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Cash Balance question for Richard

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Richard - a couple of comments w/r to you response.

1) Isn't it true that the lump-sum based on the frozen benefit would change due to a change in interest rates and an increase in participant's age and could go up or down?

2)Isn't the accrued benefit based on the account balance at 65 (assume no early ret subsidy) converted to an annuity (of course grandfathering the frozen benefit)? As opposed to the frozen accrd benefit plus future account balance converted accruals? Or does it depend on the plan design?

3) And based only on the account balance, isn't it possible the lump sum could be greater than the account, due to 417(e) lump sum of accrued benefit?

Like to hear your thoughts


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OK, let me answer your questions by number.

#1 - yes, the "frozen" lump sum will increase due to age.

As far as the impact of changes in interest rates on the "frozen" lump sum, it depends on the lump sum conversion factors in the prior, traditional DB plan. If lump sums were based on the floating (e.g., PBGC or GATT) interest rates, then yes, the "frozen lump sum" will vary based on the actual PBGC or GATT factors in effect at the employee's termination.

However, if the lump sum conversion factors were more favorable, such as a flat 5% (always, of course subject to the PBGC/GATT rates if more favorable), then the flat 5% might have to be used (again, as long as it were more favorable than the PBGC/GATT rates at the employee's termination).

#2 - it depends on the plan design. The company could convert the accrued benefit into an initial account balance, and then add on future "interest and contribution credits" to this account balance. The employee would receive his new account balance, subject to the grandfathering requirement of his accrued benefit when the plan was switched to a cash balance plan (see #1 above).

Note that the conversion of accured benefit to an initial account balance can be done using the plan's lump sum factors or more restrictive lump sum factors. If the latter is used, the employee will likely be affected by the grandfathered minimum for a longer period of time.

Alternatively, the company could freeze the old accrued benefit (and keep it completely separate), and start a cash balance starting with a zero initial account balance. This would avoid the employee misunderstanding of cutbacks, etc. a la Wall Street Journal. This is like having two separate plans, the traditional DB plan being frozen and the cash balance plan ongoing (which, by the way, the employer could do).

I could also see an initial account balance being set up based on a formula unrelated to benefit from the old DB plan. The initial account balance would be computed by this formula, and the account balance would increase with "interest and contribution credits," again being subject to the usual grandfathered minimum, per #1.

Choices of other approaches are limited only by the plan sponsor's and actuary's imagination.

#3 - The problem you describe is known as the "whipsaw" effect. Here, the account balance must be defined in terms of an accrued benefit payable at NRD (say age 65). This is usually defined in terms of the interest crediting rate, and is calculated by projecting the account balance to age 65 with this interest crediting rate, and dividing by an immediate annuity factor (using this interest rate and the plan's stated mortality rate). With this deferred annuity calculated, the lump sum payable would be calculated by using the PBGC or GATT rate (or the plan's rate, if more favorable --- let's ignore this possibility, however). If the interest crediting rate were higher than the PBGC or GATT rate, the lump sum required to be paid to a terminating employee would be higher than the employee's current account balance.

This is a particularly serious problem, since the appeal of cash balance plans is for the employer to credit the employees with a favorable interest, not merely a money market type rate. The situation was worse pre-GATT due to the artificially low 417(e) PBGC rates; it has become somewhat better with the GATT rates.

The solution of an employer not offering lump sums prior to age 65 would theoretically solve the problem, but would be impractical. The inherent appeal of cash balance plans is not only allowing the employee to see his/her lump sum grow, but for him/her to take it when they leave.

The IRS issued a Revenue Ruling (or Notice or Announcement, I forget which) in early 1998. In it, they said that the 415(e) rates would not apply (and hence the whipsaw problem would go away) if the plan used one of several interest crediting rates. I believe these allowable rates were all tied to Treasuty Rates (or CPI), with a small margin allowed in some cases (such as 1 year Treasury Bond Rate plus 0.5%, I think). This, at least, is something, but it still doesn't solve the whipsaw problem for those companies that would like to credit a higher interest rate.

I have heard of rumblings of some innovative solutions to this problem, but they tend to be complex. Then again, if they work, the complexity is worth it.

Hope this helps.

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