

on pay above the Social Security wage base.13 For example, two plans

provide 4 percent of pay for earnings that are subject to Social Security

taxes ($76,200 in 2000) and 8 percent for earnings that are not subject to

Social Security taxes.

Cash balance plans generally credit interest to participant hypothetical

accounts using an index tied to a Treasury security. About 80 percent of the

cash balance plans in our survey tie interest credit rates in their plan

formulas to the rate of return on a Treasury security. For example, we

found that many cash balance plans credit interest based on the rate of

return to 30-year Treasury bonds, but some cash balance plans credit

interest based on the rate of return to 1-year Treasury bonds or another

Treasury index.

Firms Adopt Cash

Balance Plans for

Different Reasons

Firms sponsoring cash balance plans told us that their decision to adopt

these plans was based on a combination of factors, such as the desire to

become more competitive within their specific industry and the need to

address changing workforce demographics. For example, some firms

decided to adopt cash balance plans to improve their ability to recruit new

workers by providing them with higher pension benefits earlier in their

careers and allowing lump sum distributions so that pension benefits are

more portable. Other firms told us, however, that they decided not to use

13For additional information about the integration of pensions with Social Security, see

Integrating Pensions and Social Security: Trends Since 1986 Tax Law Changes (GAO/HEHS98-191R, July 6, 1998).
B-286323

Page 18 GAO/HEHS-00-207 Cash Balance Plans

cash balance plans because they had older or long-tenured workforces that

could be adversely affected by a plan change.

Reasons Firms Gave for

Adopting a Cash Balance

Plan

Some firms we surveyed that chose to convert their plans cited the

financial implications of changing to a cash balance plan as a key reason

for their decision. Reducing the overall cost of the defined benefit plan was

a primary reason some firms converted to a cash balance formula. For

example, some firms have reduced costs by eliminating early retirement

subsidies on future accruals. A survey of 100 cash balance plan sponsors by

PricewaterhouseCoopers found that 56 percent of firms expected the longterm cost of their defined benefit plans to decrease after conversion. Even

when enhancements to other retirement programs were considered in

conjunction with a conversion, 33 percent of the firms expected a decrease

in the costs of their total retirement benefits package.14 However, a few

firms we surveyed reported that converting to a cash balance plan

increased the cost of their defined benefit plan because their plan provided

a higher level of benefit for all workers.

Firms that adopted cash balance plans reported that the opportunity for the

increased portability of benefits influenced their decision to adopt such

plans. The lump sum benefit distribution feature common to many cash

balance plans allows eligible workers, upon separation, to gain access to

their pension benefit.15 These firms believed that offering a pension plan

with such a benefit feature would enhance their recruitment of younger,

relatively mobile workers. While traditional defined benefit plans can

provide lump sum payments, historically many of these plans have not

done so. Most of the plans in our survey did not allow lump sum

distributions above $5,000 before converting to a cash balance plan.

Instead, participants received most, if not all, of their benefits as an annuity

at retirement. The percentage of plans in our survey offering lump sum

distributions at both separation and retirement increased from 15 percent

for traditional defined benefit plans before conversion to 83 percent for

14A UNIFI Survey of Conversions From Traditional Pension Plans to Cash Balance Plans,

PricewaterhouseCoopers, 2000. The report presented the results of a survey of 100

conversions of traditional defined benefit formulas to cash balance formulas.

15Lump sum distributions received before age 59-1/2 are subject to a 10-percent excise tax in

addition to ordinary income taxes. Generally, employers are required to withhold 20 percent

of any distribution not rolled over into an individual retirement account or a qualified

employer retirement plan.
B-286323

Page 19 GAO/HEHS-00-207 Cash Balance Plans

cash balance plans after conversion. Most of the firms with whom we

conducted indepth interviews stated that, after conversion, the majority of

vested participants who had separated from the firm or retired opted for a

lump sum payment, indicating its popularity.

Finally, firms that decided to convert told us that employees better

understand benefits under cash balance plans than under traditional

defined benefit plans. Because benefits under cash balance plans are

expressed as lump sum values rather than retirement age annuities,

employees may better understand and value such plans. Furthermore,

according to company officials, given that many of these employees also

have a 401(k) plan, the cash balance plan is more “visible” and comparable

to benefits under 401(k) plans.16 This contrasts with the way many

employees view their benefits under traditional defined benefit plans.

Human resource and benefits officials at several firms we visited said that

defined benefit plans have been one of the least understood and least

appreciated benefits in a worker’s compensation package. Employees

rarely focus on the benefits of a defined benefit plan until they near

retirement age.

Converting to cash balance plans is also an alternative to terminating a

pension plan. Firms can terminate their defined benefit plans but doing so

imposes various economic costs. When plan sponsors terminate defined

benefit plans, the sponsors must pay income and excise taxes on any

surplus assets, immediately vest participants in their accrued benefits, and

provide participants with annuities or lump sum payments. These costs

may prevent some firms from terminating their plans.17 Instead, firms can

convert to cash balance plans and achieve economic benefits from surplus

pension funds without incurring certain costs related to plan termination.

For example, converting to a cash balance plan can extend the period of

time a firm would not have to make a contribution to the pension plan

while still having the plan considered fully funded or overfunded; that is,

the value of plan assets would meet or exceed the value of currently

16Conversely, visibility in the press and employee response to adverse publicity resulting

from some conversions were cited by firms that decided not to convert as significant

drawbacks of cash balance plans.

17Participants generally earn a nonforfeitable right to benefits after meeting a plan’s vesting

requirement. Federal pension law sets specific minimum vesting requirements. When firms

terminate their plans, affected participants become 100 percent vested in their accrued

benefit as of the date of termination.
B-286323

Page 20 GAO/HEHS-00-207 Cash Balance Plans

accrued pension benefits. Also, after a conversion, if the pension fund

assets can achieve a higher rate of return than the interest rate credited to

hypothetical employee accounts, plan sponsors can use these gains to fund

future pension benefits.

