GAO

United States General Accounting Office

Report to Congressional Requesters

September 2000 PRIVATE PENSIONS

Implications of 

Conversions to Cash 

Balance Plans

GAO/HEHS-00-185

Page 1 GAO/HEHS-00-185 Cash Balance Plans

Contents

Letter 3

Appendixes Appendix I: Scope and Methodology 42

Appendix II: Pension Benefits Simulation Model 45

Appendix III: Cash Balance Plans and Minimum Lump Sum

Distributions 58

Appendix IV: Comments From the Department of the Treasury 64

Tables Table 1: Lump Sum Distributions From a Traditional Final Average

Pay Formula and a Cash Balance Formula After 

Conversion 22

Table 2: Lump Sum Wearaway Created at Conversion for a 

45-Year-Old Worker 29

Table 3: The Creation of Wearaway Periods After Conversion by 

Fluctuation in the Mandatory Discount Rate for Defined

Benefit Plans 31

Table 4: Early Retirement Benefit Wearaway Payable at Age 60 32

Table 5: Assumptions for the Baseline Simulations We Report 50

Figures Figure 1: Participant Coverage in Fortune 1000 Cash Balance 

Plans 11

Figure 2: Annual Annuity Benefits Under a Cash Balance Formula 

and a Final Average Pay Formula 17

Figure 3: Rate of Accrual for a Cash Balance Formula and

a Traditional Final Average Pay Formula 20

Figure 4: How Conversion to a Cash Balance Plan Potentially 

Lowers Annuities 26

Figure 5: Incremental Benefit Accruals for Workers of Different

Ages Under Different Formulas 27

Figure 6: Comparison of Benefits From Weighted Pay Credit 

Formulas, Basic Cash Balance Formula, and Final 

Average Pay Formula 35

Figure 7: The Whipsaw Effect: Hypothetical Balance Is Less 

Than Lump Sum Benefit 60

Figure 8: Hypothetical Balance Is Greater Than Lump Sum Benefit 61
Contents

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Abbreviations

BLS Bureau of Labor Statistics

EEOC Equal Employment Opportunity Commission

ERISA Employee Retirement Income Security Act of 1974

IRA individual retirement account

IRC Internal Revenue Code

IRS Internal Revenue Service

PBGC Pension Benefit Guaranty Corporation

PWBA Pension and Welfare Benefits Administration

SPD summary plan description
Page 3 GAO/HEHS-00-185 Cash Balance Plans

United States General Accounting Office

Washington, D.C. 20548

Health, Education, and

Human Services Division

B-283648 Letr

September 29, 2000

The Honorable William J. Coyne

Ranking Minority Member

Subcommittee on Oversight

Committee on Ways and Means 

House of Representatives

The Honorable Robert Andrews

Ranking Minority Member

Subcommittee on Employer-Employee Relations

Committee on Education and the Workforce

House of Representatives

The Honorable Major R. Owens

Ranking Minority Member

Subcommittee on Workforce Protections

Committee on Education and the Workforce

House of Representatives

Employer-provided pensions are an important source of income for many 

retired persons. To encourage employers to establish and maintain pension 

plans for their employees, the federal government provides preferential tax 

treatment under the Internal Revenue Code (IRC) for plans that meet 

certain requirements. The Joint Committee on Taxation estimates that in 

fiscal year 2000 the tax expenditure for qualified employer-sponsored 

pension plans will be about $76 billion.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. There has been recent controversy concerning how 

conversions of traditional defined benefit pension plans to cash balance 

1

Fiscal year 2000 estimate, from 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. Pension contributions and 

investment 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.
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plans can affect workers, especially those nearing retirement.2 Questions 

have also been raised about the application of current tax qualification 

requirements to this new type of pension plan. 

You asked us to (1) describe the prevalence and major features of cash 

balance plans and reasons why firms adopt them; (2) discuss how the use 

of cash balance plans can affect the pension benefits for workers of 

different ages and tenure, particularly after conversion; and (3) determine 

what information employers converting to cash balance plans typically 

provide to plan participants and how disclosure might be improved.

To address your questions, we conducted a random sample survey of 420 

firms on the 1999 Fortune 1000 list and reviewed pension plan documents 

to examine the features of cash balance plans.3

 In addition, we conducted 

in-depth interviews with officials from 14 firms with cash balance or similar 

plans to discuss why they adopted such plans and to obtain information 

about how firms disclosed changes to their pension programs. We modeled 

pension plan design features to compare pension benefits provided by a 

“basic” cash balance plan and a defined benefit plan with a final average 

pay formula, common to large defined benefit plans.4

 Also, we interviewed 

various federal agency officials, pension consultants, and actuaries. We 

conducted our work between September 1999 and August 2000 in 

accordance with generally accepted government auditing standards. (See 

app. I for details on our scope and methodology.)

Results in Brief Our survey of 1999 Fortune 1000 firms indicates that the number of firms 

sponsoring cash balance plans has increased within the past few years, 

with few firms sponsoring such plans before the early 1990s but increasing 

to about 19 percent of all Fortune 1000 firms this year. These plans cover an 

estimated 2.1 million workers. Firms in many sectors of the economy 

2

Defined benefit plans generally pay retirement benefits on the basis of years of service, 

earnings, or both. Unlike traditional defined benefit plans, cash balance plans determine 

benefits on the basis of hypothetical individual accounts.

3

The Fortune 1000 list ranks for-profit companies by operating revenue. The results of our 

survey can be generalized to all 1999 Fortune 1000 firms but not to all other firms. For 

purposes of this report, when we discuss the results of our survey, we refer to firms on the 

1999 Fortune 1000 list. 

4

Final average pay formulas base benefits on a percentage of the participant’s final average 

earnings, multiplied by number of years of service.
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sponsor these plans but greater concentrations are found in the financial 

services, health care, and manufacturing industries. About 90 percent of 

the firms we surveyed that sponsor such plans previously covered their 

workers under a traditional defined benefit plan. Most of the conversions 

occurred within the past 5 years. Key reasons firms gave for converting 

include lowering total pension costs; adding a lump sum feature to increase 

the portability of pension benefits, thereby improving the firm’s ability to 

recruit more mobile workers; and facilitating communication of the value 

of plan benefits. As with traditional pension plans, cash balance plan 

designs vary significantly. 

Conversions to cash balance plans can be advantageous to certain groups 

of workers—for example, to those who switch jobs frequently—but can 

lower pension benefits for others. Cash balance plans provide a larger 

share of a participant’s accumulated benefit earlier in a career, compared 

with a traditional defined benefit plan that is based on final average pay. As 

a result, conversions can increase the value of some workers’ benefits, 

especially younger or short-tenured workers who leave firms before 

retirement. For example, a 30-year-old worker at the time of a conversion, 

who leaves a firm 10 years later, would receive a lump sum distribution 

from a cash balance plan about 1.5 times larger than that from a traditional 

plan based on final average pay, all other factors being equal. Other 

workers, however, can be disadvantaged after conversion to a cash balance 

plan. 

Unlike traditional defined benefit plans, cash balance plans can result in a 

declining rate of normal retirement benefit accrual over time. This 

declining accrual rate can result in older workers’ receiving lower benefits 

at retirement from a cash balance plan than they would have received from 

a traditional final average pay plan if it had not been converted. However, 

workers could also receive lower retirement benefits under a traditional 

plan if an employer reduces future accruals or terminates the plan. Under 

some circumstances, conversions to cash balance plans can also result in 

periods during which some workers do not earn additional pension 

benefits while other workers continue to accrue benefits. These situations, 

known as “wearaway,” tend to last longer for older or long-tenured workers 

and occur because a participant’s initial cash balance benefit is less than 

the value of the benefit accrued under the prior plan. While most of the 

firms in our survey that adopted cash balance plans included transition 

provisions to help protect the future benefits of workers, these provisions 

can vary in the extent to which they accomplish this objective. 
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Current disclosure requirements provide minimum standards for the 

information sponsors must give participants about plan changes. We found 

wide variation in the type and amounts of information workers receive. The 

communications provided to employees vary from general statements 

about plan changes to specific examples of how a conversion to a cash plan 

might affect workers of different ages and tenure. For example, some firms 

provided employees with a short written notice while others gave them a 

copy of the actual plan amendment to inform them about the conversion to 

a cash balance plan. This type of information was often difficult to 

understand and provided employees little or no information on how the 

change could affect their future pension benefits. In other instances, firms 

provided employees with extensive educational materials and automated 

benefit calculators to help them understand how conversion to a cash 

balance plan could affect their individual benefits. Often, however, 

sponsors did not ensure that participants received sufficient information 

about plan changes that could reduce future benefit accruals.

This report includes matters for consideration by the Congress related to 

improving disclosure to participants about plan changes and preventing 

situations in which some participants do not accrue new pension benefits 

for a period of time after conversion to a cash balance plan. We also 

recommend actions to the Department of Labor concerning improvements 

to current disclosure requirements and to the Department of the Treasury 

and the Internal Revenue Service (IRS) concerning administrative actions 

they can take to clarify the regulatory treatment of cash balance plans. 

Today we are issuing another report on cash balance plans, particularly on 

the effects of such plans on the adequacy of retirement income.5

Background IRC defines pension plans as either defined benefit or defined contribution 

plans and includes separate requirements for each type of plan. According 

to Bureau of Labor Statistics (BLS) survey data, most participants in large 

and medium-sized firms’ defined benefit plans are covered by plans that 

use a final average pay formula that is based on years of service, average 

earnings over a specific number of years, and a multiplier. For example, a 

final average pay formula might determine benefits on the basis of 1.25 

percent multiplied by years of service completed multiplied by the

5

Cash Balance Plans: Implications for Retirement Income (GAO/HEHS-00-207, Sept. 29, 

2000).
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employee’s average salary over the past 5 years of service.6 Defined benefit 

plans typically express an accrued pension benefit as an annuity beginning 

at the plan-specified normal retirement age.7

 The firm, as the plan sponsor, 

is responsible for funding the promised benefit, investing and managing the 

plan assets, and bearing the investment risk.

Under defined contribution plans such as 401(k) plans, workers have 

individual accounts to which employers, employees, or both make periodic 

contributions. Defined contribution plan benefits are based on the 

contributions to and investment returns on these accounts. Employees 

bear the risk of poor investment performance and often control, at least in 

part, how the funds are invested. 

Cash balance plans are referred to as hybrid plans because legally they are 

defined benefit plans but contain features that resemble defined 

contribution plans. Similar to traditional defined benefit plans, cash 

balance plans use a formula to determine pension benefits. However, cash 

balance plans express benefits as an “account balance.” An employee 

account balance is based on hypothetical pay credits (percentage of salary 

or compensation) and hypothetical interest credits to employee accounts 

rather than an annuity. As with other defined benefit plans, under cash 

balance plans, employee pension 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, and hypothetical accounts are not 

credited with the plan’s actual investment gains or losses. Employees 

neither own these “accounts” nor generally make investment decisions. 

Cash balance plans are defined benefit plans because federal pension law 

defines any pension plan that does not provide individual accounts with 

benefits based solely on those accounts as a defined benefit plan.8

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.

7

Defined as a series of periodic payments over a specified period of time or for the life of the 

recipient.

8

26 U.S.C. 414(j).
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Federal law provides specific rules on how pension benefits must be 

accrued in order for plans to receive favorable tax treatment as well as 

safeguards to preserve benefits that participants have already earned. The 

law prohibits firms from amending a plan’s benefit formula to reduce 

benefits that have already accrued. Firms can, however, change a pension 

plan’s benefit formula to prospectively reduce or eliminate future benefit 

accruals. For example, defined benefit plan formulas can be amended to 

reduce the percentage of final pay used in the future to determine the 

annual benefit or limit the number of years over which benefits accrue. 

Firms can also terminate their pension plans. Defined benefit plan 

sponsors that terminate their plans are subject to an excise tax of up to 50 

percent on any surplus assets in their pension trusts if they do not share 

excess pension assets with participants. 

The Employee Retirement Income Security Act of 1974 (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 that describes the terms of the plan. Furthermore, whenever 

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

must provide participants with a summary of the changes no later than 210 

days after the end of the plan year in which the changes are adopted, 

known as a summary of material modification. 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.

IRS, the Pension Benefit Guaranty Corporation (PBGC), and the 

Department of Labor’s Pension and Welfare Benefits Administration 

(PWBA) are primarily responsible for enforcing laws related to private 

pensions. IRS enforces participation, vesting, and funding standards that 

concern how participants become eligible to participate in benefit plans 

and earn rights to benefits and that ensure that plans have sufficient assets 

to pay promised benefits. PWBA enforces ERISA’s reporting and disclosure 

provisions and fiduciary standards, which concern how plans should 

operate in the best interest of participants. PBGC insures the benefits of 

participants in most private defined benefit pension plans. Employers can 

voluntarily submit an application to IRS, seeking approval of their plan 

when it is started, when the plan is amended to comply with law changes or 

plan design changes, or when the plan is terminated. 
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Under the Age Discrimination in Employment Act, it is unlawful for 

employers to sponsor a defined benefit plan that stops a benefit accrual or 

reduces the rate of an employee’s benefit accrual because of age.9

 The 

Equal Employment Opportunity Commission (EEOC) enforces federal law 

prohibiting employment discrimination, including discrimination based on 

age (aged 40 and older). IRC and ERISA have similar provisions prohibiting 

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

because of the attainment of any age.10

Prompted by concern from members of the Congress and charges by 

participants in plans that were converted, federal agencies are now 

reviewing age discrimination and other issues raised by cash balance plans. 

