How do they work & what is their value?

A cash balance scheme is a form of defined benefit pension under which what is promised to the member is not a defined amount of pension at retirement but a defined lump sum. The member is left to take whatever tax free cash they want, up to 25% of the sum, and then required to buy an annuity with the balance.

The lump sum at retirement is generally defined as a proportion of salary in the year it is accrued e.g. the member paying 5% might be promised 20% at retirement. It is therefore Career Average Revalued Earnings (CARE) based rather than Final Salary-based. This means it is very important, as with a CARE scheme, how the amount of lump sum promised is revalued up to retirement. It might be guaranteed to rise in line with a measure of inflation e.g. CPI.  The lump sum promised would only be available in full at normal pension age and would be actuarially reduced in the event of early retirement. 

This means that they should be regarded as being much closer to a defined contribution scheme than they are to a final salary pension, or a defined benefit/pension scheme.  In cash balance schemes members pensions are not readily predictable as a proportion of their income before retirement and this means a further key element of what members value in a final salary scheme is missing.

At retirement the amount of pension would be determined by annuity rates prevailing at the time, which will be determined by the insurance market’s views of life expectancy and of interest rates. So members are bearing all the mortality risk extending right through their career and all post-retirement investment risk.

In a cash balance scheme the employer is, in effect, guaranteeing a minimum return on member’s contributions but how valuable that is depends on the percentage of salary guaranteed and the basis on which it is revalued.

What is the value of a cash balance scheme where the member has to contribute 5% and gets a cash balance on retirement at age 65 of 20% of their pay each year revalued by CPI inflation (assumed to be 2.5% p.a) ?

If a 64 year-old contributed for one year and bought an annuity with 20% of their pay it would only be equivalent to around a 1/120 pension.

If a 35 year old was in the scheme for 30 years and their pay rose in line with CPI, then they would also get a pension of 1/120 of their final pay.  However, if their pay rose by 4%, between ages 35 to 65, then the pension would only amount to 1/195 of their final pay. To the extent that pay rises faster than the rate at which cash balances are revalued the resulting pension as a proportion of final salary would shrink.  For members at intermediate ages the accrual would be somewhere between these figures.

Another way of assessing the value of the cash balance promised is to consider what the member might have got had they invested their contribution in a DC scheme.  Clearly for the 64 year old the investment return on their 5% contribution in a DC scheme could never match the return the cash balance gives, as that gives a return of 300%. But the return guaranteed falls steadily for contributions made at younger ages

Below are given figures for the investment return on a 5% contribution made at different ages as would give a member the same as a cash balance of 20% of pay revalued by CPI inflation at 2.5%. Also shown are the investment returns required given a 10% contribution (e.g. as might apply in a DC scheme where the employer matched the employees 5%). 

For the 35 year-old with 30 years to retirement if they invested 5% of their pay and it earned investment returns of 7.5% p.a then they would achieve at age 65 an amount equal to the cash balance, which as a guaranteed investment return would be attractive. If, however, the 35 year-old had been in a DC scheme and given a matching 5% by their employer they could have got an equivalent lump sum if their DC fund had achieved an investment return of 5%. This looks rather less attractive, as if higher returns were achieved the DC would have delivered a much better pension.

This analysis indicates that cash balance schemes tend to offer limited value to their members but much better relative value to older contributors than to younger contributors.