Reasons Firms Gave for Not

Adopting a Cash Balance

Plan

Most firms that had not adopted a cash balance plan reported that they had

considered doing so. They cited the potential of changing plan type to have

an adverse effect on older, longer-tenured, and less mobile workers;

regulatory uncertainty; the impact of adverse employee and public reaction

to cash balance plan conversions; and increased costs as key reasons for

their decision not to adopt such plans. Increased costs included increased

administrative costs, such as consultants’ fees to design the plan formula

and the costs of developing individualized participant statements. In

addition, cash balance plans can have ongoing administrative costs that are

higher than those typically incurred by traditional defined benefit or

defined contribution plans. Firms also cited the potential cost of special

plan provisions to protect the benefits of workers nearing retirement as

another reason not to convert.

Cash Balance Plans

Offer Opportunities

and Challenges to

Ensuring Adequate

Retirement Income

The effect of cash balance plans on retirement income varies with plan

features and participant choices, offering both opportunities and

challenges to workers seeking to ensure adequate retirement income. Cash

balance plans are generally structured so that workers earn benefits more

quickly earlier in their careers than later. This feature, combined with the

lump sum payouts also common to such plans, provides the opportunity for

more mobile workers to secure and retain higher benefits when they

change jobs than they would under most traditional defined benefit plans.

The extent to which such workers realize this opportunity depends to a

large extent on their career and investment choices. Whether they stay in

the plan long enough to vest, for example, is crucial to whether they will

benefit from these earlier pension accruals. Special challenges exist for

workers who earn part of their retirement benefits under a traditional

defined benefit plan where they earn few benefits until late in their career

and earn part under a cash balance plan. Older workers may be

disadvantaged if their employer converts from a traditional plan to a cash

balance plan, or if they leave a firm with a traditional plan for one with a

cash balance plan. These workers may have little time to make up for the

benefits they expected under a traditional defined benefit plan. To mitigate

the impact of conversion, many Fortune 1000 employers provide transition
B-286323

Page 21 GAO/HEHS-00-207 Cash Balance Plans

provisions for workers they had previously covered under a traditional

defined benefit plan.

Cash Balance Plan

Participants Earn Benefits

Earlier Than Under Certain

Other Plan Types

Workers covered by many cash balance plans tend to earn or “accrue”

benefits faster the further they are from normal retirement age, compared

with traditional defined benefit pension plans.18 IRS requirements for taxqualified plans are part of the reason for this difference in the rates of

accrual. In accordance with IRS Notice 96-8, cash balance plans generally

treat hypothetical, future interest on annual pay credits as accruals for the

year in which the pay credit was made. Thus, future interest is included in

the determination of the accrued benefit even though the employee may

terminate employment and begin receiving a benefit before normal

retirement age. The accrued benefit in lump sum dollars will be equal to the

hypothetical account balance only when the participant reaches the normal

retirement age specified in the plan. However, as shown in figure 6, the

accrued benefit in lump sum dollars payable at normal retirement age is

higher than the hypothetical account balance up until that point.19 As a

result, as in the illustration in figure 6, a 25-year-old participant is entitled to

a pension benefit at normal retirement age based on an amount far higher

than the hypothetical account balance after 1 year of work. Assuming a pay

credit of 5 percent, salary increases of 3 percent, and a fixed interest credit

of 6 percent, at age 30, after 6 years, the participant has a hypothetical

account balance of about $7,500. However, he or she is entitled to a pension

benefit based on approximately $57,500 payable at age 65 even if he or she

leaves the firm at age 30.

18The accrual rate is the change in the accrued benefit for an individual plan participant from

one year to the next.

19In calculating the actual lump sum benefit payable before retirement, the hypothetical

account balance is projected forward with plan-specified interest earnings to the planspecified normal retirement age. Next, the projected balance is converted into a normal

retirement age annuity using a plan-specified discount rate and mortality assumptions.

Finally, the value of the annuity is discounted back to current dollars, using mortality factors

and the federally mandated discount rate, which is the rate specified by federal regulation

that must be used to convert the normal retirement age annuity benefit into an equivalent

lump sum in current dollars.
B-286323

Page 22 GAO/HEHS-00-207 Cash Balance Plans

Figure 6: Comparison of a Cash Balance Accrued Benefit With the Hypothetical Account Balance

Note: For purposes of illustration, the accrued benefit payable at age 65 and the hypothetical account

balance are both expressed as a lump sum and are cumulative. For simplification, we assumed a 3-

percent salary increase, 5-percent pay credit, a 6-percent interest credit, and a normal retirement age

of 65.

Cash balance plans also have a different rate of accrual than do traditional

defined benefit plans. When the increase in the cumulative accrued benefit

(expressed in lump sum dollars at normal retirement age), discussed above

and shown in figure 6, is converted into annual incremental amounts, as

shown in figure 7, the simple cash balance formula provides a larger share

of a participant’s total accrued benefit earlier in the worker’s career. This is

commonly referred to as “frontloading.” Because the annual accrued

benefit for the cash balance plan includes all the hypothetical interest the

annual pay credit would earn until the normal retirement age specified in

the plan, the younger a participant is, then the more years of interest will be

0

20,000

40,000

60,000

80,000

100,000

120,000

140,000

160,000

180,000

200,000

220,000

240,000

260,000

25 30 35 40 45 50 55 60 65

Dollars

Age

Hypothetical Account Balance

$57,509

$7,482

Lump Sum Value of

Accrued Benefit

Payable at Normal

Retirement Age
B-286323

Page 23 GAO/HEHS-00-207 Cash Balance Plans

included in the benefit accrued in any one year. This differs from the

accrual patterns of a traditional defined benefit plan, in which participants

earn higher benefits the closer they come to retirement, a pattern referred

to as “backloading.” Typically, participants under a traditional defined

benefit plan using a final average pay formula accrue the greatest share of

their benefits in the final years of their careers because benefits are based

on completed years of service and final average salary, both of which

generally increase the longer the worker stays with the same employer. As

shown in figure 7, plan participants in the simplified final average pay plan

in our illustration earn less than 5 percent of their normal retirement

benefit in the first 5 years of their career but almost 25 percent in the final 5

years of their career.
B-286323

Page 24 GAO/HEHS-00-207 Cash Balance Plans

Figure 7: Comparison of Annual Changes in Accrued Benefits for a Cash Balance Plan and a Final Average Pay Plan

