Converting a traditional DB Plan into
a Cash Balance Plan
Employers are not required to establish pension plans for their
employees because the private pension system is voluntary. Employers are also allowed
substantial flexibility in deciding whether to terminate or amend their
existing plans. Therefore, employers generally may change by plan amendment
their traditional pension plans and the benefit formulas they use.
Federal law does place restrictions on plan changes generally. For
example, advance notification to plan participants is required if, as a result
of the amendment, the rate that plan participants may earn benefits in the
future is significantly reduced. Additionally, there are other legal
requirements that have to be satisfied, including prohibitions against age
discrimination. In addition, while employers may amend their plans to cease
future benefits or reduce the rate at which future benefits are earned, they
generally are prohibited from reducing the benefits that participants have already
earned. In other words, an employee generally may not receive less than his or
her accrued benefit under the plan formula at the effective date of the
amendment. For example, assume that a plan's benefit formula provides a monthly
pension at age 65 equal to 1.5 percent for each year of service multiplied by
the monthly average of a participant's highest three years of compensation, and
that the plan is amended to change the benefit formula. If a participant has
completed 10 years of service at the time of the amendment, the participant
will have the right to receive a monthly pension at age 65 equal to 15 percent
of the monthly average of the participant's highest three years of compensation
when the plan amendment is effective. This pre-amendment benefit (including
related early retirement benefits) is protected by law and cannot be reduced.
In addition, there are additional restrictions that apply
specifically in the case of an amendment that converts a plan formula to a cash
balance plan formula. Specifically, participants must receive the sum of the
pre-amendment benefit plus benefits under the new cash balance formula (as a
result, there cannot be a "wear away" period during which the
participant does not accrue additional benefits, as could occur if participants
were merely entitled to the greater benefit). Furthermore, all benefits under a
cash balance plan (including benefits accrued prior to a conversion) must be
fully vested after 3 years of service.
Changing Formulas
When an employer amends its plan to convert the plan's traditional
defined benefit plan formula to a cash balance plan formula, the plan's assets
remain intact and continue to back all of the pension benefits under the plan.
Employers cannot remove funds from the plan, unless the plan has been
terminated and has assets remaining after payment of all of the benefits under
the plan.
If a participant has worked long enough to be vested under the
plan, the participant should receive the sum of (1) the accrued benefit under
the formula in effect before the amendment, and (2) the additional benefits you
earned under the plan formula in effect after the amendment. However, the
participant may have to wait until a retirement age under the plan to receive
your benefit.
Neither ERISA nor the IRC requires employers to give employees the
choice of remaining in the old formula. Employers have several options,
including:
- Providing no choice, replacing the old
formula and applying the new formula to all participants.
- Allowing employees to remain under the
old formula, while restricting new hires to the new formula.
- Stipulating that certain employees who
have reached a specific length of service or who have reached a certain age may
choose to stay with the old formula.
- The law permits employers to have such
flexibility, but whatever option applies has to satisfy legal requirements.
Under each of these options, benefits already earned by the
participants, as of the effective date of the amendment that converts the old
formula to a cash balance formula, may not be reduced.
Employee Notices
Many employers voluntarily provide helpful information about these
conversions in advance of the change becoming effective. If a participant is
not sure if they have enough information to understand the plan change, they
have a right to contact the plan administrator and ask for more information or
help in understanding the change and any choices in conjunction with the
change.
Plan administrators are generally required to give at least 45
days advance notice of plan amendments that significantly reduce the rate at
which plan participants earn benefits in the future.
After the plan is amended, the plan administrator is required to
provide all plan participants with a Summary of Material Modifications to the
plan or a revised Summary Plan Description. This document will summarize the
changes to your plan.
In addition, under the Age Discrimination in Employment Act
(ADEA), an employer requiring an employee to sign a waiver of rights and claims
when choosing between plans is required to provide enough information to enable
the employee to make a knowing and voluntary decision to waive ADEA rights. In
most cases, an employee must be given at least 21 days to sign the waiver and
at least 7 days to revoke the agreement.