Question

(a)   Explain how a cash-balance scheme works, outlining its common features with both defined-benefit and defined-contribution schemes.

Answer 1

·         Cash-balance Scheme.

A percentage of salary is set aside each year for each member. Each year’s accrual is indexed up to retirement at a guaranteed minimum rate, for example in line with price inflation or investment returns. The member’s fund is available at retirement to secure retirement benefits (usually by purchasing an annuity with an insurance company). The targeted benefits are in the form of a lump sum.

·         Cash balance common features with both defined-benefit and defined-contribution schemes.

A cash balance is a defined benefit plan that defines benefits in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance. Although a cash balance pension plan is a defined-benefit plan, unlike the regular defined-benefit plan, the cash balance plan is maintained on an individual account basis much like a defined contribution plan. The cash balance plan acts similarly to a defined contribution plan because changes in the value of the participant’s portfolio do not affect the yearly contribution.

·         Cash-balance Scheme. A percentage of salary is set aside each year for each member.