Note: For purposes of illustration, we assume that both plan types result in the same benefit at normal

retirement age. This assumption does not mean that the formulas used in this illustration would provide

equivalent benefits at times other than normal retirement age or would result in equivalent costs to the

sponsor. Both the cash balance and traditional defined benefit plans are expressed as changes in a

lump sum payable at normal retirement age. For simplification, we assumed a 3-percent salary

increase, 5-percent pay credit, 6-percent interest credit, and a normal retirement age of 65.

Many Fortune 1000 cash balance plans exhibit features that vary from the

simple cash balance formula illustrated above. The use of more complex

cash balance formulas beyond those illustrated in figures 6 and 7 can

reduce the extent to which plan participants earn higher normal retirement

benefits earlier in their careers. Increasing cash balance pay credits for

older and longer-service workers makes annual accrual rates in cash

balance plans more like those of traditional defined benefit plans. Many

cash balance plans provide such higher pay credits. For example, one

complex plan formula we examined included as many as 1,265 different

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

25 30 35 40 45 50 55 60 65

Dollars

Age

Cash Balance

Traditional Final Average Pay
B-286323

Page 25 GAO/HEHS-00-207 Cash Balance Plans

pay credits based on age and service. The extent to which variable pay

credits result in benefit accruals more like those of traditional defined

benefit plans varies depending on the range of pay credits used in the plan.

For example, one Fortune 1000 firm has pay credits ranging from 1 to 18.6

percent. With all other factors being equal, this would result in a benefit

accrual pattern more like that of a traditional plan than that of a firm that

had pay credits ranging from 3 to 7 percent (see fig. 8).

Figure 8: Comparison of Annual Change in Benefit Accruals for Cash Balance Plans With Differing Age-Weighted Formulas

Note: For purposes of illustration, the annual change in accrued benefits is expressed as a lump sum

payable at age 65. The formulas are based on actual plans in our survey and would not result in

equivalent benefits at normal retirement age. For simplification, we assumed a 3-percent salary

increase, 5-percent pay credit, 6-percent interest credit, and a normal retirement age of 65.

The difference in the value of the accrued benefit and the hypothetical

account balance in a cash balance plan can be significant for all plan

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

25 30 35 40 45 50 55 60 65

Dollars

Age

3 to 7%

1 to 18.6%

1 to 18.6% With Age-Weighted

Interest Credits From 7 to 8.6%
B-286323

Page 26 GAO/HEHS-00-207 Cash Balance Plans

participants as they choose when and in what form to receive their pension

benefit. Under current law, all defined benefit plans are required to offer

participants an annuity payable at normal retirement age. Workers covered

by plans that offer retirement benefits in the form of an annuity but do not

offer a lump sum option will receive the value of the accrued benefit at

normal retirement age rather than the hypothetical account balance if they

terminate employment before retirement. Therefore, a worker in our

simplified illustration in figure 6, without knowing the difference between

the accrued benefit and the hypothetical account balance, could assume

that, upon leaving the firm after 6 years at age 30, he or she would get an

annuity at retirement based on the hypothetical account balance of about

$7,500. In fact, the worker would get an annuity at retirement based on an

amount almost 8 times greater.

In addition to the annuity benefit, current law also allows firms sponsoring

defined benefit plans to offer workers the option of receiving their benefit

as a lump sum, either at retirement or at termination. However, workers

who are given this choice cannot determine which option would ultimately

provide the greater retirement benefit without understanding that, if they

do not select an immediate lump sum, the annuity at retirement will be

based on the projected account balance at the plan’s normal retirement age

rather than the hypothetical account balance. Workers who select an

immediate lump sum need to know that the lump sum may not be

equivalent to but can be larger or smaller than the hypothetical account

balance. The relationship between the two is dependent on whether the

plan-specified interest rate is the same as, larger, or smaller than the rate

used to determine the present value of the benefit payable at normal

retirement age.

Cash Balance Plans Can

Benefit Mobile Workers

Consistent with the views of many firms we surveyed, cash balance plans

can lead to greater retirement income for more mobile workers. With other

factors being equal, workers employed by more than one employer during

their career can receive more retirement income under multiple cash

balance plans than under multiple traditional defined benefit plans. This

difference in retirement benefits is a function of how benefits are accrued

under each plan type.

Workers under multiple cash balance plans can get higher benefits at the

normal retirement age than under multiple final average pay (FAP) plans.

As shown in table 2, the worker under multiple cash balance plans will

receive a larger retirement benefit than the worker who retired under
B-286323

Page 27 GAO/HEHS-00-207 Cash Balance Plans

multiple FAP plans. The benefit earned by the worker who changed

employment under multiple cash balance plans will accrue a retirement

benefit that is almost 22 percent larger than the benefit received by the

workers under multiple FAP plans.

Generally, the final average salary increases as the worker progresses

through his or her career due to increased experience, productivity, and the

effects of inflation. For a worker who remains under a final average pay

plan until normal retirement age, the worker will receive a benefit based on

a formula that includes total service and some measure of the worker’s

final salary. However, for a worker who changes jobs under a FAP, the

salary level used to calculate the benefit from the first year of service will

generally be lower.

