Cash Balance Plan - Types of Pensions

Types of Pensions

The ubiquitous 401(k) plan is an example of a defined contribution plan because the Internal Revenue Code §414(i) states hat the term defined contribution plan means any plan that provides retirement benefits to a worker based solely on the amount contributed to the (worker’s individual) account and any (investment) income, gains net of any expenses and losses.

Under the definition of accrued benefit under Code §411(a)(7)(ii) in the case of a plan that is not a defined benefit plan, means the balance the employee’s account. On the other hand for defined benefit plans, Section §411(a)(7)(i) states that “accrued benefit” means “the employee’s annual benefit” as it is “determined under the plan … expressed in the form of an … … commencing at normal retirement age.” Finally, the Code’s definition for defined benefit plans are all plans that are not defined contribution plans.

Cash balance plans are defined benefit plans that look like defined contribution plans. A worker’s right to a pension in a defined benefit plan represents a contingent and hence uncertain financial obligation to the employer sponsoring the plan. Section 412 of the Code requires the employer to make annual contributions to the plan to ensure that the plan assets will be sufficient to pay the promised benefits later at retirement. As part of this process the plan is required to have an actuary perform annual “actuarial valuations” in which the present value of each worker’s “accrued benefit” is estimated and then each present value for each worker covered by the plan is added up so that the minimum annual contribution can be determined.

The “actuarial present values” for the “accrued benefit” for each worker is the lump sum dollar amount that represents the financial value of the employer’s liability on the date of the valuation. It does not include the future accrual of pension benefits nor does it include the effect of projected future salary increases. Thus the lump sum value for each worker is not based on that worker’s projected final salary at retirement, but only the worker’s salary on the date of valuation.