In September 1999, EEOC began a review of potential age discrimination 

issues in cash balance conversions and is coordinating with agencies that 

are responsible for administering federal pension laws. Within the past 

year, more than 800 workers and retirees have filed age discrimination 

charges with EEOC concerning cash balance plans. EEOC has opened 34 

cases to investigate these charges. The Department of the Treasury and IRS 

are currently reviewing tax qualification issues raised by cash balance 

plans. For example, in September 1999, IRS announced that it would begin 

requiring that applications for the approval of cash balance formula designs 

be forwarded to its headquarters for technical review, resulting in an 

effective moratorium on approving conversions to cash balance plans. In 

addition, in October 1999 IRS announced that it was soliciting public 

comments on issues related to the conversion of traditional defined benefit 

formulas to cash balance formulas. Further, in July 2000, the Office of 

Management and Budget issued a Statement of Administration Policy 

proposing legislative action to address certain issues raised by conversions 

to cash balance plans. 

Cash Balance Plans 

Are Increasingly 

Common, and Plan 

Features Vary

Few firms that we surveyed on the 1999 Fortune 1000 list that sponsor cash 

balance plans adopted such plans before the early 1990s. Our analysis 

indicates that as of July 2000, about 19 percent of these firms sponsor cash 

balance plans. Firms adopted cash balance formulas for a variety of 

reasons, including reducing total pension costs, increasing portability to 

enhance the recruitment of younger or more mobile workers, and adding a

9

29 U.S.C. 623 (i)(1)(A).

1029 U.S.C. 1054(b)(H)(i) and 26 U.S.C. 411(b)(1)(H).
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lump sum benefit feature that can be used to better explain pension 

benefits to workers. As with traditional defined benefit plans, cash balance 

plans exhibit a considerable variety of designs, particularly in the amount 

of pay credited to participants’ hypothetical accounts. 

About One of Five Fortune 

1000 Firms Sponsors Cash 

Balance Plans 

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

cover an estimated 2.1 million active participants.11 Similar to traditional 

pension plans, many cash balance plans that we identified generally do not 

cover all workers at a firm. Instead, these plans cover particular segments 

of a firm’s workforce such as managers or salaried employees or certain 

workers in a firm’s subsidiary. Most cash balance plans we identified in our 

survey (an estimated 69 percent) have fewer than 10,000 active participants 

(see fig. 1), including 8 percent with no active participants because benefit 

accruals are frozen.12 The most common reason sponsors froze a cash 

balance plan was that the plan was acquired as part of a merger or 

acquisition and the firm did not want to continue the cash balance plan.

11About 4 percent of Fortune 1000 firms that we surveyed sponsor pension equity plans. 

Under pension equity plans, employees earn a percentage of final average pay expressed as 

a lump sum amount. These plans 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.

12Frozen plans have stopped participants’ benefit accruals and allow no new entrants into 

the plans but distribute benefits to participants and beneficiaries.
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Figure 1: Participant Coverage in Fortune 1000 Cash Balance Plans

The earliest known cash balance plan has been in use since 1925, but such 

plans have become prominent since the 1980s. The earliest a firm in our 

survey had adopted a cash balance plan was 1985; more than 60 percent of 

the cash balance plans we identified have been adopted in the past 5 

years.13 Firms sponsoring these plans exist in many sectors of the economy, 

but the 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 who had been covered by different plans. Most firms in our 

survey that sponsor cash balance plans previously covered their workers 

under another defined benefit plan. Other firms started cash balance plans 

as their first pension plan or to supplement existing defined contribution 

plans.

While we were told by pension practitioners, employer associations, and 

agency officials of firms’ continuing interest in cash balance or similar 

13Our survey of 1999 Fortune 1000 firms indicates that sponsors of cash balance plans can 

adopt these plan formulas in several ways—by converting from a prior defined benefit 

formula, freezing a prior plan and starting a new cash balance plan, or starting a new cash 

balance plan as a first pension plan. 

Active Participants

0

8%

10,000+

31%

1-999

17%

1,000-9,999

44%

No Active Participants
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hybrid plan designs, few of the firms we surveyed expected to adopt a cash 

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

that they were considering whether to adopt a cash balance plan within the 

next 5 years, and about a third of these, or 1 percent of Fortune 1000 firms, 

told us that they plan to adopt a cash balance plan next year. All the firms 

considering adopting a cash balance plan told us that the continuing 

uncertainty as to whether such plans violate pension and age 

discrimination laws might discourage them from converting their plans. 

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 to address 

changing workforce demographics. For example, some firms decided to 

adopt cash balance plans in order 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 

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

could be adversely affected by a change to 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 in 

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 PricewaterhouseCoopers survey of 100 

cash balance plan sponsors found that 56 percent of firms expected the 

long-term 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. 

14PricewaterhouseCoopers, A UNIFI Survey of Conversions From Traditional Pension 

Plans to Cash Balance Plans (Teaneck, N.J.: July 2000). The study surveyed 100 conversions 

of traditional defined benefit formulas to cash balance formulas. 
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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.15 Instead, firms can 

convert to cash balance plans and achieve economic benefits from the 

surplus pension funds without incurring the 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 to be fully funded or 

overfunded—that is, the value of plan assets meet or exceed the value of 

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

plan’s assets earn a higher rate of return than the interest rate credited to 

hypothetical employee accounts, this can lower the overall cost of 

maintaining the cash balance plan.

Firms deciding not to adopt a cash balance formula cited increased costs as 

influencing their decision. These 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.

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 most cash 

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

15Participants 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 on the termination date.
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their pension benefit.16 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 generally received 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 

before conversion to 83 percent after conversion. Most of the firms we 

conducted in-depth interviews with stated that after conversion the 

majority of vested participants who have separated from the firm or retired 

opted for a lump sum payment, indicating its popularity.

Most firms that expressed a desire to attract and hire more mobile workers 

as a reason for converting did not, however, change their vesting 

requirement when converting from a traditional defined benefit plan to a 

cash balance plan. As under traditional defined benefit plans, workers 

under a cash balance plan must remain with a firm long enough to earn a 

right to such benefits. Large defined benefit plans typically have a “cliff”

vesting requirement—that is, participants are 100 percent vested in their 

benefits after a certain number of years, with no rights to a pension benefit 

if they leave the firm before then. Most of these large plans have 100 

percent vesting after 5 years. Seventy-two percent of the firms we surveyed 

with cash balance plans had a 5-year cliff vesting requirement, while the 

remaining firms sponsoring cash balance plans had various vesting 

requirements, including graded vesting.17

Finally, firms deciding 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, some employees may 

better understand and value such plans. Furthermore, according to 

company officials, given that many of these employees also have a 401(k) 

16Lump sum distributions received before age 59-1/2 and not rolled into an individual 

retirement account (IRA) or another qualified employer plan 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 IRA or a qualified employer 

retirement plan.

17Participants earn a right to a percentage of pension benefits over a period of up to 7 years.
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plan, the cash balance plan is more “visible” and comparable to benefits 

under the 401(k) plans.18 This is in contrast to the view many employees 

have of 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 focused on 

the benefits from a defined benefit plan until they neared retirement age. 

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 younger than 30 that increases in increments up to 11 percent 

for participants aged 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 were integrated with Social Security, provided participants 

with higher pay credits on pay above the Social Security wage base.19 For 

example, two plans provided 4 percent of pay for earnings that were 

subject to Social Security taxes ($76,200 in 2000) and 8 percent for earnings 

that were 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 tied 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 on the basis of the yield 

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

interest on the basis of the yield to maturity for 1-year Treasury bonds or 

another Treasury index.

18Conversely, firms deciding not to convert cited the visibility of cash balance plans in the 

press and the employee response to adverse publicity that has resulted from some 

conversions as a significant drawback of cash balance plans.

19For additional information about the integration of pensions with Social Security, see

Integrating Pensions and Social Security: Trends Since 1986 Tax Law Changes

(GAO/HEHS-98-191R, July 6, 1998).
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Conversions Can Be 

Advantageous for 

Some Workers but Can 

Result in Lower 

Benefits at Retirement 

for Others

Conversions to cash balance plans can result in higher pension benefits 

accruing earlier in a worker’s career and increased portability of benefits, 

which can be advantageous to younger or more mobile workers. However, 

the declining rate at which normal retirement benefits accrue in “basic”

cash balance plan formulas (providing a level pay credit for all workers) 

can result in older workers receiving smaller annuities after conversion 

from a plan with a final average pay formula, assuming that the traditional 

plan remained unchanged. Conversions can also result in periods during 

which older workers accrue no new pension benefits while others do. 

While most Fortune 1000 firms in our survey that adopted cash balance 

plans have included transition provisions to mitigate the effects of plan 

formula changes on some participants, these provisions can vary in the 

extent to which they accomplish this objective. 

Defined Benefit Plans With 

Final Average Pay Formulas 

Accumulate Benefits 

Differently Than Cash 

Balance Plans

Cash balance plans provide a larger share of a participant’s accrued benefit 

earlier in the worker’s career than a traditional defined benefit plan based 

on a final average pay formula. Traditional defined benefit plans express 

benefits as the normal retirement age annuity the participant has accrued 

to date. Typically, participants under a defined benefit plan with 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 usually increase as workers 

age. Generally, under a cash balance plan, the basis for determining 

benefits payable at normal retirement age includes both the hypothetical 

account balance (annual pay and interest credits) accrued to date plus the 

value of future hypothetical interest credits each pay credit would earn up 

to the plan’s normal retirement age. As shown in figure 2, workers under a 

cash balance plan who have many years before reaching normal retirement 

age earn a greater proportion of their benefits early in their careers. 
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Page 17 GAO/HEHS-00-185 Cash Balance Plans

Figure 2: Annual Annuity Benefits Under a Cash Balance Formula and a Final Average Pay Formula

Note: Figures based on participation in a traditional final average pay formula or cash balance formula. 

Results are based on the assumption of a $31,000 salary at age 25 (see app. I for details). Our 

assumption of equal benefits at the normal retirement age for purposes of illustration does not mean 

that the two formulas in this example would provide equivalent benefits at times other than normal 

retirement age or would result in equivalent costs to the sponsor. 

Cash balance plans can result in a decreasing rate at which normal 

retirement benefits accrue over time. The rate at which normal retirement 

benefits accrue in both defined benefit final average pay plans and cash 

balance plans depends on the number of years participants have remaining 

until they reach the plan-specified normal retirement age. However, in a 

defined benefit plan with a final average pay formula, the rate of normal 

retirement benefit accrual increases as participants age, being driven by 

growth in service and wages. As with defined benefit plans, under the law, 

the accrued benefit in cash balance plans must be expressed as an annual 

benefit beginning at normal retirement age. Cash balance plans must

Age

0

10,000

20,000

30,000

40,000

50,000

60,000

25 30 35 40 45 50 55 60 65

Annuity (Annual Retirement Benefit in Dollars)

Traditional Formula

Cash Balance Formula
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Page 18 GAO/HEHS-00-185 Cash Balance Plans

express benefits in this manner to comply with defined benefit plan rules.20

For the purposes of satisfying these rules, employee hypothetical accounts 

are not equal to the accrued benefits participants are entitled to receive. As 

a result, cash balance plans cannot simply provide participants 

hypothetical account balances as their benefit. Instead, the hypothetical 

balance must be calculated to comply with defined benefit plan accrual and 

other requirements.21

When a worker’s hypothetical account balance in a given year is projected 

forward with hypothetical interest to normal retirement age, the rate of 

normal retirement benefit accrual declines as the employee ages, because 

each additional year’s pay credit will have one less year in which future 

interest will compound. This declining rate of accrual results from plans 

providing for future interest credits in accordance with IRS Notice 96-8. 

The notice discusses the applicability of defined benefit plan rules to cash 

balance plans and provides that the accrual of future interest credits 

attributable to hypothetical pay credits may be required in the year in 

which the pay credit is allocated to a worker’s account.

To demonstrate how a worker earns pension benefits under a traditional 

final average pay plan and a basic cash balance plan, we calculated several 

scenarios for workers of different ages. These hypothetical scenarios 

assume that a worker participates under either a basic cash balance plan or 

traditional final average pay formula (no conversion) until retirement and 

that the formulas result in equivalent benefits at retirement. In reality, 

workers may have very discontinuous work histories, work at many 

different places under various pension plans, or retire early.

Our comparative design scenarios illustrate the declining rate of normal 

retirement benefit accrual inherent in cash balance plans.22 The basic cash 

2026 U.S.C. 411 and 26 U.S.C. 417.

21In a calculation of the actual benefit, the hypothetical account balance is projected 

forward with interest earnings to the plan-specified 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 the assumptions for mortality and interest specified by federal 

regulations, to convert the normal retirement age annuity into an actuarially equivalent 

lump sum in current dollars.