The accrual pattern under a FAP plan is illustrated in table 2, where we first

compare two workers employed for 30 years who have the same career

salary pattern. Both workers are continuously covered by FAP plans with

identical formulas. However, they have different employment histories; one

changed employers (and FAP plan) after 15 years, while the other remained

with the same employer and plan for 30 years. As shown, although both

workers were covered by identical FAP plans and had identical salaries, the

worker who changed employers will receive only 82 percent of the annual

retirement benefit of the worker who remained with the same employer.

Table 2: Comparison of Effect of Changing Jobs on Annual Pension Benefit Under a Traditional Final Average Pay Plan and a

Cash Balance Plan

Note: Salary for each employee is assumed to increase at 3 percent per year. Pension benefits for the

FAP plan are calculated through the formula: 1 percent x prior final average salary x years of service.

The benefit for the cash balance plan is calculated to ensure that the benefit at normal retirement age,

assumed to be age 65, with the same age and years of service, is equivalent to the FAP plan benefit.

Salary (starting

at $20,000)

Worker who remains with same

employer for 30 years

Worker who changes employers

after 15 years

Final average pay

plan benefit

Cash balance

plan benefit

Final average pay plan

benefit

Cash balance

plan benefit

After 15 years $30,252 $4,538 (15% of $30,252) $8,564

After 30 years $47,131 $14,139 (30% of

$47,131)

$14,139 $7,070 (15% of $47,132, 15

years with second employer)

$5,575 (15 years

with second

employer)

Final annual

retirement

benefit

$14,139 $14,139 $11,608 (benefits from both

employers)

$14,139 (benefits

from both employers)
B-286323

Page 28 GAO/HEHS-00-207 Cash Balance Plans

This does not assume that the plans would be equivalent in cost to the sponsor. The pay credit is

approximately 7 percent, and the interest rate is approximately 6 percent.

Because a key variable in the FAP formula is final salary, the retirement

benefit a worker earns for any one year of service is unknown until the

worker terminates employment or reaches the normal retirement age. In

our simplified illustration, the normal age 65 retirement benefit that the

first worker earned, after retiring with 30 years of continuous service, was

1 percent of $47,131 or $471, based on his or her first year of service with

the employer. The normal age 65 retirement benefit that the second worker

earned for the same year working for the same firm was 1 percent of

$30,252 or $303.

The accrual pattern under cash balance plans is different. The worker who

switches jobs under a simple cash balance plan does not experience this

difference in accrued benefit for leaving an employer prior to normal

retirement age. The benefit earned under a cash balance plan can be

determined in the year it was earned because it is based on the worker’s

pay and age that year, regardless of future earnings or service. If we were to

calculate the normal retirement benefits for the two workers under a

simple cash balance formula, their normal retirement benefits would be

equal, as shown in table 2.20 In addition, including all interest on the pay

credit until normal retirement age in the normal retirement accrued

benefit, regardless of when the participant terminates employment,

partially mitigates the effects of inflation.21

20The diversity in plan features and worker characteristics would likely make our scenario

rare. However, this illustration highlights the underlying dynamics of the accrual patterns of

FAP and cash balance plans and should be viewed in that context.

21In our scenario, the workers under cash balance plans did not obtain their benefits until

normal retirement age. However, making reasonable assumptions about interest rates, these

results would hold even if a lump sum payment feature was available, either to both workers

under multiple final average pay plans and cash balance plans or to workers under multiple

cash balance plans alone.
B-286323

Page 29 GAO/HEHS-00-207 Cash Balance Plans

Value of Increased Benefit

Earned Early in Career Is

Limited by Maintaining

Maximum Permissible

Vesting Requirements

The extent to which younger and more mobile workers gain the benefits of

increased normal retirement pension accruals early in their career under

cash balance plans is greatly influenced by the vesting requirements the

employer has chosen to include in the plan design. “Vesting” refers to the

length of time a plan participant must work for a firm to gain a

nonforfeitable right to an accrued pension benefit. In general, federal rules

require that firms must allow participants full rights to their accrued

benefits after no longer than 5 years of service; the employee can receive

no pension benefit if he or she leaves before 5 years, regardless of the

accrued benefit he or she has earned.22

While some Fortune 1000 firms we surveyed reported that a major reason

for adopting a cash balance plan was to improve their ability to recruit

younger workers by providing them with higher pension benefits earlier in

their careers, most firms did not alter their vesting requirements to

complement this objective. As shown in figure 9, most firms retained the 5-

year vesting requirement. Although separate data on employee turnover are

not readily available for firms with cash balance plans, nationally, a

majority of adult workers are not likely to stay with their firms long enough

to reach the 5-year vesting period.23

22Plans can offer a “graded” vesting schedule in which participants gain a legal right to a

portion of their benefits after 3 years and the requirement for full vesting is delayed until 7

years of service have been completed.

23The Bureau of Labor Statistics reported that, in 2000, the median number of years any

employee had with one employer was 4.7 years, while the median number of years for

younger employees was less. For example, the median tenure for those aged 25 to 34, when

cash balance plans are accruing benefits at their fastest rate, was 2.6 years. See BLS,

Employee Tenure in 2000, the Current Population Survey, 2000.
B-286323

Page 30 GAO/HEHS-00-207 Cash Balance Plans

Figure 9: Percentage of Fortune 1000 Firms Maintaining a 5-Year Vesting

Requirement After Conversion

Prudent Investment of

Lump Sum Is Needed to

Protect Retirement Income

Designing a plan to include a provision for lump sum benefits can have

both a positive and negative effect on the amount of money a plan

participant has available for retirement, depending on the individual

participant’s preferences and behavior. The impact of lump sum benefits

from cash balance plans differs from that of lump sum benefits from

traditional defined benefit plans because of the significant differences in

the rate at which participants can accrue benefits under the different

formulas.

