Are Cash Balance Plans the Answer?

Andrew G. Biggs
Publication Date: 
October 2011

Nebraska presents what could be a model for public sector pension reform, the so-called “cash balance” plan that offers some of the better aspects of both traditional defined benefit pensions and the defined contribution, 401(k)-type plans that dominate in the private sector. This study examines the factors that make cash balance plans attractive as well as examining some of their potential shortfalls.

Cash balance plans offer far greater portability than defined benefit pensions, allowing public employers to attract young mobile employees and removing current disincentives for mid-career employees to leave. However, cash balance plans share with defined benefit pensions a set of accounting rules that economists almost universally believe to understate pension liabilities and hide the investment risks that are borne by taxpayers. In the case of Nebraska's cash balance plans, this arises through the government’s guarantee of a 5 percent annual return on account balances regardless of the returns available in the market. Such a guarantee, which resembles a financial product known as a “put option,” is easily priced and shows the true costs of the Nebraska cash balance plan to be far greater than currently understood. While the cash balance plan claims to be 95 percent funded, when the market value of the rate of return guarantee is included the plan is only around 50 percent funded. Claims by pension managers that market values do not apply to government plans are not supported by the vast majority of economists. A pure defined contribution plan in which participants bear the investment risk would be more transparent in terms of the costs imposed on government budgets and the taxpayer.