22The comparative design scenario calculations are additional computations we performed 

outside our cash balance conversion simulations. See app. I for more information on these 

scenarios. 
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Page 19 GAO/HEHS-00-185 Cash Balance Plans

balance plans we simulated add annuity benefits to a participant’s total 

pension benefit at smaller dollar increments each year that the participant 

ages.23 For example, a 25-year-old worker who is assumed to participate in 

a cash balance plan until retirement at age 65 accrues an incremental 

annuity benefit of approximately $1,660 at age 26 but earns a smaller 

incremental benefit of about $630 at age 65. In contrast, the traditional final 

average pay plan provided normal retirement benefits at an increasing rate 

as workers age. The same 25-year-old worker earns an incremental annuity 

benefit of $310 at age 26 but earns a higher incremental benefit of about 

$2,440 at age 65. The basic cash balance plan produced a declining rate of 

normal retirement benefit accrual for all hypothetical workers we modeled. 

(See fig. 3.)

23We measure the rate of benefit accrual by calculating the incremental annuity benefit 

added by the traditional final average pay and cash balance formulas each year to the total 

annuity benefit. The incremental annuity added by both formulas for a given year is 

determined by subtracting the total annuity benefit of the previous year from the total 

annuity benefit of the current year. See app. II for a discussion of how cash balance 

accounts were converted to annuity equivalents. 
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Page 20 GAO/HEHS-00-185 Cash Balance Plans

Figure 3: Rate of Accrual for a Cash Balance Formula and a Traditional Final Average Pay Formula

Note: Results are based on the assumption of a $31,000 salary at age 25 and an entire career under a 

cash balance formula or a traditional final average pay formula. 

A cash balance plan’s declining rate of normal retirement benefit accrual as 

workers age is the reason some have charged that these plans are age 

discriminatory. Cash balance proponents define the accrued benefit as the 

employee’s hypothetical account balance. Under this definition, cash 

balance plans generate a level rate of accrual for all employees regardless 

of age and therefore do not appear to raise issues of disparate treatment of 

employees based on age. Critics state that cash balance plans, as defined 

benefit plans under the law, must express an employee’s accrued benefit as 

an annual benefit beginning at normal retirement age or the actuarial 

Age

0

500

1,000

1,500

2,000

2,500

3,000

25 30 35 40 45 50 55 60 65

0

500

000

500

000

500

000

25 30 35 40 45 50 55 60 65

Additional Annuity (in Dollars)

Cash Balance Formula

Traditional Formula
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Page 21 GAO/HEHS-00-185 Cash Balance Plans

equivalent to a deferred annuity.24 When cash balance plans are viewed in 

this way, the amount of the actuarially determined benefit is a function of 

the participant’s age and decreases as the participant ages. Therefore, 

critics argue, cash balance plans violate the prohibition on age 

discrimination. Federal agencies are considering the issue of whether cash 

balance plans violate age discrimination statutes. Participants have filed a 

number of court cases alleging that cash balance plans are age 

discriminatory but no definitive decision has been reached. 

There is uncertainty concerning whether plan sponsors must adhere to IRS’

guidance on calculating cash balance benefits. The methodology described 

in Notice 96-8 has been subject to legal challenge in federal court. Two 

recent U.S. Court of Appeals decisions have approved the methodology.25

When Notice 96-8 was issued, IRS characterized it as including proposed 

interest rate equivalencies that were to be incorporated in a subsequent 

regulation, but nothing more has been promulgated on this subject. 

However, IRS has determined whether cash balance plans comply with 

current defined benefit plan requirements on the basis of its position that 

Notice 96-8 represents current law. 

It should be noted that a cash balance plan can result in a declining rate of 

normal retirement benefit accrual over a worker’s career but not 

necessarily a lower benefit than a defined benefit plan with a final average 

pay formula would provide. The actual benefit that any individual worker 

would receive under either plan would depend on a variety of factors, 

particularly the actual design of the specific pension plan. Workers under a 

cash balance plan who leave a firm before retiring could ultimately achieve 

either a higher or a lower pension benefit at retirement. For example, a 

worker who elected a lump sum payment option could receive a higher or 

lower retirement benefit, depending on the rate of return of the 

investments and whether the money were preserved until retirement. We 

discuss these issues in more detail in another report we issued 

2426 U.S.C. 411(a)(7).

25Lyons v. Georgia Pacific Corporation Salaried Employees Retirement Plan, No. 99-10640, 

2000WL 1140673 (11th M.D.S.P. Cir. Aug. 11, 2000), reversing 66 F. Supp. 2d 1328 (N.D. Ga. 

1999), and Esden v. Retirement Plan of the First National Bank of Boston, No. 99-7210 (2nd 

Cir. Sept. 12, 2000), reversing 182 F.R.D. 432 (D. Vt. 1998).
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Page 22 GAO/HEHS-00-185 Cash Balance Plans

concurrently on the potential implications of cash balance plans on 

retirement income.26

Conversions to Cash 

Balance Plans Can Provide 

Higher Benefits for Some 

Workers

Conversions to cash balance plans can have distributional effects in terms 

of the lump sum benefits that favor vested younger workers and shorttenure workers. This group can be a significant percentage of a firm’s 

workforce, depending on the specific firm and industry. Plan sponsors told 

us that the vast majority of participants under cash balance plans elect a 

lump sum distribution rather than an annuity when they are given a choice. 

For many workers, these distributions can be greater than those provided 

by a plan with a final average pay formula.

We compared lump sum benefits that basic cash balance plans can provide 

with lump sum benefits from the traditional final average pay formula after 

conversion for the workers we modeled. 27 Compared with the final average 

pay formula, the basic cash balance plan formula can provide larger lump 

sum distributions for the younger workers we modeled for a period of time 

after conversion. For example, anytime within the next 14 years, a 35-yearold worker at conversion would receive higher lump sum benefits from the 

cash balance plan upon leaving the firm. As shown in table 1, a 30-year-old 

at conversion would when leaving a firm receive a larger lump sum 

distribution from the cash balance plan at any given age until reaching 53. 

Table 1: Lump Sum Distributions From a Traditional Final Average Pay Formula and 

a Cash Balance Formula After Conversion

26Cash Balance Plans: Implications for Retirement Income (GAO/HEHS-00-207, Sept. 29, 

2000).

27Working with plan consultants and actuaries, we developed a model that provides 

illustrative scenarios of the effects of conversion to a cash balance plan on the benefits of 

workers of different ages and tenure. While there is significant variation in cash balance 

plan designs, the design features we modeled for both the traditional and cash balance 

formulas, and related assumptions, are consistent with those that large firms commonly use. 

See app. II for information on our simulations. 

Age at separation Final average paya Cash balanceb

30 $2,476 $2,476

35 7,849 13,699
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Page 23 GAO/HEHS-00-185 Cash Balance Plans

Note: Results are based on baseline scenario assumptions for a 30-year-old worker at conversion and 

show several possible ages when the worker might leave the firm. The 30-year-old worker was 

assigned a tenure and income value at conversion that correspond to the worker’s age. Lump sum 

distributions paid from the traditional formula are calculated on the basis of annuity values that the 

formula would have produced had no conversion occurred and in accordance with IRC 417(e) 

regulations. Lump sum values are comparable at given ages but are not comparable across years. 

a

Based on normal retirement age annuity.

b

Nominal account balance.

As with traditional defined benefit plans, workers must meet a plan’s 

vesting requirement before they have a right to their accrued pension 

benefit. BLS reported that median tenure among all workers aged 25 and 

older was 4.7 years in 1998, indicating that some workers change jobs 

before vesting. As we discussed earlier, most cash balance plans, like many 

traditional defined benefit plans, have a 5-year vesting requirement. Plan 

sponsors we interviewed told us that the 5-year vesting requirement of 

many cash balance plans results in some short-term, mobile workers’ not 

benefiting from the higher benefits provided by cash balance plans because 

they leave before vesting and forfeit their accrued benefits.

In addition to increasing the value of preretirement lump sum distributions 

for many workers, conversions to cash balance plans can benefit workers 

in other ways. For example, because cash balance plans spread benefit 

accruals more evenly over a worker’s career than a traditional defined 

benefit plan with a final average pay formula does, workers can accrue 

higher benefits sooner. This is especially important for workers who 

change jobs frequently or move in and out of the workforce. According to a 

Society of Actuaries study of vested workers with 5 or more years of 

service, 45 percent of workers terminate employment before completing 10 

40 18,684 30,358

45 39,618 54,510

50 79,096 88,926

53 117,686 116,000

55 152,611 137,322

60 288,878 204,673

65 544,153 297,625

(Continued From Previous Page)

Age at separation Final average paya Cash balanceb
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Page 24 GAO/HEHS-00-185 Cash Balance Plans

years of service.28 This length of service allows workers to earn a right to 

their pension benefits. Generally, cash balance plans allow vested 

participants to receive preretirement lump sum distributions when they 

leave a firm. Many traditional defined benefit plans, however, do not offer 

such an option. When participants leave firms that sponsor final average 

pay or other traditional defined benefit plans, their normal retirement-age 

annuity benefits are frozen when they separate. Because many cash 

balance plan participants can receive preretirement lump sum 

distributions, they can invest these funds for retirement or transfer the 

distribution to their new employer’s pension plan. Finally, as with other 

defined benefit plans, PBGC insures cash balance plan participants’

benefits against the risk of benefit loss when a plan terminates with 

insufficient assets to pay promised benefits.

Conversions to Cash 

Balance Plans Can Reduce 

Older Workers’ Future 

Benefits 

Depending on the age of a participant at conversion and a plan’s design 

features, conversions of defined benefit plans with final average pay 

formulas to cash balance plans can result in lower annuities for some 

participants than they would receive if no conversion occurs.29 We used our 

model to compare the annuity benefit provided by a basic cash balance 

plan at normal retirement age with the annuity that a traditional final 

average pay formula would have generated at retirement had no conversion 

occurred and the traditional plan continued unchanged. After conversion, 

the decreasing rate of normal retirement benefit accrual in the basic cash 

balance plan we modeled produces a lower annuity at retirement compared 

with the annuity benefit that traditional final average pay formula would 

generate.30 For example, a 45-year-old worker at the time of conversion 

receives an annual annuity of about $18,500 at retirement from the cash 

balance plan instead of the $39,800 annuity the worker could have received 

28Steve Kopp and Lawrence Sher, “A Benefit Value Comparison of a Cash Balance Plan With 

a Traditional Final Average Pay Defined Benefit Plan,” The Pension Forum (Schaumburg, 

Ill.: Society of Actuaries, 1998). 

29Lower annuity benefits accrued after conversion to a cash balance formula may be offset 

to the extent that sponsors increase other benefits at the time of conversion. For example, 

several representatives of firms we spoke with stated that firms increased contributions to 

their defined contribution plan or added a stock-purchase plan to the benefit package.

30Except where indicated, the traditional final average pay formula we modeled does not 

include an early retirement subsidy, and neither the traditional formula nor the cash balance 

formula we modeled is integrated with Social Security. See app. I for more information. 
B-283648

Page 25 GAO/HEHS-00-185 Cash Balance Plans

from the defined benefit plan with a final average pay formula.31 Likewise, a 

worker 50 years old at conversion receives an annual annuity of about 

$17,800 from the cash balance plan rather than the $35,100 annuity the final 

average pay formula could have provided. For all workers we modeled, 

conversions to the basic cash balance plan resulted in lower annuities at 

the plan’s normal retirement age than resulting from the final average pay 

formula. 

For workers with equal salary and tenure at conversion, the basic cash 

balance plan we modeled produces the lowest annuity at retirement for the 

worker who was oldest at conversion. This results from older workers 

having fewer years after conversion to earn benefits from the cash balance 

formula and a lower rate of normal retirement benefit accrual compared 

with the prior final average pay formula. For example, we modeled benefits 

from a basic cash balance formula for a 35-, 45-, and 55-year-old worker 

with equal salary and tenure at conversion.32 At retirement, the worker who 

was 55 years old at conversion receives an annual annuity of $6,900 from 

the cash balance plan, while the 35-year-old and 45-year-old workers 

receive annuities of approximately $24,300 and $12,600 per year, 

respectively, at retirement (see fig. 4). Conversion to the cash balance plan 

resulted in lower annuities for each of these workers compared with the 

annuities they would have received had no conversion occurred. The rate 

of normal retirement benefit accrual generated by the cash balance plan is 

lowest for the 55-year-old worker (see fig. 5.) 

31Worker age refers to the age of a worker at conversion to a cash balance formula. The 45-

year-old worker has a salary of $45,000 and 20 years of tenure at conversion, and the 50-yearold worker has a salary of $47,000 and 25 years of tenure at conversion. App. II discusses the 

hypothetical worker profiles we developed.

32For all three workers whom we modeled, salary is $40,000 and tenure is 10 years at 

conversion.
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Page 26 GAO/HEHS-00-185 Cash Balance Plans

Figure 4: How Conversion to a Cash Balance Plan Potentially Lowers Annuities

Note: Model results are based on the assumption of $40,000 salary and 10-year tenure at conversion 

for both the 35-year-old and the 55-year-old worker at conversion. See additional assumptions in app. 

II.

Age

0

10,000

20,000

30,000

40,000

50,000

60,000

25 30 35 40 45 50 55 60 65

Annuity (Annual Retirement Benefit in Dollars)

} 55 Year Old

} 35 Year Old

Traditional Formula

Traditional Formula

Cash

Balance

Formula

Cash

Balance

Formula
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Page 27 GAO/HEHS-00-185 Cash Balance Plans

Figure 5: Incremental Benefit Accruals for Workers of Different Ages Under Different Formulas

Note: Model results are based on the assumption of $40,000 salary and 10-year tenure at conversion 

for both the 35-year-old and the 55-year-old worker at conversion. See additional assumptions in app. 

