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The rise of the cash balance strategy in retirement plans is a well-documented phenomenon. Cash balance pension plans are “hybrid” between defined benefit and defined contribution, but they share many features with both types of plan. The cash balance approach was offered by IBM to its employees in 1981 after Congress passed legislation permitting companies to convert from traditional pensions to cash-balance or 401(k) arrangements for new hires.

Today, it's estimated that about one third of private sector workers have some form of hybrid plan in their retirement package. For these people, converting might be an option worth considering. However, before you can decide what type of plan will work best for your situation, it's important to understand the difference between the two options.

A conventional pension plan is an arrangement between an employer and employee to provide retirement income through fixed or variable payments for life, based on factors such as age, years of service, earnings history and salary levels. The basic element of a conventional pension plan is the benefit that will be provided at retirement.

Cash balance plans are often considered a type of defined contribution or 401(k) plan, because the employer contribution is fixed and the employee's benefit at retirement depends upon how much has been contributed. In cash balance plans, employees do not accrue benefits based on their years of service; instead, they receive an account balance that includes both hypothetical earnings and hypothetical employer contributions.

Employers set up cash balance plans to replace the defined benefit conventional pension, because cash balance plans provide employers with an alternative way to help them reach their financial goals by controlling their own contribution rate rather than depending on investment returns that are outside of their control.

Cash-balance plan conversions are also attractive to employees who have a large investment in their traditional pension. In those cases, the value of the benefit being offered may have been grossly overestimated. A cash balance plan conversion provides an opportunity to salvage some degree of retirement wealth for employees near or at retirement age.

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