The cash balance plan as a real option: Financial innovation and implicit contacts

Abstract

This study examines, from the employer's perspective, the conversion from a defined benefit plan to a cash balance plan. The conversion to a cash balance plan presents a real option that is a financial innovation for the firm. The reasons to exercise this option (convert from a defined benefit plan to a cash balance plan) are discussed. The conversion can offer several benefits for the company. The firm may profit by taking the surplus assets of the pension plan without a tax penalty; the firm can increase risk sharing between the company and the employee (by reducing the company's pension liability risk and improving the predictability of the company's pension costs); the firm may choose to reduce future pension liabilities (by changing contribution and accrual patterns); and if the firm converts to a cash balance plan, the firm may improve recruitment and employee retention. The real option approach does not necessarily conflict with the implicit contract theory of pension plans. From the real option point of view, the fuzzy nature of defined benefit plans includes more than one possible real option. Most discussions of implicit contracts for pension plans focus on the concept of an implicit lifetime employment guarantee. The implied contract of the defined benefit plan could be included in the legal provisions of a cash balance pension contract. Even though a lifetime employment guarantee is not included in the current legal contract agreement, a cash balance plan can be structured to offer alternatives that provide the benefits that current employees would expect based on the implicit promises. The real option alternatives for converting to a cash balance plan can be used by the company to change provisions for the un-accrued pension benefits in ways that benefit the company and the employees. Owing to the difficulties in valuing these complex options, the model developed and analysed focuses on the potential value to the company of the option to change future pension plan contributions and the concomitant pension fund accruals for employees. A model is developed to find an optimal conversion time for employers based on the accrual patterns of the two types of plans.