13%

Graded

72%

5-Year Cliff 7%

Immediate

8%

Less Than

5-Year Cliff
B-286323

Page 31 GAO/HEHS-00-207 Cash Balance Plans

Cash balance plans are more likely than traditional defined benefit plans to

offer participants the option of receiving their benefits in a lump sum either

at retirement or at termination of employment. Fifteen percent of firms in

our survey who converted a traditional defined benefit plan into a cash

balance plan had allowed plan participants to elect a lump sum benefit over

$5,000 rather than an annuity in their prior final average pay plans.24 After

conversion, 95 percent of firms allowed a lump sum distribution, although

13 percent limited the option by offering it only at normal retirement age or

on only a portion of pension benefits. Numerous plan sponsors told us that

they converted to a cash balance plan because they wanted to offer a lump

sum benefit. However, many were unaware that they could legally offer a

lump sum benefit in a traditional defined benefit plan.

Employers who did offer lump sum benefitsunder either the traditional

defined benefit plan or the cash balance plangenerally reported that

almost all employees chose that option. Furthermore, some expressed

concern that, as a result, the firm was losing a key benefit of an employersponsored retirement plan, namely, the assurance that employees would

have sufficient retirement income to be able to terminate work at an

appropriate time. This concern was a key reason that some firms provided

for choosing not to allow a lump sum distribution. For example, one

employer we interviewed reported that plan participants leaving the firm

prior to retirement took lump sum payments even though the plan was

designed so that the value of the annuity payments was significantly higher.

Furthermore, they told us that terminating workers often asked that the

firm distribute the lump sum for nonretirement purposes directly to

businesses such as auto repair shops. This is consistent with numerous

studies on participant behavior that found that, in spite of incurring tax

penalties, many workers who receive lump sum distributions cash out the

funds, potentially reducing future retirement income in exchange for

current consumption.25 For example, the Congressional Research Service

recently reported that 33 percent of recipients report having reinvested

their lump sum distribution in another tax-qualified plan. In addition, they

24The Code allows both tax-qualified defined benefit and defined contribution plans to

distribute pension benefits either as a series of payments or as a lump sum amount. It

requires only defined benefit plans to provide plan participants the option of receiving an

annuity or series of payments at normal retirement age when the present value of the

accrued benefits exceeds $5,000.

25What Happens When You Show Them the Money?: Lump-Sum Distributions, Retirement

Income Security, and Public Policy, Leonard Burman, Norma Coe, and William Gale, Nov.

1999.
B-286323

Page 32 GAO/HEHS-00-207 Cash Balance Plans

found that younger workers were less likely than older workers to reinvest

their retirement benefit; 27 percent of workers ages 25 to 34, compared

with 42 percent of those ages 45 to 54, reinvested their retirement benefit.26

Assuming that a worker preserves the lump sum benefit as retirement

savings, he or she could have more assets available for retirement than

with the benefit most often offered under a traditional defined benefit

plana series of payments or annuity payable at normal retirement age.

There are two primary reasons for this. First, under a cash balance plan,

the value of the benefit is not frozen at the time the worker leaves the plan.

Second, the lump sum benefit could earn greater returns on actual

investments rather than a plan-specific hypothetical interest credit.

Assuming the continuation of historical investment returns, the rates of

return on individual investment of lump sum benefits could be higher than

the hypothetical interest credit provided under a plan. For example, several

cash balance plans offered fixed interest credits of 6 percent while

inflation-adjusted returns on stock market investments have averaged

roughly 7 or 8 percent over the past 60 to 70 years.27 Nevertheless, earning

higher returns would require investing in riskier assets such as stocks.

Therefore, the impact of lump sum distributions on the income available

for retirement would depend on how workers, who may have little

investment experience, invest their pension benefit and whether they

actually earn higher returns.

Challenges Resulting From

Changing Types of Plans

With the increased prominence of cash balance plans, workers are

increasingly faced with the consequences of a move from a traditional plan

to a cash balance plan. This can happen when the employer changes the

type of plan it is sponsoring or when workers change employers. The

employer changes the type of plan either by freezing or terminating a prior

plan or by amending the plan formula. Differences in the rate at which

benefits accrue over time under different types of plans can affect the

amount of money that participants who change plans receive from private

26Patrick J. Purcell, Pension Issues: Lump-sum Distributions and Retirement Income

Security, Mar. 14, 2000. The report is based on CRS’s analysis of the Census Bureau’s Survey

of Income and Program Participation.

27Depending on the interest rate that plan sponsors credit to hypothetical accounts, a

terminating worker could be better off if he or she left the benefit in the cash balance plan

until normal retirement age rather than opting for the lump sum payment. For example, one

plan we surveyed used interest rates as high as 16 percent in their benefit formula.
B-286323

Page 33 GAO/HEHS-00-207 Cash Balance Plans

pension plans. For example, as illustrated in figure 10, if a participant

begins pension coverage under a traditional defined benefit plan and moves

to a simple cash balance plan, he or she could accrue benefits under each

plan where the rate of accrual is the lowest.28 The illustration represents a

“worst case” scenario and would result in decreased pension benefits. In

contrast, a worker moving from a cash balance plan to a traditional defined

benefit plan could accrue benefits under each plan where the rates of

accrual are the highest. Assuming that these funds are not withdrawn, a

participant moving from a defined contribution 401(k) plan to a cash

balance plan would continue to accrue interest on his or her 401(k)

account balance even after moving to the cash balance plan.29

28Changing from a traditional defined benefit plan to a cash balance plan can result in a

reduction in the rate at which normal retirement benefits accrue at any age. However, the

effect on expected retirement income is greater the closer the participant is to normal

retirement age when the change occurs.