II.

Age

0

500

1,000

1,500

2,000

2,500

3,000

25 30 35 40 45 50 55 60 65

Additional Annuity (in Dollars)

Traditional Formula

Cash Balance Formula

Traditional Formula

Cash Balance Formula

} 55 Year Old

} 35 Year Old
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Page 28 GAO/HEHS-00-185 Cash Balance Plans

Conversions to Cash 

Balance Plans Can Create 

Periods When Participants 

Accrue No New Pension 

Benefits 

Conversions to cash balance plans sometimes result in “wearaway”

situations in which some workers do not earn additional pension benefits 

after conversion while other workers continue to accrue benefits.33 A 

wearaway period is created at conversion when a participant’s opening 

hypothetical account balance is set at less than the present value of his or 

her prior accrued benefits—that is, the amount benefits would currently 

equal if paid out as a lump sum. During wearaway, hypothetical pay and 

interest credit contributions do not represent new pension accruals until 

the cash balance account exceeds the value of benefits accrued under the 

prior formula. This is because workers who leave a firm during a wearaway 

period are entitled to receive the higher benefit they had accrued under the 

old formula before conversion.

Wearaway established at conversion tends to be longer for older workers. 

For example, the basic cash balance plan we modeled as establishing 

opening account balances at less than the present value of prior accrued 

benefits generated a 2-year lump sum wearaway for a 35-year-old worker, a 

4-year wearaway for a 45-year-old worker, and an 11-year wearaway for a 

55-year-old worker at conversion (see table 2).34 This is because older 

workers generally accrue larger benefits before conversion. Thus, older 

workers must wait longer before their hypothetical balances catch up to 

the value of prior accrued benefits and new benefits begin to accrue. 

Wearaway created at conversion is also problematic for older workers 

because these periods often occur during the years when the traditional 

formula would have provided the most favorable rate of pension benefit 

accrual for them had no conversion occurred. 

33See app. II for a discussion of how we determined opening balances and the assumptions 

we used in valuing prior accrued benefits. Except for simulations in which we modeled a 

lump sum wearaway at conversion, all opening balances were established by calculating the 

present value of prior accrued benefits in accordance with IRC 417(e)(3) at conversion. To 

model lump sum wearaway at conversion, we assumed a discount rate higher than the 

mandatory rate used to determine minimum distributions from defined benefit plans. 

34Assuming no change in the mandatory discount rate for determining the minimum lump 

sum distribution from defined benefit plans. At conversion, the 35-year-old worker has a 

salary of $40,000 and 10 years of tenure, the 45-year-old worker a salary of $45,000 and 20 

years of tenure, and the 55-year-old worker a salary of $47,500 and 30 years of tenure.
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Page 29 GAO/HEHS-00-185 Cash Balance Plans

Table 2: Lump Sum Wearaway Created at Conversion for a 45-Year-Old Worker 

Note: The 30-year Treasury rate represents the monthly rate for December of the previous year. 

Results are baseline scenario assumptions. The opening account balance was established as the 

present value of prior accrued benefits at the date of conversion, using an interest rate of 6.99 percent 

or the December 1997 30-year Treasury rate plus 1 percent. This example assumes no change in the 

mandatory discount rate (5.99 percent) used to calculate the lump sum value of prior accrued benefits. 

Lump sum values are comparable at given ages but are not adjusted to be comparable across years. 

App. II describes the model’s operation and the assumptions used in calculating pension benefits.

a

Minimum lump sum at conversion.

b

Valued at 6.99 percent.

We also simulated several examples in which workers’ salary and tenure 

were equal at conversion in order to determine whether the length of a 

wearaway created at conversion can differ for workers of different ages.35

In most of these simulations, the length of a lump sum wearaway created at 

conversion was extended 1 to 2 years for workers with equal salary and 

tenure but different ages. For example, we found that a 45-year-old faces a 

4-year wearaway at conversion, while a 55-year-old with the same salary 

and tenure at conversion faces a 6-year wearaway. Another simulation we 

modeled indicates that a 40-year-old worker faces a 3-year wearaway at 

conversion while a 50-year-old worker with the same salary and tenure 

faces a 4-year wearaway. Although our simulations show that differences in 

wearaway periods based on age can be small, the older worker faces the 

longer wearaway at conversion in every instance in which a difference in 

wearaway periods emerged.

Plan sponsors determine whether to create wearaway at conversion. When 

defined benefit plan sponsors provide accrued benefits as preretirement 

lump sum distributions, they must follow federally mandated assumptions. 

January 1 Value of prior accrued benefit Hypothetical cash balance account

1998 $30,849a $23,709b

1999 32,749 27,294

2000 34,774 31,157

2001 36,931 35,317

2002 39,231 39,792

35To model lump sum wearaway at conversion, we established opening account balances 

upon conversion, using a discount rate higher than the mandatory rate used to determine 

minimum distributions from defined benefit plans. For these simulations, all plan features 

and the discount rate were held constant.
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Page 30 GAO/HEHS-00-185 Cash Balance Plans

However, current federal law does not govern how plan sponsors set 

opening hypothetical account balances for cash balance plans, provided 

that a plan ensures that participants do not receive less than the present 

value of prior accrued benefits if they separate from the employer. Plan 

sponsors can set the opening balances with any discount rate and set of 

mortality assumptions they choose. Thus, at conversion, cash balance plan 

sponsors can select assumptions that establish opening account balances 

at amounts lower than those they would be required to pay as lump sum 

distributions of benefits accrued under the prior formula. Many firms, 

however, choose not to create a wearaway at conversion. According to a 

recent survey by PricewaterhouseCoopers, 60 percent of cash balance plan 

conversions that established opening account balances at the value of prior 

accrued benefits used a discount rate equal to or lower than the mandatory 

discount rate at conversion, thereby avoiding wearaway at conversion.36

Wearaway can also occur outside the control of plan sponsors after a 

conversion. In this instance, wearaway occurs because of fluctuations in 

the federally mandated discount rate for determining lump sum 

distributions from defined benefit plans. The value of the distributions rises 

when the mandatory discount rate falls, and the value falls when the 

mandatory discount rate rises. Therefore, a falling mandatory discount rate 

can generate wearaway while participants remain with the sponsor, even 

when no wearaway was created at conversion. For example, we modeled a 

scenario in which no wearaway was created at conversion and the 

mandatory discount rate changes after conversion. Table 3 shows that the 

fall in the discount rate 1 year after conversion causes the value of the 

annuity benefit accrued under the prior formula to exceed the value of the 

35-year-old worker’s hypothetical account balance, resulting in a wearaway 

period. Two years after conversion, the mandatory discount rate rises, and 

the lump sum value of the participant’s prior accrued benefit falls below the 

participant’s hypothetical account balance. 

36PricewaterhouseCoopers, A UNIFI Survey of Conversions From Traditional Pension 

Plans to Cash Balance Plans (Teaneck, N.J.: July 2000). Eighty-three of the 100 plan 

conversions established opening account balances as the present value of prior accrued 

benefits.
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Page 31 GAO/HEHS-00-185 Cash Balance Plans

Table 3: The Creation of Wearaway Periods After Conversion by Fluctuation in the 

Mandatory Discount Rate for Defined Benefit Plans

Note: The 30-year Treasury rate represents the monthly rate for December of the previous year. 

Results are for a 35-year-old worker at conversion and are based on baseline scenario assumptions. 

The lump sum values are comparable at given ages but are not adjusted to be comparable across 

years. App. II describes the model’s operation and the assumptions used in calculating pension 

benefits.

In addition to arising from conversion of a final average pay formula to a 

cash balance formula, wearaway can arise in relation to annuity benefits 

that participants have earned as of conversion. For purposes of this report, 

annuity wearaway refers to a period of time after conversion when the 

annuity benefit produced by the cash balance formula is less than the 

annuity benefit earned under the prior formula up to the date of 

conversion. Whether annuity wearaway results from conversion to a cash 

balance formula depends on several factors, including how the plan 

sponsor determines opening balances, the cash balance formula design, 

and whether the prior formula has an early retirement benefit. 

Annuity wearaways can arise as a result of conversion to a cash balance 

formula, depending on the form of annuity benefit that the worker selects 

and the design of early retirement benefits in the prior formula. Even when 

no lump sum wearaway is established at conversion, annuity wearaway can 

arise on the worker’s accrued normal or early retirement benefits. For 

example, as indicated above, the 45-year-old worker described in table 2 

has a 4-year lump sum wearaway, assuming the account balance is 

established with a 6.99 percent interest rate (the rate of return on 30-year 

Treasuries plus 1 percent), but there would be no lump sum wearaway if 

the opening account balance was established with a 5.99 percent interest 

rate. Table 4 is based on an example in which the participant’s opening 

account balance was established as the minimum lump sum distribution of 

prior accrued benefits from conversion of a final average pay formula with 

an early retirement subsidy. In this example, there is a wearaway on both 

the accrued normal retirement benefit and the early retirement benefit

January 1

30-year

Treasury rate

Value of prior

accrued benefit

Hypothetical cash

balance account

1998 5.99% $7,590 $7,590

1999 5.06 11,196 10,017

2000 6.35 7,553 12,649
B-283648

Page 32 GAO/HEHS-00-185 Cash Balance Plans

earned as of the date of conversion.37 Specifically, if the prior formula had 

included a subsidized early benefit, the 45-year-old worker who elects to 

receive early retirement benefits at age 60 has a 9-year wearaway of the 

early retirement annuity benefit even if the opening balance is established 

with the mandatory 417(e) discount rate.38

Table 4: Early Retirement Benefit Wearaway Payable at Age 60

Note: Results are for a 45-year-old worker with a $45,000 salary and 20 years of tenure at conversion. 

At conversion, the participant’s prior accrued normal retirement age annuity benefit is $10,188. The 

opening account balance was established as the present value of prior accrued benefits at the date of 

conversion, using an interest rate of 5.99 percent or the December 1997 30-year Treasury rate. The 

cash balance formula credits interest at 5.99 percent and credits pay at 5 percent. The prior formula’s 

early retirement subsidy is based on eligibility at age 55 with 30 years of service, where the normal 

retirement benefit is reduced by 4 percent annually for benefits received before age 62. 

a

Ninety-two percent of the normal retirement age benefit of $10,188.

37A 2-year wearaway on the participant’s prior accrued normal retirement annuity benefit 

occurred as a result of conversion to the cash balance formula.

38In the 10th year after conversion, the employee comes out of the wearaway period on the 

early retirement benefit because the life annuity beginning at age 60 is $9,373 annually, 

based solely on benefits before conversion, and is $9,679 annually, based on the hypothetical 

account balance at age 60 (which is the sum of the opening account balance established 

with a 5.99 percent interest credit rate, 10 years of pay credits thereafter from age 45 to age 

55, and 15 years of interest on those amounts to age 60 at 5.99 percent annually).

January 1 Final average paya Cash balancea

1998 $9,373 $6,196

1999 9,373 6,622

2000 9,373 7,038

2001 9,373 7,444

2002 9,373 7,840

2003 9,373 8,226

2004 9,373 8,603

2005 9,373 8,971

2006 9,373 9,379

2007 9,373 9,679
B-283648

Page 33 GAO/HEHS-00-185 Cash Balance Plans

Transition Provisions Vary 

in How They Mitigate the 

Adverse Effects of Plan 

Changes on Older Workers 

Most of the Fortune 1000 firms we surveyed that adopted cash balance 

plans included various provisions to mitigate the potential reductions in 

some workers’ benefits, but these provisions can vary in the extent to 

which they mitigate potential reductions in expected benefits.39 While 84 

percent of the firms in our survey that adopted cash balance plans included 

one or more features to mitigate potential reductions in future benefits for 

some or all participants, our analysis indicates that these provisions can 

provide varying levels of protection. Some firms protected against a 

potential reduction in future benefits by grandfathering plan participants at 

the time of conversion. Grandfathering allows eligible participants to 

continue accruing benefits under the prior formula or entails operating 

both formulas and providing eligible participants with the greater benefit. 

Grandfathering can be implemented in various ways, each affecting 

different groups of workers. For example, in one firm in our survey eligible 

participants who had a minimum of 60 points based on age and service at 

the date of conversion receive benefits from the formula that provides the 

greater benefit. Another firm in our survey allowed all participants aged 45 

and older with a minimum of 60 points, based on age and service, to 

continue accruing benefits under the prior formula. 

To mitigate the potentially adverse effects of adopting a cash balance 

formula on older participants, some firms incorporated features such as 

formulas that provide additional pay credits on the basis of a participant’s 

age or years of service or they increased opening account balances. For 

example, one plan in our survey provides additional pay credits that range 

from 5 to 10 percent (above the ongoing pay credit in the plan formula) for 

eligible participants 40 years old or older at conversion that increase with 

age. Another plan in our survey enhanced opening account balances by 

increasing initial balances on the basis of a specific percentage related to a 

participant’s age and service. 

