TO SOME, cash-balance plans are the black sheep of retirement plans. They're defined-benefit plans structured to look more like 401(k)s, but many argue that they have the advantages of neither.
The controversy over these plans became front-page news in the late 1990s, as more large companies with traditional pensions began converting to cash-balance plans in an attempt to cut down on costs and gain appeal with younger workers. But the transformations were often ugly. Major corporations — like IBM — were skewered by the press as older and middle-aged employees (justifiably) howled about the reduction in benefits that resulted. Not surprisingly, lawsuits soon followed (although at lesser-known companies).
But it's funny how some bad PR combined with the risk of legal action can correct a situation. These days, the flood of companies converting to these plans has all but dried up. And those still doing it have learned from past mistakes. Now many companies that have made the switch, like Eastman Kodak, have chosen to give all their employees the option of either staying in the traditional pension plan or joining the new cash-balance plan. And despite all the hoopla, you might be surprised to learn that for many employees, a cash-balance plan is going to be a better deal. Fact is, if you're a young employee who doesn't plan to stick around until your hair turns gray, this black sheep just might be your white knight.
If you're joining a company that offers a cash-balance plan (or if you work for one of the rare companies these days that's making the switch), here's what you need to know about these confusing plans. Be sure to also check out the calculator above, which will help you understand how you'd fare under a traditional pension versus a cash-balance plan.
Cash-Balance Plans 101
In a cash-balance plan, employers make annual contributions to an account in your name, which typically earns interest somewhere around the rate of long-term Treasury bonds. This so-called defined-contribution method (also used in 401(k)s) transfers risk from the company — which under a pension plan was wholly responsible for funding your retirement — to you. Generally, companies guarantee an interest-rate floor of, say, 4%. Unfortunately, as with a traditional pension plan, you have no control over how your account is invested.
The reason these plans favor younger employees is that they start building retirement benefits early — usually right away — whereas in a traditional pension most of the benefit is earned in the final years of service. That's why older employees suffer: In a pension plan, that fat end-of-service pension calculation is made on their highest salary levels. In many cash-balance plans, they'll get a percentage cut that's only slightly higher than everyone else, without the years to make it count.
So how does a cash-balance plan compare to a decent 401(k)? In many ways, it comes up short. Sure, with a generous cash-balance plan your employer could contribute, say, 10% of your salary into your account (and that's certainly more than most employers provide with a company match in a 401(k)) But there are still a lot of limitations. For starters, with a cash-balance plan you don't have the flexibility to invest as you please, meaning you're stuck with those 4% returns. And you aren't able to supplement your employer's contribution with pretax contributions of your own.
The good news is that if you don't plan to spend the bulk of your career at your current company, you'll probably walk away with a significantly bigger benefit than you would with a traditional pension. Also, you can roll over a cash-balance account into an IRA or another qualified plan if you switch jobs. With a pension, any benefit you've earned must stay with the company.
In the best of circumstances, a company converting to a cash-balance plan will give employees a choice of whether to stay with the traditional pension or switch to the new plan. Here's a breakdown of who typically stands to win and lose with these conversions:
Conversion Scenarios:
Young Employee
Say you're 23 years old and you've worked at your company for a year or two. Things are going well, but it's not as if you're going to spend the rest of your life here. For you, a cash-balance plan is probably better than a traditional pension.
Right away, your employer's contributions toward your retirement will increase from next to nothing to something like 4% of your salary. And, once you're vested (usually five years), you'll probably be able to take your account balance with you to another qualified plan or an IRA.
Long-Time Employee Nearing Retirement
For you, a cash-balance plan may be worse than the potato salad you've eaten at company BBQs for the past 25 years. That's because it will dramatically reduce your employer's annual contributions toward your retirement benefit. Here's why.
You've entered the peak earning period for pension benefits. These benefits are typically calculated by multiplying your years of service by your final average pay and a multiplier of, say, 1.5%. Under the cash-balance plan, remember, the contribution is just a percentage of your salary, generally ranging from 4% to 8% (plus interest). See the difference? Fortunately, most companies making a switch to a cash-balance plan will at the very least grandfather older employees so that they can stay in the traditional pension plan.
The Retirement Plan Cheat Sheet
| |
TRADITIONAL
PENSION |
CASH
BALANCE |
401(k) |
| Plan Participation |
Automatic for eligible employees |
Automatic for eligible employees |
Elective |
| Employer Contributions |
1.5% x final 5-year average pay x years of service (max. 30 years) |
4% of annual pay plus interest (29-year Treasury bond) |
Company match: Typically 50 cents per $1.00 on first 6% of pay.* |
| Employee Contributions |
Not allowed |
Not allowed |
Limited to $11,000 in pretax contributions; $12,000 for those who will be age 50 or older at year-end. |
| Account Allocation |
Determined by employer |
Typically determined by employer |
Determined by employee |
| Withdrawals at 65 |
Annuity or lump sum |
Annuity or lump sum |
Annuity or lump sum |
| Rollovers Before 65 |
Typically not permitted |
Generally permitted |
Always permitted |
 |
| Plan Winners |
Long-term employees |
Young employees/new employees |
Employees who take full advantage of company match and invest wisely |
| Plan Losers |
Short-term employees |
Long-term employees |
Nonparticipants |
|
* Source: Profit Sharing/401(k) Council of America. |
Midlife Employee, 40
So far the choices have been somewhat straightforward. New employees benefit, long-time employees suffer. But what about the folks in the middle?
Good question. The answer lies in variables that you may not even be able to answer. If you continue to receive large raises at your current job, chances are you would have been better off with the pension. But if you're earning paltry raises and not planning on sticking around much longer, the cash-balance plan could be a welcome change.
If you get to choose whether to stay in the old plan or switch to the new, run a few different scenarios through our calculator to help you evaluate which one is best. What if you don't have a choice? Get ready for a fight. In some cases — as with IBM — middle-aged employees banded together and successfully fought for the right to stay in the traditional pension. Given the potential difference in benefits, it's certainly a battle worth waging.
