States and Localities Consider Cash Balance Plans

July 05, 2012

As public pension liabilities around the nation continue to grow, public officials and pension fund boards are looking into alternatives to traditional defined benefit (DB) pension plans. Two kinds of “hybrid” retirement plans have achieved particular prominence in the past year: plans that combine a smaller DB plan with a supplemental 401(k)-style plan, known as “DB+DC”[1] and cash balance (CB) plans. Pension reform legislation considered by the Illinois General Assembly during the spring legislative session included a cash balance component.

To understand how a cash balance or other hybrid plan differs from other pension options, it is important to know the basic provisions of the two most common plans in the public sector and private sector. According to the Bureau of Labor Statistics, 84% of public employees in the United States have access to a defined benefit plan and 58% of private sector employees have access to a defined contribution plan. A defined benefit plan provides a guaranteed lifetime retirement benefit based on years of service and final salary. The employer ensures there are sufficient assets in the fund to pay benefits and manages and invest assets. Employees typically are required to enroll.

A defined contribution plan provides a retirement benefit that is based on an account built up through employee contributions and employer contributions (if any). The employee generally makes most of the decisions including whether or not to participate, how much to contribute and how the account is invested, though there may be pre-determined investment options to choose from. Any balance in the account at retirement is the basis for the employee’s retirement income. Once the employee retires, the employer has no further obligations, other than health care if it is subsidized by the employer. A defined benefit plan is typically not portable, meaning that employees cannot take their accrued pension benefits with them if they leave government employ, just their contributions with or without interest. A defined contribution plan is completely portable and can be “rolled over” into individual retirement accounts, including any and all contributions made by the employer.

According to their proponents, hybrid plans retain many aspects of a traditional DB plan that promote retirement security for the employee while costing less to the employer and sharing various risks more evenly than either a traditional DB plan or a traditional DC plan. In a traditional defined benefit pension plan, the employer bears most of the actuarial, investment and longevity risks while in a defined contribution plan the employee bears most risks.

According to Pensions and Investments and the National Council of State Legislatures, more than 15 cities, counties and states have cash balance and other hybrid plans. As discussed in a previous blog post, in 2011 Rhode Island passed a landmark pension reform law that as of July 1, 2012 transferred its current employees to a DB+DC plan and will enroll new employees in the same plan. Virginia also chose to close its DB plan to new employees and created a hybrid plan for employees hired on or after January 1, 2014. Two states adopted cash balance plans in 2012, Kansas and Louisiana.[2] Louisiana will close its DB plans to new state employees and teachers as of July 1, 2013 and Kansas will close its DB plan to all new state employees in as of January 1, 2015.
 

What is a Cash Balance Plan?

While classified as a DB plan, cash balance retirement plans are quite different in structure from traditional final salary defined benefit pensions. Cash balance plans are like defined contribution plans in that an employee has a notional account and can receive the balance of her account as a lump sum at retirement. The employee’s account is also portable and can be rolled over to a new employer or individual retirement account. However, CB plans also operate like defined benefit plans in that a minimum benefit is guaranteed for the employee and the employer commingles the assets of all of the employee “accounts” for investment purposes and bears investment risk.

How it works: In a typical cash balance plan, the participant’s notional or hypothetical account is credited annually with set employer and employee contributions that are based on salary and each account also receives a minimum credit meant to simulate investment returns, generally based on government bond yields. Thus, each “account” grows at a rate somewhat above inflation and is guaranteed by the plan. If investments perform better than the guaranteed floor rate, many plans allow each account to receive part of the upside as a bonus credit, but there is no debit to the account if investments do not reach the minimum credit, protecting the employee from investment risk. Upon retirement the employee can choose to have the value of the account converted into an annuity that provides lifetime benefits or to receive the account value in a lump-sum payment.

Pros and Cons for the Employer: With a cash balance plan, the employer retains mortality risks for those employees who choose annuities. This is because the employer would be required to make up any shortfall in funding should the employee live longer than anticipated. The employer also retains investment risk that portfolio returns will not meet the floor rate, though the risk is somewhat less than for a traditional DB plan with a higher discount rate. However, because the retirement benefit in a CB plan is not based upon final salary, the employer is not exposed to the risk of end-of-career salary inflation and other pension gaming. With regard to recruitment and retention, CB plans are more attractive to a younger, more mobile workforce as they are portable and do not penalize employees who do not remain with one employer throughout their entire career. Because there is not a point at which employees maximize their benefits as with a DB plan, cash balance plan may also help retain experienced employees beyond their minimum retirement age. However, if an employer values longevity in an employee, a CB plan does not provide strong incentives for workers to remain with the employer their entire career to maximize a pension benefit. Finally, a CB plan may not reduce employer costs unless it is designed to provide a lesser benefit than a DB plan.

Pros and Cons for the Employee: In comparison to a defined benefit pension, a CB plan provides portability that is beneficial for mobile employees and people who leave the workforce for periods of time. The fact that CB plan value grows at the same rate throughout an employee’s career is also favorable for younger mobile employees, who accumulate less wealth in their younger years under a DB plan. Conversely, DB plans favor long-term, older employees and create an incentive for workers to remain with the employer in order to maximize the DB benefit. CB plan benefits are also arguably easier for employees to understand and track because they are expressed as an account balance throughout the career rather than a formula based on future years of service and salary. The guaranteed rate of return provides protection from investment risk in comparison to defined contribution plans, although some employees may prefer to direct their own investments in a defined contribution plan. In many cash balance plans, the guaranteed interest rate credit is less than a typical long-term equities market return. However, the guaranteed rate does provide protection from market downturns and pooled investments also benefit from lower fees than individual mutual fund accounts.
 

Cash Balance Plans in Illinois

In addition to its other provisions relating to reduced annual annuity increases and transfer of normal costs from the state to certain employers, pension reform legislation considered by the Illinois General Assembly during the spring session included a cash balance plan for new downstate and suburban teachers and university and community college employees. The major characteristics of the cash balance plan included in Senate Bill 1673, as amended, were:

• Employee contributions of 8%-9.5% of salary, depending on the type of employee;
• “Notional” employer contributions of 3.4% to 4.4% of salary, depending on the pension fund;
• Actual employer contributions based on the actuarial needs of the plan;
• 4% annual minimum interest credit;
• Provisions for sharing of investment returns above the 4% rate with a maximum interest credit of 10%;
• A retirement annuity based on the employee “account” balance, future interest return assumptions, an annual simple interest annual annuity increase of 3% and other actuarial calculations.

Additionally, Representative Daniel Biss introduced House Bill 6149 on April 5, 2012 that would create a cash balance plan for new members of all five state retirement funds hired on or after July 1, 2013. The legislation was not considered by either chamber of the Illinois General Assembly.

To read summaries of other public employer cash balance plan provisions, read the National Association of State Retirement Administrators, “NASRA Issue Brief: State Hybrid Retirement Plans” and “State Retirement Legislation 2009-2012” by Ron Snell of the National Conference of State Legislatures (NCSL).