Including age-weighted pay credits in the cash balance formulas that we 

modeled usually produced a larger annuity for the participant at retirement 

than the basic cash balance formula. We modeled conversions to several 

39Our analysis of transition provisions includes cash balance plans we identified as 

becoming operational through a formula amendment (conversion of a traditional defined 

benefit formula) and cash balance plans started as new plans after the plan sponsor froze a 

prior defined benefit formula. Measuring the effectiveness of various transition provisions 

in order to address the potential loss of expected benefits would require an analysis of 

individual plan designs and firm workforce data. 
B-283648

Page 34 GAO/HEHS-00-185 Cash Balance Plans

variations of cash balance formulas with weighted pay credits for 

hypothetical participants ranging from age 30 through age 55 at conversion, 

and they produced similar results. For example, a 45-year-old participant 

would receive an annuity of approximately $29,200 per year from a cash 

balance plan with weighted pay credits compared with $18,500 from the 

basic cash balance plan (see fig. 6). However, under another, less generous 

formula with age-weighted credits that we modeled, the same participant 

would receive an annuity of only $21,200.40

40We also modeled conversions to cash balance formulas with enhanced opening account 

balances and grandfathering provisions. See app. II for a discussion of the sensitivity 

analysis we performed regarding transition provisions.
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Page 35 GAO/HEHS-00-185 Cash Balance Plans

Figure 6: Comparison of Benefits From Weighted Pay Credit Formulas, Basic Cash Balance Formula, and Final Average Pay 

Formula

Note: Results are for a 45-year-old worker with 20 years of service. The pay credits in the more 

generous weighted formula ranged from 3 to 11 percent. The pay credits in the less generous formula 

ranged from 3 to 8 percent. We also modeled formulas with pay credits that ranged from 4 to 7 percent 

and 3 to 10 percent. 

Participants Often 

Receive Inadequate 

Information About 

Plan Changes

Current disclosure requirements provide only minimum guidelines that 

firms must follow on the type of information they provide participants 

about plan changes. We found wide variation in the type and amounts of 

information workers receive about plan changes. In many instances of 

conversions to cash balance plans, sponsors did not ensure that 

participants received sufficient information about plan changes that can 

reduce future benefit accruals.

Age

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

25 30 35 40 45 50 55 60 65

Annuity (Annual Retirement Benefit in Dollars)

Traditional

Formula

Basic Formula

Weighted Formula

(Less Generous)

Weighted Formula

(More Generous)
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Page 36 GAO/HEHS-00-185 Cash Balance Plans

Notice About Plan Changes 

May Not Adequately Inform 

Participants

Under current disclosure requirements, firms may have broad flexibility in 

the type of information they provide participants about plan changes. 

ERISA specifically requires that plan sponsors notify plan participants 

about any plan amendment that may significantly reduce the rate of future 

benefit accruals for some or all employees. Employers must provide the 

notice no later than 15 days before the implementation of an amendment.41

Notification must be in writing and must state that the plan formula has 

been amended as well as give the effective date of the amendment. 

However, the law does not specifically require that plan sponsors articulate 

the nature of the formula amendment or identify groups of participants 

who may be adversely affected. Also, no notice is specifically required for 

reductions to early retirement benefits. Consequently, the communications 

provided to employees typically vary from general statements about plan 

changes to specific examples of how conversions to cash balance plans 

might affect workers of different ages and tenure.

We found significant variation in the information provided to participants 

about conversions to cash balance plans. Some firms went beyond the 

minimum disclosure requirements and provided extensive information to 

participants about how the conversion to a cash balance plan could affect 

their benefits. Firms that provided extensive communications to plan 

participants often engaged in a communications process with them, 

sometimes a year or longer, before conversion. Disclosure included 

briefing participants and issuing them brochures or newsletters, benefit 

calculators to compare benefits under the traditional and cash balance 

formulas, and individualized benefit statements. Several plan sponsors we 

spoke with indicated that the firms designed a communications process to 

provide information to and give opportunity for dialogue with plan 

participants at regular intervals before conversion. The communications 

began with very basic information about a firm’s decision to convert to a 

cash balance plan and culminated with information about how the 

conversion might affect various groups of employees. One firm provided its 

employees the following notice about reductions in future accruals:

“Generally, the change we are making results in a reduction in the rate of future pension 

accruals. There will be no change in the basic pension formula for employees who are 

‘grandfathered.’ Reductions for those who are well into their working careers but do not 

41In contrast, if employers intend to terminate a pension plan, they must notify everyone 

affected, including current participants, between 60 and 90 days before the proposed 

termination date.
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Page 37 GAO/HEHS-00-185 Cash Balance Plans

meet the grandfathering criteria will be lessened to some extent through special transition 

provisions. There may be large reductions in the rate of future pension accruals compared 

to the current pension plan for those who are furthest from retirement today.”

Other firms, however, satisfied the notice requirement concerning 

reductions in future accruals by providing participants with the minimum 

amount of information necessary to satisfy the specific ERISA 

requirement—namely, a summary of the plan amendment detailing the cash 

balance formula or a copy of the actual plan amendment. It is likely that the 

technical language contained in the plan amendment is difficult to 

understand and does not adequately convey changes made to the plan or 

identify types of employees who might be adversely affected. 

Summary Plan Descriptions 

Can Provide Additional 

Information

Summary plan descriptions (SPD) are another means of providing 

information to employees about how conversions to cash balance plans 

can affect their pension benefits. New employees must receive a copy of 

the plan sponsor’s latest SPD 90 days after becoming covered by the plan. 

These descriptions are used to convey basic information about company 

pension benefits in clear, nontechnical language. 

We reviewed many of the SPDs of cash balance plans identified in our 

survey and found a range in the quality of information they contained. 

Some SPDs provided a clear statement regarding the nature of the cash 

balance plan, indicating that the accounts were hypothetical and that 

employees did not own the assets in the accounts. For example, one SPD 

we reviewed included the following description:

“Because your pension benefit grows as an account balance, it is referred to as a cash 

balance type plan. Although your benefit is referred to as an ‘account,’ no assets or funds are 

set aside to fund an individual account in your name. Rather plan assets are held and 

managed in a single retirement trust.”

However, many of the SPDs we reviewed did not clearly explain that the 

cash balance accounts were hypothetical and that participants did not 

actually own individual accounts as in a 401(k) plan. About half of the cash 

balance plan SPDs we analyzed did not make any reference to the 

hypothetical nature of cash balance plan accounts. Not stating that the 

accounts are hypothetical or making claims that the cash balance accounts 

are similar to 401(k) plan accounts can prevent plan participants from 

understanding how cash balance plans work and the benefits they are 

entitled to receive. For example, without making reference to the 

hypothetical nature of cash balance accounts, one firm described its cash 
B-283648

Page 38 GAO/HEHS-00-185 Cash Balance Plans

balance plan as a “personal retirement account” that grows on the basis of 

compensation credits and interest credits. Other summary plan 

descriptions or related plan information described cash balance plans in a 

similar manner, including providing illustrations of the growth in cash 

balance accounts alongside of examples of how 401(k) plan accounts can 

increase over time without explicitly explaining that participants did not 

“own” the cash balance accounts and did not control how the assets are 

invested.

Conclusions Cash balance and similar hybrid plans have become more common among 

large firms than they were in the 1980s and point to a desire firms have to 

offer pension benefits that more closely complement their business 

strategies. In particular, conversions to cash balance plans allow firms to 

redistribute pension benefits among different groups of employees. This 

redistribution can be advantageous for young or mobile workers but can 

have adverse effects for older workers. Recognizing that some workers 

face reductions in future benefits or periods of no new benefit accruals, 

many firms have adopted transition provisions to mitigate the loss of 

expected benefits for some of their workers. The trend toward cash 

balance plans and other hybrid plan designs underscores the challenge of 

developing a pension system that provides retirement income for a broad 

complement of workers while ensuring benefit equity among various 

groups of workers. 

The increased use of cash balance plans highlights the growing mismatch 

between the continuing innovation in pension plan design and a regulatory 

framework that is much slower to adapt to new designs. Although cash 

balance plans legally are defined benefit plans, they do not fit neatly within 

the current defined benefit plan regulatory structure. Consequently, this 

mismatch has now resulted in considerable regulatory uncertainty for 

employers, as well as litigation with potentially significant financial 

liabilities and contradictory court decisions. For many workers, this 

mismatch has also raised questions about the security of their retirement 

income and the rights they have to their pension benefits. As a result, 

additional protections are needed to address issues raised by the 

emergence of cash balance and similar hybrid plan designs. For example, 

requirements for setting opening account balances could protect plan 

participants, especially older workers, from experiencing periods of no 

new pension accruals after conversion while other workers continue to 

earn benefits.
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Page 39 GAO/HEHS-00-185 Cash Balance Plans

Another major issue in the debate over cash balance plan conversions has 

been the clarity and usefulness of information provided to employees about 

changes in their retirement benefits. We found considerable variation in the 

clarity and comprehensiveness of the information disclosed to employees 

affected by past plan conversions. At a minimum, employees should have 

clear, understandable information about pension plan modifications that 

will help them make intelligent employment and retirement savings 

decisions. Such information is especially important when workers must 

choose whether to remain under a traditional formula or participate in a 

cash balance plan. Participants could benefit from more timely notice of 

plan changes that can reduce future benefit accruals. Such an extended 

notification period would be comparable to the advance notice provided in 

the event of a proposed pension plan termination and would provide 

participants more time to evaluate plan changes and the potential effects 

on their benefits. The notice could also provide employees a clear, written 

description about changes to the plan and which groups of participants 

might have lower future benefit accruals under the amended plan.

Matters for 

Congressional 

Consideration

To improve disclosure related to pension plans, the Congress should 

consider amending ERISA so that it specifically requires firms to provide 

participants with more timely information, in plain language, about plan 

changes that can reduce future pension benefits. Such notice could be 

provided to employees no less than 90 days before the effective date of the 

plan amendment rather than the current 15 days. This notice requirement 

could also be expanded to include instances in which a plan amendment 

will significantly reduce or eliminate early retirement benefits. 

To better ensure continuity of pension accruals for workers affected by 

conversions to cash balance formulas, the Congress should consider 

amending the Internal Revenue Code and ERISA to establish requirements 

to prevent firms that convert to cash balance plans from creating a 

wearaway period at conversion on the value of prior accrued benefits on an 

annuity and lump sum basis.

Recommendations To address the continuing regulatory uncertainty concerning cash balance 

and other hybrid plan designs, the relevant federal agencies should take 

steps to clarify how these plan designs will be treated under current 

pension law. Specifically, we recommend that the Secretary of the Treasury 

direct the Commissioner of Internal Revenue to continue the effective 
B-283648

Page 40 GAO/HEHS-00-185 Cash Balance Plans

moratorium on determination letters approving conversions to cash 

balance or similar hybrid plan designs until IRS acts on our 

recommendations by promulgating regulations addressing key issues 

concerning these plans. 

We also recommend that in clarifying the regulatory treatment of cash 

balance and similar hybrid plans, the Secretary direct the Commissioner of 

Internal Revenue to 

• develop a regulatory framework that—where appropriate on issues 

under its authority, including coordination with other appropriate 

agencies such as EEOC—provides requirements on key issues for cash 

balance and similar formulas, recognizing the hybrid nature of these 

new plan designs, and 

• define the accrued benefit provided by cash balance plans under the 

framework for hybrid pension plans. 

We also recommend that the Secretary of Labor direct the Assistant 

Secretary of the Pension and Welfare Benefits Administration, under 

authority as provided by ERISA, to amend the disclosure requirements for 

summary plan descriptions and summaries of material modifications to 

plans to 

• include a clear statement regarding the hypothetical nature of cash 

balance accounts, including that employees do not own the accounts, 

and how such accounts differ from any defined contribution accounts 

an employer may also provide and 

• clearly identify the potential of the conversion to reduce future pension 

accruals and early retirement benefits and under what circumstances 

such reductions are likely to occur. 

The Secretary of Labor should also direct the Assistant Secretary of the 

Pension and Welfare Benefits Administration to develop standardized 

language that firms may use to meet the amended disclosure requirements.

Agency Comments We provided EEOC, IRS, Labor, and Treasury the opportunity to comment 

on a draft of this report. Treasury generally agreed with our findings, 

conclusions, and recommendations and agreed that legislation like that 

proposed in our matters for congressional consideration is needed. 

Treasury’s comments are included in appendix IV. In its comments, IRS 

concurred with Treasury. In their comments, EEOC and Labor also 
B-283648

Page 41 GAO/HEHS-00-185 Cash Balance Plans

generally agreed with the report’s findings, conclusions, and 

recommendations. Treasury and Labor said that they are currently 

considering the appropriate course of action to take in response to our 

recommendations. 

Treasury and Labor also provided technical comments, which we 

incorporated where appropriate, including clarification of our 

recommendations. 

We are sending copies of this report to the Honorable Charles E. Grassley, 

Chairman, Senate Special Committee on Aging; the Honorable Lawrence H. 

Summers, Secretary of the Treasury; the Honorable Alexis M. Herman, 

Secretary of Labor; the Honorable Ida L. Castro, Chairwoman of the Equal 

Employment Opportunity Commission; the Honorable Charles O. Rossotti, 

Commissioner of Internal Revenue; and others who are interested. We will 

also make copies available to others on request.

If you or your staffs have any questions concerning this report, please call 

me on (202) 512-7215. Major contributors to this report are Charles A. 

Jeszeck, George A. Scott, Daniel F. Alspaugh, Jeremy F. Citro, Andrew M. 

Davenport, Lise L. Levie, and Roger J. Thomas.