29We provide a more detailed explanation of the impact of changing plan type in Private

Pensions: Implications of Conversions to Cash Balance Plans (GAO/HEHS-00-185, Sept. 29,

2000), which we are issuing concurrently. In this report, we model conversion from a FAP to

a cash balance plan, including periods of time when older participants may earn no

additional pension benefits while younger workers do, a phenomena commonly referred to

as “wearaway.” Under the rules for defined contribution plans, employees can withdraw

their funds under certain conditions and with certain penalties.
B-286323

Page 34 GAO/HEHS-00-207 Cash Balance Plans

Figure 10: Annual Accrued Benefit With Mid-Career Change From Traditional Final Average Pay Plan to Cash Balance Plan

Note: For purposes of illustration, we assume that the traditional final average pay formula and cash

balance formula result in the same benefit at normal retirement age. This assumption does not mean

that the formulas used in this illustration would provide equivalent benefits at times other than normal

retirement age or would result in equivalent costs to the sponsor. Both the cash balance and traditional

defined benefit plans are expressed as annual changes in a lump sum payable at normal retirement

age. For simplification, we assumed a 3-percent salary increase, 5-percent pay credit, 6-percent

interest credit, and a normal retirement age of 65.

Many employers design cash balance plans to reduce the adverse effect of

changing plan type on workers. Federal pension rules require only that taxqualified plans guarantee the benefit a worker has accrued to date and do

not guarantee future expected benefits. Nevertheless, an estimated 84

percent of the Fortune 1000 firms that adopted a cash balance plan for

workers previously covered under a traditional defined benefit plan

included transition provisions in their plan design to mitigate at least

partially the effect of changing to a cash balance plan on workers’

expectations of future benefits. In 11 percent of cash balance plans that

0

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

25 30 35 40 45 50 55 60 65

Dollars

Age

Cash Balance FAP

Accrual Under One Plan

Accrual When Switching Plans at

"Worst-Case" Scenario
B-286323

Page 35 GAO/HEHS-00-207 Cash Balance Plans

replaced a final average pay plan, or 9 percent of cash balance plans in our

survey, there will be no reduction in expected normal retirement benefits

for any plan participant. Participants will experience no reduction because

the plan guarantees future expected benefits under the old plan for all

current workers, as shown in figure 11. All but one of these plans do this by

keeping current workers under the prior plan or by offering all workers the

greater of the benefits earned under both formulas until they terminate or

retire, which is commonly referred to as “grandfathering.” The one

exception guarantees benefits by offering employees a choice of benefits

under the old or new formula at retirement.

Figure 11: Percentage of Participants With Expected Benefits Protected by

Transition Provisions

Note: Determining the extent to which transition provisions for plans categorized as “partially

protected” protect the expected normal retirement benefit of participants is based on the

circumstances of each plan and the individual worker.

14%

No Protection

68%

Participants

Partially Protected

9%

Fully Protected

9%

No Previous Benefits 

to Protect
B-286323

Page 36 GAO/HEHS-00-207 Cash Balance Plans

The majority of plans offered partial protection by (1) limiting their

protection to only a specific group of workers, (2) limiting the period of

time the protection is offered, and/or (3) providing weighted pay credits to

a designated group, which may not fully mitigate reduction in expected

benefits. For example, 78 percent of the firms from our survey who offered

workers the greater of the benefit earned under both formulas, often

referred to as “grandfathering,” limited the offer to those employees who

met specific age and/or service criteria, or limited the period of time for

employees to accept the offer, such as 1 or 5 years. One firm allowed

participants age 45 and older with at least 10 years of service to continue

accruing benefits under the prior formula. Another firm allowed

participants with a minimum combination of 60 years of age and service to

receive the better of pension benefits provided by the prior formula or the

cash balance formula at retirement. About one-half of the firms offering

transition provisions provided additional pay or interest credits or

increased the value of the benefit accrued under the old formula for

workers who met specific age and/or service criteria at the time they

adopted the cash balance formula.30 Two plans offered workers a choice of

participating in the traditional or the cash balance plan at conversion.31

The greater amount of choice often afforded to workers under cash

balance plans can complicate efforts to estimate retirement income. In

general, the traditional defined benefit plan generally expresses the

replacement rate by expressing normal retirement benefits as an annual

payment that is a percentage of the worker’s pay.32 Social security benefits

are represented as a monthly allowance that can be easily converted into a

percentage of pay. To determine the effect of the lump sum on the

replacement of his or her annual income at retirement, the participant must

be able to estimate the annual value of the lump sum benefit at a future

retirement age, either through an annuity and/or through projected

investment returns. This is a complex assessment that requires making

numerous assumptions, including assumptions about expected termination

30These firms include some of the firms offering limited grandfathering.

31According to some pension practitioners, choice at conversion can be problematic

because participants may not have the information needed to decide which formula would

provide the greatest benefit. Some also believe that choice would have to be offered again

any time a plan that offered choice is amended.

32One common measure of retirement income adequacy is the replacement rate, which

seeks to measure the retirement income for a single worker or household in relation to a

measure of preretirement earnings, such as the earnings in the year before retirement.
B-286323

Page 37 GAO/HEHS-00-207 Cash Balance Plans

or retirement date, the future value of money, future investment returns,

and life expectancy.

