Cash Balance Plans: Insights, Framework and Solutions

Liability driven investing (LDI) has been established as an effective strategy to increase predictability and reduce volatility for defined benefit plan sponsors. Throughout this paper we compare and contrast a “traditional plan” to a “cash balance plan.” The employee benefit under a traditional plan is typically based on a mathematical formula that accounts for the number of years of service and the employee’s salary (or a fixed dollar per year of service) at retirement. The employer is then responsible for delivering the defined benefit pension payments, usually in terms of monthly income, upon retirement. 

In a cash balance plan, the benefits provided at retirement are linked to the contributions made by the plan sponsor (and sometimes the participant), accumulated up to retirement using a plan-defined interest crediting rate. The benefit is expressed as an account balance, much like a defined contribution plan. A common approach to determining the interest crediting rate for a cash balance plan is to peg it to either a 30-year or 10-year Treasury yield. At retirement, the accumulated account balance is paid out as a lump sum (an account-based benefit) or can be converted into an annuity form of payment (an annuity[1]based benefit similar to traditional plans). 

As the costs and risks of providing traditional final average pay pension plans have increased over time, and as employee preferences for portability and an easy to understand benefit have evolved, plan sponsors have looked to alternative forms of benefit design. Cash balance plans have become increasingly popular and have grown significantly within the retirement plan universe.