Barbara D. Bovbjerg

Associate Director, Education, Workforce,

 and Income Security Issues
Page 42 GAO/HEHS-00-185 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 

1999 Fortune 1000 firms with cash balance plans as of July 2000.1

We obtained plan documents, including summary plan descriptions (SPD) 

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 includes data 

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

requirements, how opening balances were established, cash balance plan 

features, and whether transition provisions were provided. 

For each variable in the data collection instrument as well as for 

information on plan features that we obtained from plan documents, we 

developed a database to compile and analyze plan data. Counts were 

performed to generate the frequency of occurrence for each variable in the 

database and particular plan features. The percentage and number of 1999 

Fortune 1000 firms that sponsor cash balance plans as well as the number 

of participants in those plans were calculated at the 95 percent confidence 

level. The other statistics we report from our survey on cash balance plans 

represent sample statistics. 

1

To calculate the population estimate from the sample proportion, the assumption is 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-00-185 Cash Balance Plans

Interviews With Cash 

Balance Plan Sponsors

We conducted in-depth 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 in-depth the reasons why employers 

converted and how plan sponsors implemented conversions to cash 

balance plans. We selected firms judgmentally 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 are nonprofit 

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

the report to provide relevant examples and context. We do not mention 

firm names in order to preserve confidentiality. We provided a pledge of 

confidentiality to firms that provided us proprietary information.

Comparative Design 

Scenarios

To analyze how traditional final average pay formulas and cash balance 

formulas determine the amount of pension benefits, we calculated 

comparative design scenarios that show how benefits accrue over a 

worker’s career. For these scenarios, we assume that a hypothetical worker 

spends an entire career with a sponsor of a traditional final average pay 

plan or cash balance plan to illustrate how traditional final average pay 

formulas and basic cash balance plans provide pension benefits.2

 Because 

these scenarios are not intended to compare pension benefits received at 

any age or to illustrate the potential effects of conversion, we equalized 

annuity and lump sum benefits provided by the two formulas at age 65 the 

assumed normal retirement age. Our assumption of equal benefits at the 

normal retirement age for purposes of illustration does not mean that the 

two formulas in this example would provide equivalent benefits at times 

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

sponsor. The traditional final average pay formula provides an annuity 

commencing at age 65 based on years of service, a multiplier of 1.0 percent 

of pay, and the worker’s average final (previous) 5 years of salary. An early 

retirement subsidy was not incorporated into the traditional formula for 

these examples. We assume that cash balance plan benefits are based on 

2

We modeled lifetime participation scenarios for workers commencing employment at ages 

25, 35, 45, and 55. Worker income at age of employment is based on median incomes for fulltime workers who reported participation in a pension or retirement plan by age computed 

from analyses of the March 1999 Demographic Supplement to the Current Population 

Survey. 
Appendix I

Scope and Methodology

Page 44 GAO/HEHS-00-185 Cash Balance Plans

5.99 percent interest credits (rate of interest on the 30-year Treasury note in 

December 1997) to employee “accounts.” To equalize pension benefits at 

age 65, we held the traditional formula accrual factor and the cash balance 

formula interest credit rate constant and solved for the cash balance plan 

formula’s pay credit. For example, the 25-year-old worker we modeled 

participates in a cash balance plan that credits 5.9 percent of pay for each 

year of participation. 

We converted cash balance nominal account balances to annuity 

equivalents by projecting account balances forward to age 65 (the assumed 

normal retirement age) with the interest credit rate and applying an annuity 

conversion factor, which converts the projected balance to an annuity 

equivalent commencing at age 65. The annuity conversion factor consists 

of a discount rate (5.99 percent, or the rate on 30-year Treasuries as of 

December 1997) and unisex mortality assumptions from the 1983 Group 

Annuity Mortality table.
Page 45 GAO/HEHS-00-185 Cash Balance Plans

Appendix II

Pension Benefits Simulation Model ApendxiI

We used a computer simulation model to examine the potential effects of 

converting to a traditional defined benefit plan with a final average pay 

formula to a cash balance formula on the pension benefits for individual 

workers of different ages and tenure. We designed this actuarial model as 

an Excel file in consultation with actuaries from pension-related 

government agencies. To conduct simulations, users must input various 

parameter values to specify the design of the traditional and cash balance 

formulas, worker characteristics at conversion, and key interest rates. The 

model permits considerable flexibility in plan design, particularly for cash 

balance formulas. This flexibility includes varying the assumptions used to 

determine opening account balances and the level and structure of pay and 

interest credits. We conducted nearly 100 simulations reflecting various 

features of employer-sponsored traditional and cash balance pension plans. 

We specified parameter values for the scenarios discussed in the report 

that we based on our comprehensive review of actual cash balance plan 

conversions. This review included industry-specific data, our survey of 

Fortune 1000 firms, in-depth interviews with firms that converted to cash 

balance plans, and interviews with knowledgeable actuaries, consultants, 

and government officials. 

To analyze the potential effects of conversion from a traditional final 

average pay formula to a cash balance formula, the model computes 

benefit streams in dollars for annuity and lump sum benefits provided by 

both formulas. The model computes these streams provided by both 

formulas annually up to the plan’s normal retirement age of 65. This allows 

us to compare annuity and lump sum benefits after conversion for 

individual workers for any age at the time of conversion until age 65. To 

understand the potential effects on workers’ pension benefits that result 

from conversion to a cash balance formula, both annuity and lump sum 

benefit streams must be calculated. By computing benefit streams, we are 

able to compare benefits provided by the two formulas at any point in time 

upon conversion until retirement.1

1

Industry studies that examine the potential effects of conversions to cash balance formulas 

also model examples to provide illustrative analysis. These studies compute benefit streams 

to allow the comparison of pension benefits that workers receive under various conversion 

scenarios. For example, see The Unfolding of a Predictable Surprise: A Comprehensive 

Analysis of the Shift From Traditional Pensions to Hybrid Plans (Watson Wyatt Worldwide, 

1999) and Larry Sher, “A Workable Alternative to Defined Benefit Plans,” Contingencies

(Sept.-Oct. 1999), pp. 4-7.
Appendix II

Pension Benefits Simulation Model

Page 46 GAO/HEHS-00-185 Cash Balance Plans

Model Specification of 

a Traditional Defined 

Benefit Formula

In seeking to compare how workers fare in the event of a conversion to a 

cash balance formula, we use a benefit formula to represent a traditional 

defined benefit plan in place before conversion. The traditional defined 

benefit formula we model is based on a multiplier times the worker’s 

completed years of service times the average of the worker’s last 5 years’

earnings. At any given time, this formula provides a deferred annuity 

benefit (or a series of annual payments) that commences at the plan’s 

normal retirement age, defined as age 65 in our model. 

We chose to simulate benefits provided by a traditional defined benefit plan 

using a final average pay formula because most participants in defined 

benefit plans are covered by plans with a final average pay formula. 

According to 1997 data from the Bureau of Labor Statistics (BLS) on 

defined benefit plans sponsored by large and medium-size firms, 56 percent 

of covered employees participated in a plan based on terminal earnings or 

earnings during a specified number of years at the end of a worker’s career. 

The BLS study indicates that 78 percent of employees covered by a 

terminal earnings formula in 1997 received pension benefits based on a 5-

year averaging period. Also, a recent study by PricewaterhouseCoopers 

found that 78 of the 100 plan conversions it surveyed provided pension 

benefits based on a final average pay formula prior to conversion. Annuity 

benefits are calculated by the model because defined benefit pension law 

and regulations require all defined benefit plans to express accrued 

benefits in the form of an annual payment commencing at normal 

retirement age.2

 Traditional formula benefits are computed from the age of 

initial employment until the normal retirement age.

Model Specification of 

the Cash Balance Plan 

Formulas

Cash balance plans are defined benefit plans that provide participants with 

hypothetical accounts. The balances in these accounts are determined by a 

plan-specified formula that specifies a percentage of annual pay for each 

employee and pays interest on this amount at a rate or index of rates. In the 

event of conversion, plan sponsors generally establish opening balances by 

determining the present value of accrued benefits under the prior benefit 

formula at the time of conversion. 

The model computes benefits provided by cash balance formulas after a 

conversion from the traditional defined benefit formula to a cash balance 

2

26 U.S.C. 411(a)(7).
Appendix II

Pension Benefits Simulation Model

Page 47 GAO/HEHS-00-185 Cash Balance Plans

account formula. The cash balance formula provides hypothetical account 

balances and determines benefits on the basis of pay credits and interest 

credits contributed to workers’ accounts. To facilitate a comparison, we 

computed the benefits provided by the cash balance formulas we model 

from a worker’s age at conversion until the plan’s normal retirement age. 

Conversion from the traditional final average pay formula to the cash 

balance formula is based on computing the present value of the accrued 

benefit provided under the final average pay formula at conversion. Our 

survey of firms on the 1999 Fortune 1000 list indicates that plan sponsors 

who converted to a cash balance formula generally established opening 

account balances by determining the present value of prior accrued 

benefits. Mortality assumptions based on unisex 1983 Group Annuity 

Mortality rates and an interest rate prescribed by Internal Revenue Code 

(IRC) section 417(e) are used to determine the present value of the prior 

accrued benefit (annuity provided by the old formula) payable at the time 

of conversion.3

 The conversion to the cash balance formula is assumed to 

have been operational on January 1, 1998.

Our survey of 1999 Fortune 1000 firms indicates that there is a wide variety 

of cash balance plan designs among the firms that sponsor these plans. 

Thus, the simulation model does not seek to model any “typical” cash 

balance plan but permits analysis of a broad range of cash balance plan 

features common among actual plans. Because there is a variety of cash 

balance plans, we modeled numerous cash balance formulas including 

basic cash balance formulas that provide level annual pay credits to 

workers regardless of age and service as well as more complex cash 

balance formulas with age-weighted pay credits or enhanced opening 

balances. All the cash balance formulas we model are based on common 

features found in employer-sponsored cash balance plans. All simulations 

are illustrative, the model is not used to simulate pension benefits provided 

by any particular employer’s plan, and the model does not simulate pension 

benefits for any particular employer’s workforce. Instead, simulation 

results help explain how cash balance formulas provide pension benefits 

compared with traditional defined benefit final average pay formulas.

3

Converting the prior accrued benefit to a lump sum distribution in accordance with IRC 

section 417(e) ensures that a lump sum wearaway period is not created at conversion.
Appendix II

Pension Benefits Simulation Model

Page 48 GAO/HEHS-00-185 Cash Balance Plans

Underlying 

Assumptions for All 

Simulations

All the simulations we report, as well as those conducted in our sensitivity 

analyses, require a number of simplifying assumptions. We do not represent 

the simulations we undertook to be typical; rather, they illustrate how 

workers might fare under conversion to a cash balance formula. The model 

calculates a pension benefit stream for each formula, which permits 

analysis of the potential effects of conversion on the accrued pension 

benefits workers receive. Deferred annuity and lump sum benefits the two 

formulas provide can be compared at any age from conversion until 

retirement. Thus, users can compare preretirement lump sum distributions 

that workers receive at all possible ages of departure from the firm at or 

after conversion. Users can also compare annuity benefits received at 

retirement. 

The purpose of the model is to focus on the comparative effects on benefits 

for workers in the event of a conversion to a cash balance formula. The 

model does not simulate benefit portability scenarios based on turnover 

data or examine pension benefits based on participation in multiple final 

average pay or cash balance formulas. In reality, many individuals may 

have very discontinuous work histories and may work a number of 

different places before retirement. Except where specified in the text, we 

did not include early retirement subsidies in the traditional formula that we 

modeled, and in all cases, neither the traditional nor the cash balance 

formula is integrated with Social Security. The model does not incorporate 

other possible changes to a worker’s total benefit and compensation 

package that might accompany conversion to a cash balance formula (for 

example, the addition of a 401(k) plan or an increase in an employer’s 

match to an existing 401(k) plan). Because the model does not allow users 

to model age-based salary increases, we used BLS Economic Cost Index 

data to compute an average wage and earnings growth factor to reflect 

1990-98 wage growth among private sector workers. Interest rates, 

including the 417(e) rate, the conversion rate, and the annuity conversion 

factor (rate) used in the computation of pension benefits, are typically 

fixed throughout the modeling period, which begins at the age of 

employment and extends until retirement at age 65.

Specification of Model 

Parameters

The model operates through parameters for which users can select and 

input values. The parameters allow the manipulation of different factors, 

which then influence the model’s results. Our initial simulations for 

workers of various ages and tenure constitute a baseline scenario that 

models conversion from a traditional final average pay formula to a basic 
Appendix II

Pension Benefits Simulation Model

Page 49 GAO/HEHS-00-185 Cash Balance Plans

cash balance formula. All other simulations use sensitivity analysis, or the 

modification of one or more parameter values used in the baseline 

simulations, to analyze the potential effects of different types of cash 

balance formula design assumptions on workers’ pension benefits after 

conversion.

Parameters that the user can input values for are grouped into three broad 

categories. 

1. Worker characteristics: 

• worker age at conversion,

• worker salary at conversion,

• worker tenure (completed years of service) at conversion, and

• worker salary increase factor.

2. Pension formula parameters: 

• traditional formula multiplier (a percentage),

• cash balance formula interest credit rate,

• cash balance formula pay credit rate (level percentage or age-weighted 

pay credits), 

• an extra amount to a worker’s opening account balance (possible to add 

a flat dollar amount chosen by the user to opening account balances), 

and

• preretirement mortality factor (which is used for all simulations and 

each pension benefit calculation in simulations requiring mortality 

factors).