Current Disclosure

Often Inadequate

Individual participant choices play a more significant role in maximizing

retirement income under many cash balance plans than under most

traditional defined benefit plans. Consequently, participants need clear and

timely information to make choices that will increase rather than decrease

their future retirement income. Current disclosure requirements provide

minimum guidelines that firms must follow concerning the type of

information they provide participants about plan provisions. We found,

however, that many employers do not provide such information. These

findings supplement those we reported on in a concurrently issued report

that focuses on issues of conversion from one plan type to another rather

than on cash balance plans in general.33

ERISA establishes specific requirements concerning disclosure of

information to plan participants, including a written summary of plan

provisions. Department of Labor regulations implementing the summary

plan description (SPD) requirements provide that the material must be

“sufficiently comprehensive to apprise the plan’s participants of their rights

and obligations under the plan.” However, we found significant variation in

the quality of information explaining the cash balance formula that was

provided to plan participants. For example, about three-quarters of the

SPDs we reviewed provided no information that would allow participants

to understand the difference between the accrued normal retirement

benefit and the hypothetical account balance. Also, documents we

reviewed that firms provided to plan participants did not address these

differences directly.

We found a range in the quality of information contained in the SPDs we

reviewed. Some SPDs provided a clear statement about the nature of the

cash balance plan, indicating that the accounts were hypothetical and that

employees did not own the assets in the accounts. One plan, for example,

described the hypothetical nature of the account as follows:

A cash balance account differs from a traditional pension plan in that you have a “cash

balance account” for recordkeeping purposes. Your cash balance account is only a

33See Private Pensions: Implication of Conversions to Cash Balance Plans (GAO/HEHS-00-

185, Sept. 29, 2000).
B-286323

Page 38 GAO/HEHS-00-207 Cash Balance Plans

bookkeeping account because even though it represents the actual lump sum amount you

are entitled to under the Plan if your employment terminates, no assets are segregated into a

separate account for your benefit. Therefore, when this summary indicates that

contributions will be made to your cash balance account, it means that the Plan’s records

will reflect that your cash balance account is being increased by the amount of the

contribution.

The information provided in some SPDs, on the other hand, could easily

lead participants to believe that the cash balance formula or hypothetical

account was similar to a 401(k) plan. For example, one plan described the

cash balance plans as a plan that “... sets up an account in your name. Each

year, your account receives a basic credit, an additional credit (if eligible)

and interest.” Not stating that the accounts are hypothetical and/or making

claims that the cash balance accounts are similar to 401(k) plan accounts

prevents plan participants from understanding how cash balance plans

work and what benefits they are entitled to receive.

Understanding that the cash balance is hypothetical is also essential to

understanding the difference between the hypothetical account balance

and the accrued benefit payable at normal retirement age. While 60 percent

of SPDs we reviewed advised participants that interest credits continue

after termination of employment with the firm, no SPD explained that there

was a difference between the hypothetical account balance and the

accrued benefit. In fact, some SPDs specifically stated that the account

balance was equivalent to the accrued benefit. As a result, workers do not

have sufficient or accurate information to assess the effect that changing

jobs or the implications of choosing a lump sum payment rather than an

annuity payable at normal retirement age will have on the amount of money

available to them at retirement.

Conclusions Cash balance pension plans provide opportunities and challenges to

individual participants seeking a safe and secure retirement. Under many

cash balance plan designs, workers do not have to wait until late in their

careers to earn significant retirement benefits. These plans also often have

a lump sum payment option upon separation, which can be reinvested.

Some firms have adopted new cash balance plans or have converted from

traditional defined benefit plans precisely because these features are

attractive to younger workers who exhibit greater labor market mobility.

Provided that they are invested in a prudent manner, larger early accrual

rates and lump sum payments can lead to greater retirement income.
B-286323

Page 39 GAO/HEHS-00-207 Cash Balance Plans

Yet these features also pose challenges to retirement security. Cash balance

plans can make more retirement money available to younger workers who

are historically more likely to spend the funds for current living expenses

than those closer to retirement. Because cash balance plans feature lower

rates of accrual later in an employee’s career, younger workers who fail to

invest responsibly early on may have less opportunity to make up these

losses when they are closer to and more focused on retirement. Older

workers, particularly those affected by a conversion to a cash balance plan,

may be more focused on saving for retirement but have fewer years to

reach it and could accrue benefits under a cash balance plan at a lower rate

than they would under a defined contribution plan such as a 401(k).

For all workers, cash balance plans place a greater reliance on personal

responsibility and choice. For workers to take advantage of this greater

choice, they must have the information necessary to understand the

implications of their choices for their future retirement income. However,

our work has shown that cash balance plan participants do not generally

get the information they need to make informed choices. We found wide

variation in the quality, clarity, and comprehensiveness of the information

disclosed to employees covered by cash balance plans. At a minimum,

employees should know how their benefit accruals differ from previous or

supplemental plans the employer has offered them. They should also have

clear and understandable information to allow them to calculate the

benefits they have earned and detailed instructions about what to do if this

information is not forthcoming.

Recommendations for

Executive Action

We recommend that the Secretary of Labor direct the Assistant Secretary of

the Pension and Welfare Benefits Administration to amend the disclosure

requirements under their respective authorities, as provided under ERISA

for Summary Plan Descriptions, to include

• a clear statement regarding the difference between the hypothetical

account balance and the accrued benefit payable at normal retirement

age under the cash balance plan,

• specific information about the impact the timing of interest crediting

has on deferred pension benefits for terminating workers, and

• standardized language providing plan participants with their rights to

contact PWBA and/or IRS if they are unable to understand the

information provided and the relevant addresses and telephone

numbers necessary for such contacts.
B-286323

Page 40 GAO/HEHS-00-207 Cash Balance Plans

Agency and Other

Comments

We provided Treasury and Labor with the opportunity to comment on a

draft of this report. Labor’s comments are included in appendix II. Labor

generally agreed with our findings and conclusions, noting that the report

was consistent with an administration proposal to amend current law

regarding the disclosure provided to pension plan participants. Labor is

currently giving consideration to the appropriate action to be taken in

response to our recommendations. Treasury and Labor also provided

technical comments, which we incorporated as appropriate.

