Words can intimidate. A Cash Balance Pension Plan sounds both intimidating and boring all at once. But should we be content to ignore confusing or not well-known terms? Not if the matter is critical to our future. Retirement plans are important vehicles for American workers. We need money available when no longer working, whether due to age or physical inability to work.
So, let's break down cash balance pension plans. First, the big picture. Retirement plans are generally divided into two groups – defined contribution plans and defined benefit plans. A defined contribution plan means that your employer has agreed to make a certain contribution to a retirement plan on your behalf. For example, your employer contributes up to 3% of whatever you contribute to an account. There is no guarantee as to the amount of the balance you will have for retirement. There is only a guarantee as to the amount of the employer's contribution. A good example of that is the 401(k). It only provides security as to the amount contributed to the plan.
The defined benefit plan promises a certain level of benefit that the participant will have at retirement. Often that is based on years of service and the earnings in the years closest to retirement. For example, if you have 20 years of service and your pay averaged $75,000 over the last five years, your pension is $1000 per month based on the plan formula. A pension benefit is an example of that. It provides security as to the amount to be received.
Pension benefit plans are running into difficulty. There is a trend of fewer workers earning wages to help fund pensions while more retirees are receiving those benefits. Pensions become underfunded when that happens. If investment earnings cannot make up the difference, employers do not like taking up the slack. Traditional pension plans are then far less attractive to many employers.
Defined contribution plans also have seen recent downsides. When there is a market downturn, 401(k) plans can take a hit and hurt retirees or those nearing retirement. That is because the 401(k) plan leaves the employee with the investment risk. It has been recently reported that many retirees who left money in their 401(k) lost at least 10% of their retirement. Those workers still contributing to a 401(k) and using riskier investments have seen losses above 20%.
Is there something in between? There may be – a cash balance pension plan. What is a cash balance pension plan? It is still a pension benefit, but it appears on the surface to be a hybrid between a 401(k) and a pension benefit. It promises an employee a contribution equal to a percentage of each year's earnings and a guaranteed rate of return on that contribution. An example would be an employer promising a 5% contribution to the plan, with a 5% rate of return each year. So an employee making $50,000 would receive $2500 toward retirement and earn 5% each year.
With a 401(k), the employee may have options regarding investments, and the employee takes the risk regarding the performance of those investments. However, with a cash balance pension plan, the employer takes the risk of investment earnings. The employee is guaranteed that promised rate of return regardless of market performance. On the other hand, like a 401(k), it is often portable. A typical pension is not. Thus, if you leave your job, you can usually roll over your cash balance pension into an IRA or other plan. Also, like a 401(k), you can receive your cash balance pension in a lump sum upon retirement. That is often not the case with a pension. Unlike a 401(k) plan, a cash balance pension plan is covered by the PBGC's insurance program, meaning your benefits are protected even if the plan or the company runs into financial difficulty.
So are there downsides that employees should watch out for? If you are a younger worker, a cash balance pension plan favors you since pensions may often take into account the higher earning years of a retiree just before retirement. Obviously, an older worker would prefer a pension as the higher earning years will have less impact on the cash balance pension plan. There has been litigation against employers who forcibly switched their pension plan over to a cash balance pension plan as it disfavored older workers and resulted in a reduction of pension benefits.
So what are the upsides for an employer? If an employer takes a broad market approach in investing, it is known that the market generally will pay at least 8% over the long term. All employee “accounts” are actually in one fund, making management fairly simple. As a result of the higher earnings of all the earnings promised to employees, the plan may be fully funded without the employer having to make ongoing contributions. These plans are also attractive to young talent, as noted above, leaving a younger employee the option of leaving employment at some point without losing the retirement benefit.
Not so bad now, was it?