3721 / What rules apply for converting a traditional defined benefit plan to a cash balance plan?

The recent history of cash balance plans began with the IRS directive released on September 15, 1999 instructing field offices to stop reviewing determination letters applications for cash balance plans. The Economic and Tax Relief Reconciliation Act of 2001 (EGTRRA) added additional disclosure requirements in situations involving the conversion of a traditional defined benefit plan to a cash balance plan and imposed an excise tax on plan sponsors failing to comply with these disclosure requirements. The law also imposed an excise tax if the plan sponsor specifically fails to notify participants of a plan benefit reduction in accruals, which often occurs for older plan participants in a conversion and created much of the early controversy around such plans. IRS Notice 2007-6¹ was then issued in 2007 providing additional detailed guidance on the creation of cash balance plans, and reopening the letter determination programs for such plans then being held for review. This plan design has flourished since.

A traditional defined benefit plan that is converting to a cash balance plan is currently subject to certain rules on the crediting of participant benefits. The plan’s benefit after conversion must not be less than the sum of the participant’s accrued benefit for years of service before the conversion under the prior formula, plus the benefit the participant earns under the new formula for service after the conversion.² This formula is known by actuaries as an “A+B” approach.

The A+B approach is designed to eliminate a plan issue referred to as “wearaway,” which refers to situations where certain participants in the plan do not accrue any additional benefits until benefits under the prior plan are worn away to equal benefits under the new plan. This occurred in some conversions where older employees might not accrue additional benefits under the cash balance formula until their new hypothetical account balance caught up with their prior accrued benefit. Requirements for calculation of the present value of a participant’s accrued benefit in such cases are set forth in IRC Section 411(a)(13)(A) (effective for distributions made after August 17, 2006).