We are sending copies of this report to the Honorable Major R. Owens,

Ranking Minority Member, Subcommittee on Workforce Protections; the

Honorable Robert E. Andrews, Ranking Minority Member, Subcommittee

on Employer-Employee Relations, House Education and Workforce

Committee; the Honorable William J. Coyne, Ranking Minority Member,

Subcommittee on Oversight, House Committee on Ways and Means; and

other interested congressional committees. In addition, we are providing

copies to the Secretary of Labor, the Secretary of the Treasury, the

Chairwoman of the Equal Employment Opportunity Commission, and the

Executive Director of the Pension Benefit Guaranty Corporation. We will

also make copies available to others on request. If you have any questions

concerning this report, please contact me at (202) 512-5491, Charles

Jeszeck at (202) 512-7036, or George Scott at (202) 512-5932. Other major

contributors include Lise L. Levie, Dan F. Alspaugh, Jeremy F. Citro,

Andrew M. Davenport, and Roger J. Thomas.

Sincerely yours,

Barbara D. Bovbjerg

Associate Director

Education, Workforce, and

Income Security Issues
Page 41 GAO/HEHS-00-207 Cash Balance Plans
Page 42 GAO/HEHS-00-207 Cash Balance Plans

Appendix I

Scope and Methodology ApApenednxidexiIs

Survey of 1999 Fortune

1000 Companies

To determine the prevalence of cash balance plans among large employers

and to describe the major features of cash balance plans adopted by large

employers, we conducted a telephone survey of 420 employers listed

among the 1999 Fortune 1000. We selected the firms randomly. We obtained

responses from 409 firms or about 97 percent of the companies we

sampled.

Of the 409 firms that responded to our survey, 19 percent reported

sponsoring a cash balance plan. Because the survey was based on random

sampling with equal probabilities of selection, the sample proportion is a

reasonable estimate of the total population of 1999 Fortune 1000

companies sponsoring a cash balance plan. Applying the sample proportion

(19.3 percent) to the 1999 Fortune 1000 list provides an estimate of 193

firms among the 1999 Fortune 1000 firms with cash balance plans as of July

2000.1

We obtained plan documents, including Summary Plan Descriptions from

the cash balance plan sponsors we identified in the sample survey. We

summarized the major features of cash balance plans sponsored by the

1999 Fortune 1000 firms we surveyed. Information extracted from plan

documents provided by the cash balance plans we identified included data

on whether the plan was a new or converted plan, participation and vesting

requirements, procedures for establishing opening balances, cash balance

plan features, and whether transition provisions were provided.

We developed a database to compile and analyze plan data for each

variable in the data collection instrument and for information on plan

features that we obtained from plan documents. Counts were performed to

generate the frequency of occurrence for each variable in the database and

for particular plan features. The percentage and number of 1999 Fortune

1000 firms that sponsor cash balance plans and the number of participants

in those plans were calculated at the 95 percent confidence level. The other

statistics that we report from our survey on cash balance plans represent

sample statistics.

1

To calculate the population estimate from the sample proportion, the assumption was made

that the population of 1999 Fortune 1000 companies not selected for the survey has the

same proportion of cash balance sponsors as the number of survey respondents.

Confidence intervals were computed at the 95 percent level for the number and proportion

of 1999 Fortune 1000 companies sponsoring cash balance plans.
Appendix I

Scope and Methodology

Page 43 GAO/HEHS-00-207 Cash Balance Plans

Interviews With Cash

Balance Plan Sponsors

We conducted indepth interviews with officials from 14 firms that sponsor

cash balance or similar hybrid plans; 13 of these firms converted traditional

pension plans to cash balance or pension equity plan formulas. These

interviews allowed us to examine the reasons that employers converted to

cash balance plans and the ways in which plan sponsors implemented

those conversions. We selected firms on the basis of several criteria.

Selection criteria included company industry, geographic region, and

whether the company had received favorable or unfavorable press

regarding its conversion. Two of the 14 companies were nonprofit

organizations. Information from these interviews is included in the body of

this report to provide relevant examples and context. We provided a pledge

of confidentiality to firms that provided us proprietary information. We

therefore do not mention the names of firms to preserve confidentiality.
Page 44 GAO/HEHS-00-207 Cash Balance Plans

Appendix II

Comments From the Department of Labor ApendxiI
Appendix II

Comments From the Department of Labor

(207087) Letr Page 45 GAO/HEHS-00-207 Cash Balance Plans
Ordering Information The first copy of each GAO report is free. Additional copies of

reports are $2 each. A check or money order should be made out to

the Superintendent of Documents. VISA and MasterCard credit

cards are accepted, also.

Orders for 100 or more copies to be mailed to a single address are

discounted 25 percent.

Orders by mail:

U.S. General Accounting Office

P.O. Box 37050

Washington, DC 20013

Orders by visiting:

Room 1100

700 4th St. NW (corner of 4th and G Sts. NW)

U.S. General Accounting Office

Washington, DC

Orders by phone:

(202) 512-6000

fax: (202) 512-6061

TDD (202) 512-2537

Each day, GAO issues a list of newly available reports and

testimony. To receive facsimile copies of the daily list or any list

from the past 30 days, please call (202) 512-6000 using a touchtone

phone. A recorded menu will provide information on how to obtain

these lists.

Orders by Internet:

For information on how to access GAO reports on the Internet,

send an e-mail message with “info” in the body to:

info@www.gao.gov

or visit GAO’s World Wide Web home page at:

http://www.gao.gov

To Report Fraud,

Waste, or Abuse in

Federal Programs

Contact one:

• Web site: http://www.gao.gov/fraudnet/fraudnet.htm

• e-mail: fraudnet@gao.gov

• 1-800-424-5454 (automated answering system)

United States

General Accounting Office

Washington, D.C. 20548-0001

Official Business

Penalty for Private Use $300

Address Correction Requested

Bulk Rate

Postage & Fees Paid

GAO

Permit No. GI00