Plan sponsors may be overlooking this readily available solution.
Key takeaways for plan sponsors
How often have you spent time and energy searching for something, maybe your phone or glasses, only to realize the object of your search has been sitting right in front of you the whole time? There it is—hiding in plain sight!
Employers and pension practitioners have been on a similar quest. For years, they’ve searched for a benefit solution that delivers true lifetime income and investment risk protection to employees, while also providing cost predictability and fiduciary coverage to sponsors.
Cash balance plans could be the solution hiding in plain sight.
As defined contribution (DC) plans have supplanted single-employer defined benefit (DB) as the preeminent U.S. pension model, investment risk has shifted to the participants. Target date funds are the preferred solution for investment risk management in DC plans, with glide paths designed to reduce return risk with age. These generally help reduce gross investment risk for individuals over time, but there is no risk sharing per se, as employers do not provide additional funding if the funds underperform. Losses necessarily result in lower retirement benefits.
The guaranteed income problem is harder. A variety of annuitization options have become increasingly popular as a feature within DC plans. Use of this feature appears to be limited today, likely due to practical hurdles. However, there are two logical reasons for this.
First, the act of handing over one’s life savings in exchange for a future stream of payments is difficult from a behavioral economics perspective. For decades, we’ve been conditioned to accumulate assets, and exchanging the fruits of our accumulation journey for an unknown number of future payments is a tough ask.
Most non-actuaries aren’t familiar with the mortality and interest rate assumptions built into the present value calculation used in annuity conversions, or how those assumptions may or may not align with their own expected future investment returns and longevity. The complexity of the decision usually results in inertia.
The second hurdle to annuitization is cost. Individual retail annuity pricing often reflects more conservative assumptions, including lower yields and/or longer life expectancy. This means retirees may need to hand over more dollars from their 401(k) accounts to receive each dollar of lifetime income. The disappointing exchange rate discourages utilization.
This leaves many to manage their own money through old age, trying to manage market risk and ration annual withdrawals to make their nest eggs last. Sadly, this can lead to two bad outcomes: exhausting their assets or being too scared to use them, leaving significant balances unspent at death. Independent investment advisors can be valuable partners in addressing this challenge, though they too face the same inertia hurdles to annuitization.
So, despite significant innovation, effort, and expense, the search for retirement security goes on…but wait, what’s this? Enter cash balance plans—a specific type of DB plan—as a significant solution to address these challenges.
In an incredible twist of irony, the solution to how to “DB-ize” current DC plans may be to offer DB plans.
Unlike traditional DB plans that define monthly payments at retirement, cash balance plans are expressed as hypothetical accounts that increase with annual pay and interest credits. Though the benefit looks like a DC account to employees, the characteristics of cash balance plans are very similar to traditional DB plans in the following ways:
- Employers are responsible for funding the plan and controlling the investment allocation.
- The Pension Protection Act specifies annual contribution requirements.
- Benefits are insured by the Pension Benefit Guaranty Corporation (PBGC).
- Pay credits are usually expressed as a percentage of compensation.
- Universal participation cash balance plans usually feature flat or graded pay credits based on age and/or service.
- Cross-tested cash balance plans use IRS-approved testing methods to provide key employees with higher retirement contributions than a stand-alone DC plan allows.
Cash balance plans aren’t new, having first been introduced over 40 years ago.
- Investment risk sharing
Flexible interest crediting rules allow sponsors to calibrate employer/employee investment risk sharing as desired. Those seeking to shield employees from DC market risk can instead deliver guaranteed flat (5%) or conservative index-based (30-year Treasury yield) returns through a cash balance arrangement. Risky interest crediting tied to actual portfolio returns is also allowed, but the law prohibits cash balance accounts from falling below the accumulated total of pay credits. - Annuity efficiency
One of the most significant and least understood benefits of cash balance plans is their favorable annuity conversion rate. Being DB plans, conversions of lump sums to lifetime annuities (and vice versa) are based on high-quality corporate bond rates which may produce a better yield than retail annuities. Unlike retail annuities, there are no expenses or commissions payable in cash balance conversions, further increasing the probability of a higher lifetime monthly benefit. - Reverse rollover
This advantageous annuity conversion can be leveraged beyond the value of benefits earned directly through the cash balance plan itself. Though not yet popular, rollovers from DC to DB plans are allowed. Adding this feature to a cash balance plan could allow employees to purchase additional lifetime pension benefits at a favorable rate using rolled-over funds.
One can envision a future “linked” DC and cash balance arrangement in which retiring employees simply decide how much lifetime income they need, and funds could be rolled between the two plans as needed to accomplish their goal. - Cash savings
Altruism is laudable, but cash balance plans can also provide financial benefits to employers, especially those already sponsoring overfunded DB plans. Surplus pension assets can be used in lieu of cash to cover benefit accruals, so delivering them through a cash balance plan can reduce or eliminate contributions for as long as the surplus remains. This was a significant factor in IBM’s reopening of its overfunded pension plan in 2024.https://www.milliman.com/en/insight/ibm-saves-billions-by-reopening-pension-plan
As of today, only nondiscretionary pay credits are permissible in cash balance plans, but that could change. Recent discussion drafts of a proposed “Cash Balance/401(k) Harmonization Act” would allow 401(k) matching contributions to be made directly into cash balance plans instead. While there is no certainty this will ever become law, it does present intriguing possibilities for retirement plan design.
In the end, the incredible irony may be that the solution to providing DB-like retirement income and risk sharing may be to offer a DB plan.
Sponsors and fiduciaries seeking to improve employee outcomes through predictable returns and efficient annuity conversions, while maintaining cost predictability, may find that cash balance plans are the solution for their workforce management needs.
And it’s been sitting there the whole time.
Mike Clark is a fellow of the Society of Actuaries (SOA) and a member of the American Academy of Actuaries (AAA) who enjoys investment and longevity risk protection through his employer’s cash balance plan.
If you are considering a cash balance plan, we can help.
No matter where you are in your pension journey—from accumulation to hibernation or transfer—we offer tailored solutions for each stage.