3. Interest rate parameters:

• 417(e) rate (which is always the plan-specified 30-year Treasury rate and 

must be used to calculate actuarial equivalents to the accrued benefits 

(deferred annuities) provided by defined benefit plans),4

• conversion rate (converts the prior accrued benefit to a lump sum value, 

which is used as the worker’s opening account balance), and 

4

According to regulations implementing changes to IRC section 417(e) as required by the 

Retirement Protection Act of 1994, defined benefit plan sponsors have some flexibility in 

selecting the 30-year Treasury rate they must use to calculate the lump sum value of accrued 

benefits.
Appendix II

Pension Benefits Simulation Model

Page 50 GAO/HEHS-00-185 Cash Balance Plans

• annuity conversion rate (converts projected cash balance accounts to 

annuity equivalents).

Assumptions of the 

Baseline Simulations

To establish a baseline from which to examine the potential effects of 

conversions to different types of cash balance formula design parameters 

and changes to other parameters such as interest rates, we modeled the 

conversion of a final average pay formula to a basic cash balance formula. 

Modeling conversion to a basic cash balance formula enabled us to 

demonstrate what can happen to the pension benefits of individual workers 

when a plan sponsor changes from a final average pay formula to a cash 

balance formula. (See table 5.)

Table 5: Assumptions for the Baseline Simulations We Report

a

The value we selected for the conversion rate in our baseline scenario established opening account 

balances as the present value of prior accrued benefits in accordance with IRC 417(e)—governing the 

determination of lump sum distributions from defined benefit plans. Unless we note otherwise in the 

text, all simulations we modeled converted prior accrued benefits using this rate.

The parameter values we selected for our baseline simulations, including 

the traditional and cash balance formula parameters, reflect common 

Factor Assumption

Traditional final average pay 

formula

Based on 1.25 multiplier times years of service times final 

average 5 years’ salary (high 5) 

Cash balance formula “Basic” formula design based on 5 percent level pay 

credits and 5.63 percent interest credits (1997 annual 

yield on 1-year Treasury bonds) contributed to worker 

accounts 

Worker salary at conversion Based on analysis of March 1999 Current Population 

Survey data by age and gender for full-time workers who 

participated in a pension plan

Annual salary increase 3.4 percent, based on analysis of BLS Economic Cost 

Index data

Mortality factors 1983 Group Annuity Mortality table unisex rates 

Conversion ratea Converts prior accrued benefits, or annuities, to opening 

account balances

Plan-specified discount rate Discounts annuities to present value: 5.99 percent, or the 

rate of return on 30-year Treasury bonds in December 

1997

Annuity conversion rate Converts cash balance accounts to age 65 annuity 

equivalents
Appendix II

Pension Benefits Simulation Model

Page 51 GAO/HEHS-00-185 Cash Balance Plans

features and factors found among actual plan designs. We selected all the 

assumptions used to specify the formula parameters for the traditional final 

average pay formulas and basic cash balance formulas we model on the 

basis of our consultation with knowledgeable consultants and actuaries. 

• The traditional final average pay formula accrual factor. We selected 

1.25, which is below the average accrual factor of 1.48 for final average 

pay plans BLS reported in its 1997 survey of large and medium-sized 

defined benefit plan sponsors. 

• Pay credits. The level pay credit of 5 percent we selected is based on our 

review of level pay credit rates that actual cash balance plans provide 

and our consultations with actuaries. Our survey of 1999 Fortune 1000 

firms indicates that about 35 percent of cash balance sponsors use a 

level pay credit in their formulas. According to a recent 

PricewaterhouseCoopers study, 28 of 100 sponsors surveyed that 

converted to a cash balance formula use a level pay credit, and the 

median rate is 4.5 percent. 

• Interest credit rates. The interest credit rates we assume in our 

simulations are common among actual cash balance plans. The majority 

of cash balance plan sponsors we identified in our survey of 1999 

Fortune 1000 firms use a rate tied to a Treasury security, such as the rate 

on the 30-year or the 1-year Treasury bond, to credit interest to 

participants’ hypothetical accounts. According to 

PricewaterhouseCoopers, the rate of return on 1-year Treasury bonds is 

the most commonly used rate (40 of 100 cash balance plans) to credit 

interest to participant accounts. 

• Nominal account balances. The cash balance formulas we model are 

designed to provide workers who receive benefits from the plan with 

the nominal account balance. All simulations use an interest credit rate−

the rate of return on 1-year Treasury bonds or the rate of return on 30-

year Treasury bonds—from the list of rates permissible under IRS 

Notice 96-8 to credit worker accounts. According to IRS Notice 96-8, 

cash balance plan sponsors who credit interest at a rate or index equal 

or tied to the yield on 30-year Treasury securities may pay the nominal 

account balance as the benefit distribution to a vested participant. The 

selection of 1-year and 30-year Treasury rates as the interest credits rate 

for the cash balance formulas we model is designed not to produce 

“whipsaw” effects at conversion or any time after conversion to the 

plan’s normal retirement age. 

• Mortality table for annuity calculation. For all simulations, we use 

unisex mortality rates from the 1983 Group Annuity Mortality table. 

Unisex mortality factors from this table are required by law to be used 
Appendix II

Pension Benefits Simulation Model

Page 52 GAO/HEHS-00-185 Cash Balance Plans

when calculating minimum lump sum distributions payable from 

defined benefit plans because the 1983 Group Annuity Mortality table is 

the current “prevailing commissioners’ standard table.”

5

 Our use of the 

rate of return on 30-year Treasuries is also consistent with mandatory 

IRC section 417(e) requirements for calculating lump sum distributions 

from defined benefit plans. Knowledgeable actuaries with whom we 

spoke indicated that using the rate of return on 30-year Treasuries and 

1983 Group Annuity Mortality unisex mortality factors is appropriate for 

other calculations requiring the use of mortality factors and an interest 

rate. Therefore, we use these assumptions to calculate the present value 

of prior accrued benefits to establish opening account balances and 

convert nominal cash balance accounts to age 65 annuity equivalents. 

Using the rate of return on 30-year Treasury bonds and 1983 Group 

Annuity Mortality unisex mortality factors also assured us that we did 

not create a lump sum wearaway upon conversion by establishing 

opening account balances at less than the present value of prior accrued 

benefits.6

Hypothetical Worker 

Assumptions 

To compare how traditional and cash balance formulas provide pension 

benefits and to assess the potential effects of conversion to a cash balance 

formula on pension benefits of different workers, the user can select values 

for worker age, salary, and tenure at conversion. Worker age represents 

how old a worker is at the time of conversion to the cash balance formula. 

We modeled workers at ages 30, 35, 40, 45, 50, and 55 at conversion to 

examine the potential effects of conversion on younger and older workers. 

The values selected for worker salary and tenure variables represent 

worker salary and years of completed service at conversion.

The worker profiles assume that employment began at age 25 for each 

worker and that the youngest worker we modeled completed 5 years of 

service by the time of conversion. Salaries at conversion are based on 

analyses of earnings and wage data from the Demographic Supplement to 

the March 1999 Current Population Survey for full-time workers who 

5

26 C.F.R. 1.417(e).

6

For the majority of simulations we performed, we did not create a lump sum wearaway at 

conversion. Unless we note otherwise, we established opening account balances, in 

accordance with IRC section 417(e), as amounts equal to the minimum lump sum 

distribution of prior accrued benefits that workers would be entitled to receive upon 

separation at conversion.
Appendix II

Pension Benefits Simulation Model

Page 53 GAO/HEHS-00-185 Cash Balance Plans

reported participation in their firm’s pension or retirement plan by age and 

gender. We used the Current Population Survey to compute earnings 

figures because it is the source of official government income statistics 

published by the Bureau of the Census. All salary values are median values 

for workers at the specific ages modeled. 

Analyzing the Potential 

Effects of Conversion on 

Worker Pension Benefits 

Because cash balance plans are designed to provide lump sum benefits but 

must also provide annuity benefits, a complete examination of the potential 

effects of conversion on the pension benefits of workers of different ages 

and tenure depends on analyzing the potential effects on both annuity and 

lump sum benefits. The model we used simulates both annuity and lump 

sum benefit streams provided by each formula.7

1. Annuity. The annuity provided by the traditional formula and the 

“annuity equivalent” to the cash balance account (nominal cash balance 

accounts converted to annuities at age 65).

2. Lump sum. The lump sum value of the accrued benefit from the 

traditional formula—minimum distribution in accordance with IRC 

section 417(e)—and the nominal cash balance account value, based on 

the establishment of an opening account balance at conversion. Lump 

sum values represent age-specific present values and are reported in 

nominal dollars.8

Annuity Comparison We examine annuities because cash balance plans legally are defined 

benefit plans and must provide an annual benefit commencing at normal 

retirement age, usually in the form of an annuity.9

 The model computes two 

annuity benefit streams for the traditional formula. One stream shows the 

traditional formula annuity from the initial age of initial employment up to 

the age at conversion, with the annuity amount frozen at conversion until 

7

All pension benefits computed by the model are beginning-of-year benefits.

8

Lump sum values represent the “present value” of the pension benefit at a specific age (or 

nominal value). That is, the lump sum value of a traditional formula annuity benefit for a 

worker at age 35 is the present value of the worker’s accrued benefit at that age. Also, the 

cash balance account a worker has accrued at age 35 is the “present value” of the cash 

balance formula’s benefit at age 35. Thus, cash balance account balances represent the 

present value of accrued pension benefits when the balance is paid out. 

9

26 U.S.C. 414(j) and 26 U.S.C. 411(a)(7). 
Appendix II

Pension Benefits Simulation Model

Page 54 GAO/HEHS-00-185 Cash Balance Plans

normal retirement age. The other stream shows the traditional formula 

annuity from the age of initial employment to the plan’s normal retirement 

age. 

For each year upon conversion, the model converts beginning-of-year 

nominal account balances to “annuity equivalents.” To calculate the annuity 

equivalent to the cash balance account, the model incorporates the 

methodology recommended in IRS Notice 96-8. We use the methodology 

prescribed by Notice 96-8 because defined benefit plans must express 

benefits as a function of the plan’s normal retirement age, whether as a 

series of annual payments or the actuarial equivalent of normal retirement 

benefits.10 According to IRS Notice 96-8, nominal account balances are 

projected to normal retirement age using interest credits specified by the 

plan. The projected balance is converted into a deferred age 65 annuity. The 

“annuity conversion” is calculated in accordance with the mortality factors 

and interest rate prescribed by Internal Revenue Code section 417(e).11 The 

annuity equivalent to the cash balance account determined by this 

methodology represents an annual benefit beginning at the plan- specified 

normal retirement age. The cash balance account annuity equivalent is 

directly comparable to the annuity provided under the final average pay 

formula. 

Lump Sum Comparison To compare the lump sum benefits provided by the two formulas, the 

model calculates the age-specific present value (lump sum) of the annuity 

produced by the final average pay formula. The age-specific present value 

of accrued benefits that defined benefit plans provide must be determined 

in accordance with IRC section 417(e). Under this requirement, annuity 

benefits are to be discounted to an actuarially equivalent amount, or a lump 

1026 U.S.C. 411(a)(7) and 411(c)(3). 

11For all calculations that convert a deferred annuity to a lump sum value, the mortality 

factors used are the unisex mortality factors from the 1983 Group Annuity Mortality table. 

This table is the current IRS Commissioner’s standard table that IRC section 417(e) requires 

be used in determining the present value of accrued benefits when defined benefit sponsors 

pay out lump sum distributions to vested participants. Unisex mortality factors used from 

1983 Group Annuity Mortality tables in conjunction with an interest rate, to establish 

opening account balances, convert projected cash balance accounts to annuity equivalents, 

and convert deferred annuities to lump sum values. For all simulations, the probability of 

surviving to retirement age and the probability of surviving each year beyond retirement age 

(once retirement age is attained) are incorporated into all the aforementioned pension 

benefit calculations.
Appendix II

Pension Benefits Simulation Model

Page 55 GAO/HEHS-00-185 Cash Balance Plans

sum distribution, that equals the present value of the annuity generated by 

the formula. The model incorporates the mortality factors and interest rate 

mandated by IRC section 417(e) to determine the present value of the 

traditional formula annuity benefit. The lump sum value of the traditional 

formula annuity benefit is the legal minimum payment that defined benefit 

plan sponsors can provide to vested participants who can receive benefits 

in a form other than an annuity commencing at retirement (if permissible 

under the plan). The model permits the calculation of lump sum values for 

the two annuity benefit streams produced by the final average pay formula. 

That is, the model calculates lump sum values for the final average pay 

formula annuity stream frozen at conversion until the normal retirement 

age, and it calculates lump sum values for the final average pay formula 

annuity stream produced from the age of initial employment out to the 

normal retirement age.

