Cash balance schemes
A “cash balance” scheme is a form of DB pension arrangement where the defined benefit is a lump sum expressed as a formula linked to the member’s final pensionable salary. The lump sum will be available at retirement to provide benefits for the member and his or her dependants. The benefit is still calculated on the basis of service completed and on final salary but the amount of pension that can be purchased (if this is the option taken) depends on annuity rates at retirement.
Why cash balance?
Cash balance schemes combine the advantages of DB and DC pension provision by providing an accumulation of contributions at a specified rate. The emerging lump sum is defined in terms of the contributions paid in (known as the “Employer Credit”) and an annual uplift (the “Interest Credit”).
In summary:
- The employer bears the investment risk and the full cost of increases in pensionable pay until the member’s retirement. This is compensated for by more stable costs as well as steady cash flow and accounts entries.
- Funding for a lump sum means that the employer does not bear the mortality risk. The risk and cost of increasing longevity amongst pensioners is transferred to the annuity provider.
- The employee has certainty in knowing how much his or her lump sum will be at retirement but bears the risk of changes in the cost of buying an annuity.
- Cash balance schemes are generally easy to understand and communicate.
Commonly used abbreviations in pensions
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