Design of Plans
Some cash balance plans communicate to workers that these “actuarial present values” are “hypothetical accounts” because upon termination of service, the employer will give the former worker the option to take “all his money” from the pension plan out. In reality, if both the worker and employer agree, even in a normal defined benefit plan a former worker may take away “all his money” from the pension plan. There are no legal differences in this “portability” aspect between a traditional defined benefit plan and a cash balance plan.
A typical “design” for a cash balance plan would provide each worker a “hypothetical account” and pay credits in the current year of say 5% of current salary. In addition, the cash balance plan would provide an interest credit of say 6% of the prior year’s balance in each worker’s “hypothetical account” so that the current year’s balance would be the sum of the prior year’s balance and the current year’s pay credit and an interest credit on prior year’s balance. For a worker who starts at age 25 with a $2000 a month starting salary, he would start with a zero account balance and the first year’s pay credit would be $1200 leaving him with an end of first year balance of $1200 in his “hypothetical” account. Because his beginning of first year balance was zero, his interest credit for the first year is also zero. In his second year, with a 3.5% salary increase his monthly salary would be $2070 on his 26th birthday. The 5% pay credit for this second year would be $1242. Because his second year “hypothetical account” starts the year with a $1200 balance, the interest credit at 6% would be $72. Adding the beginning balance of $1200 to the $1242 pay credit and $72 interest credit would give an ending balance in the “hypothetical” account of $2514 ($2514 = $1200 + $1242 + $72) for the second year. Repeat this process for each ensuing year until termination. This creates a hypothetical account balance from which the legally required benefit -- an annuity payable for the life of the participant or beneficiary who elects to commence payment at normal retirement age(NRA) -- can be calculated. This is due to requirement that benefits be definitely determinable found in the IRS Regulations Section 1.401.
Read more about this topic: Cash Balance Plan
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