Implications of the Absence 

of Early Retirement Benefits 

Except in the case in which where we illustrate the wearaway of annuity 

benefits that can occur upon conversion to a cash balance formula, we did 

not simulate pension benefits provided by traditional formulas with early 

retirement benefit provisions. The majority of traditional defined benefit 

plans do include some form of early retirement benefit, and many include 

subsidized early retirement benefits.12 Early retirement benefits are 

designed into defined benefit pension plans by adjusting the accrued 

benefit (the deferred age 65 annuity determined by the plan formula) as of 

the date of early retirement to reflect the receipt of benefits at an earlier 

age and for a longer period of time. Adjustments to normal retirement 

annuities are based on early retirement factors or actuarial factors 

combining a set of mortality assumptions and an interest rate. Early 

retirement benefits can reflect full actuarial reductions, which discount the 

accrued normal retirement benefit to the date of early retirement. Early 

retirement benefits generated in this manner are termed “actuarially 

reduced” benefits. Early retirement benefits can also be subsidized or can 

reflect adjustments that do not actuarially reduce benefits to fully reflect 

receipt at the early retirement age. That is, defined benefit plans can 

stipulate a set of more favorable early retirement factors that reduce 

benefits on an actuarially partial basis (benefits are worth more at the early 

retirement age than if reduced on a purely actuarial basis). 

12According to BLS’ 1997 Employee Benefits Survey, 95 percent of employees who worked at 

a firm with 100 or more employees and were covered by a defined benefit plan participated 

in a plan that included an early retirement benefit in 1997. 
Appendix II

Pension Benefits Simulation Model

Page 56 GAO/HEHS-00-185 Cash Balance Plans

The absence of early retirement benefits in the traditional formulas we 

model has no effect on how the cash balance formulas we model provide 

benefits after conversion. The benefit stream and rate of benefit accrual 

provided by cash balance formulas after conversion are not altered by the 

presence or absence of early retirement subsidies in a final average pay 

formula before conversion. According to leading actuaries we spoke with, 

early retirement subsidies can be eliminated as a result of conversions to 

cash balance formulas but this does not affect how benefits accrue under 

cash balance formulas. 

Implications of Not 

Integrating Formulas With 

Social Security

Many defined benefit plan participants are covered by a plan that integrates 

benefits with Social Security.13 The model results would most likely be 

affected by integrating one or both of the pension benefit formulas 

simulated with Social Security benefits, but it is not possible to gauge 

whether the results would be more favorable or less favorable to the cash 

balance formula. Also, the earning levels of individual workers influence 

whether and how integration affects total pension benefits. 

There are two methods for integrating employer-sponsored defined benefit 

pensions with Social Security. The offset method reduces employee 

pension benefits as calculated by the plan formula by a portion of primary 

Social Security payments, or by the “offset” amount. Offset amounts may 

not exceed limits specified by federal law. The excess method involves 

adding two layers of benefits to determine the participant’s total pension 

benefit. The excess method applies the plan formula to determine the 

benefit for participant earnings up to an “integration level,” such as the 

Social Security taxable wage base or a specific fixed-dollar threshold. A 

second layer of benefits is computed at a higher rate for earnings above the 

integration level.14 Designing Social Security integration into our model 

could be more or less favorable to the cash balance formula, depending on 

whether integration was built into either the traditional formula or cash 

balance formula (or both) and the integration method used. 

13As we discuss above, according to BLS’ 1997 Employee Benefits Survey, 49 percent of 

employees who worked at a firm with 100 or more employees and were covered by a 

defined benefit plan in 1997 participated in a plan that was integrated with Social Security.

14See Dan McGill and others, Fundamentals of Private Pensions, 7th ed. (Philadelphia: 

University of Pennsylvania Press, 1996), pp. 324-31.
Appendix II

Pension Benefits Simulation Model

Page 57 GAO/HEHS-00-185 Cash Balance Plans

Sensitivity Analysis To enhance our analysis of the potential effects of conversion to cash 

balance formulas on the pension benefits, we conducted numerous 

sensitivity analyses by changing the cash balance formula design 

parameters. For example, we simulated an additional conversion scenario 

to an alternative basic cash balance plan. This alternative scenario was 

based on conversion from a traditional final average pay formula with a 

1.25 multiplier to a cash balance formula that provides flat 6 percent pay 

credits and 5.99 percent interest based on the December 1997 rate of return 

on 30-year Treasury securities. We also modeled conversion to five cash 

balance formulas with age-weighted pay credits that we selected from 

among cash balance plan sponsors we identified in our survey of Fortune 

1000 firms. For example, we modeled conversion to a cash balance formula 

with age-weighted pay credits ranging from 3 to 8 percent, and we modeled 

conversion to a cash balance formula with age-weighted pay credits from 3 

to 11 percent. We also modeled examples of conversions to cash balance 

formulas with enhanced opening balances, enhanced opening balances and 

age-weighted pay credits, and grandfathering provisions. These formula 

design assumptions did not change our key findings. 

The simulations we conducted reflect a range of features commonly found 

in cash balance formula designs, including conversions. We conducted a 

range of sensitivity analyses to assess the effects of changes to various 

model parameters, including cash balance formula design parameters. 

Parameter values for the simulations were selected on the basis of our 

review and analysis of actual cash balance plans sponsored by large 

employers, review of the literature on cash balance plans, and interviews 

with knowledgeable pension actuaries and consultants involved in cash 

balance plan designs. 
Page 58 GAO/HEHS-00-185 Cash Balance Plans

Appendix III

Cash Balance Plans and Minimum Lump Sum 

Distributions ApendxiI

IRC provides that any form of payment from a defined benefit formula 

other than an annuity must be the actuarial equivalent of an annuity 

beginning at normal retirement age.1

 The actuarial equivalent of an annuity 

commencing at normal retirement age is the present value or lump sum 

equivalent to the annuity benefit. IRC defines how the actuarial equivalent 

of a normal retirement age annuity must be determined. Specifically, IRC 

section 417(e)(3) stipulates that defined benefit sponsors that permit lump 

sum distributions must calculate distributions to departing participants by 

using a mandatory discount rate and a set of mortality assumptions. The 

mandatory discount rate is the rate of interest on 30-year Treasury bonds, 

and the current mortality table is the prevailing IRS Commissioner’s table 

used to determine reserves for group annuity contracts—the 1983 Group 

Annuity Mortality unisex table.2

 To determine the lump sum distribution of 

a participant’s accrued benefit under a traditional formula, the IRC section 

417(e) methodology must be applied to the individual’s accrued benefit. 

The actuarial present value of an annuity beginning at normal retirement 

age determined in accordance with federal regulations represents the 

minimum lump sum distribution payable under law to a departing vested 

employee.

Cash balance plans must pay accrued benefits as an annuity or the lump 

sum equivalent to a normal retirement age annuity.3

 Cash balance plans 

that provide preretirement lump sum distributions must do so in 

accordance with federal regulations governing defined benefit plans. 

Hypothetical account balances are proxies for the lump sum equivalent of 

participants’ accrued benefits. However, because cash balance plans do not 

initially express benefits as annuities commencing at normal retirement 

age like most other traditional defined benefit plans do, hypothetical 

account balances paid as lump sum distributions must be calculated as the 

actuarial equivalent of deferred annuities. This calculation ensures that 

cash balance plan sponsors pay separating employees the minimum benefit 

they are entitled to under the law.

Under a cash balance plan, the hypothetical account balance represented 

to the participant may not equal the minimum lump sum distribution the 

participant is entitled to receive. The extent to which the hypothetical 

1

26 U.S.C. 411(c)(3) and 29 U.S.C. 1054(c)(3).

2

26 C.F.R. 1.417(e)-1.

3

26 U.S.C. 411(a)(7), 26 U.S.C. 411(c)(3), and 29 U.S.C. 1054(c)(3).
Appendix III

Cash Balance Plans and Minimum Lump Sum 

Distributions

Page 59 GAO/HEHS-00-185 Cash Balance Plans

balance equals the minimum lump sum distribution payable from a defined 

benefit plan depends primarily on the relationship between two key 

interest rates—the rate at which the plan credits hypothetical earnings and 

the mandatory discount rate. If the plan interest credit rate exceeds the 

mandatory discount rate, the plan sponsor must legally pay a lump sum 

benefit greater than the participant’s hypothetical account balance, known 

as the “whipsaw” effect. Conversely, when the hypothetical account 

balance exceeds the minimum lump sum benefit payable, IRC does not 

prohibit a sponsor from paying the lesser amount.4

For example, a 35-year-old worker with a hypothetical account balance of 

$7,590 may receive a lump sum payment of $9,064 when the plan interest 

credit rate is 6.99 percent and the discount rate is 5.99 percent (see fig. 7). 

4

However, cash balance plan sponsors have stated that they will voluntarily pay the 

hypothetical account balance when the hypothetical balance is larger than the minimum 

lump sum distribution required under law.
Appendix III

Cash Balance Plans and Minimum Lump Sum 

Distributions

Page 60 GAO/HEHS-00-185 Cash Balance Plans

Figure 7: The Whipsaw Effect: Hypothetical Balance Is Less Than Lump Sum Benefit 

Note: At conversion the 35-year-old worker has a $40,000 salary and 10 years of service. See model 

assumptions in app. II.

Conversely, if the plan interest credit rate is 4.99 percent, the same 

employee receives a lump sum payment of $5,146 (see fig. 8).

Has

Account Balance

of $7,590 

Lump Sum

Benefit

$9,064

Projected to Age

65 Balance

$57,615

Annuity

Equivalent

$5,408

Project Forward With

6.99% Interest Credits

Convert to an

Annuity at

5.99%

Discount to

Present Value

at 5.99%
Appendix III

Cash Balance Plans and Minimum Lump Sum 

Distributions

Page 61 GAO/HEHS-00-185 Cash Balance Plans

Figure 8: Hypothetical Balance Is Greater Than Lump Sum Benefit

Note: At conversion the 35-year-old worker has a $40,000 salary and 10 years of service. See model 

assumptions in app. II.

IRS Notice 96-8 prescribes a methodology for cash balance plans to 

generate the actuarial equivalent of the annuity commencing at normal 

retirement age, which represents the minimum lump sum amount that can 

be paid under law. Calculating the minimum benefit amount payable under 

a cash balance formula requires additional steps beyond calculating the 

hypothetical balance. According to Notice 96-8, the participant’s 

hypothetical account balance must be projected forward to the date of 

retirement, using hypothetical earnings that are based on the interest credit 

rate specified by the plan. Hypothetical account balances are projected 

forward with interest credits to the plan’s normal retirement age because 

future interest credits are part of participants’ nonforfeitable benefits. That 

is, Notice 96-8 requires cash balance plans to be “front-loaded”—or 

requires determining accrued benefits by including all future interest 

earned on each year’s pay credit as of the date the pay credits were 

contributed to hypothetical accounts. Next, the projected balance is 

Has

Account Balance

of $7,590 

Lump Sum

Benefit

$5,146

Projected to Age

65 Balance

$32,710 

Annuity

Equivalent

$3,070

Project Forward With

4.99% Interest Credits

Convert to an

Annuity at

5.99%

Discount to

Present Value

at 5.99%
Appendix III

Cash Balance Plans and Minimum Lump Sum 

Distributions

Page 62 GAO/HEHS-00-185 Cash Balance Plans

converted into a normal retirement age annuity by using a plan-specified 

discount rate and mortality factors. Finally, the value of the normal 

retirement age annuity is discounted back to current dollars, using the 

mandatory discount rate—the rate specified by federal regulation that must 

be used to convert the benefit into an equivalent lump sum in current 

dollars—and mortality factors. 

IRS Notice 96-8 permits cash balance plan sponsors to pay hypothetical 

account balances as minimum lump sum distributions to satisfy defined 

benefit plan rules. To help sponsors avoid the potential for whipsaw, IRS 

guidance allows plan sponsors to pay the hypothetical balance as the 

accrued benefit by adopting an index from a list of recommended indexes 

for crediting interest to hypothetical accounts. Plan sponsors are allowed 

to credit interest on the basis of the rate of return to 30-year Treasury 

securities or on one of several indexes tied to the 30-year Treasury bond 

rate. 

The Notice allows a sponsor crediting hypothetical interest at a rate equal 

to or tied to the mandatory discount rate to pay the hypothetical balance if 

the sponsor uses one of the standard indexes that appear in the notice to 

credit hypothetical interest earnings.5

 As we stated above, figure 7 shows 

that because the 6.99 percent interest credit rate exceeds the 5.99 percent 

mandatory discount rate, the plan sponsor must pay a departing participant 

a lump sum distribution of $9,064, which is greater than the $7,590 

hypothetical account balance. However, the sponsor in this example would 

be allowed to pay a lump sum distribution of $7,590 when the interest 

credit rate is based on one of the standard indexes contained in the notice, 

even if that rate is higher than the mandatory discount rate, such as 6.61 

percent.6

 Although it is not explicitly stated in IRS Notice 96-8, federal 

agency officials stated that the Notice implies that a plan adopting a 

standard index may project the balance forward and discount it back, using 

the mandatory discount rate. As a result, the hypothetical account balance 

and the minimum lump sum benefit would always be assumed to be equal, 

regardless of any differences between the rate (as determined by the 

specific index) used to credit hypothetical earnings and the mandatory 

5

Provided that the plan also uses appropriate annuity conversion factors.

6

1997 annual yield on 30-year Treasury bonds at the time of conversion.
Appendix III

Cash Balance Plans and Minimum Lump Sum 

Distributions

Page 63 GAO/HEHS-00-185 Cash Balance Plans

discount rate. In practice, the hypothetical balance becomes the payable 

benefit.
Page 64 GAO/HEHS-00-185 Cash Balance Plans

Appendix IV

Comments From the Department of the 

Treasury ApendxiIV

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