| Topic - The Low Down on Cash Balance Plans | Education Center |
THESE DAYS, the future of the much maligned cash-balance pension plan seems uncertain at best.
First there was the memo issued in mid-1999 by the Internal Revenue Service to its field offices, asking them to put further approvals of cash-balance plans on hold. That was after the IRS district office in Cincinnati fingered a local company for violating age-bias laws in its cash-balance plan. Soon after, the Senate also began investigating the legality of the plans. And finally, IBM, one of the most prominent companies recently to convert, announced that it would loosen the rules surrounding its conversion, thus doubling the number of employees who can now choose between the old plan (which is a traditional pension plan) and the new cash-balance plan.
Given all the heat, you can pretty much guarantee that the steady stream of companies announcing conversions is going to dry up -- at least until the future of cash-balance plans is clear. Companies that have received approval for cash-balance plans but have yet to roll them out will probably wait to see if any new regulations are passed. If the law changes, these plans will be given the opportunity to comply with the changes, according to an IRS spokesman.
If you're an employee at one of these companies or at a company that has recently implemented a cash-balance plan, chances are all this news has left you more confused than ever. So here's a primer on who wins and who loses when it comes to these plans. The long and the short of it, though, is that older employees tend to get screwed, while younger ones may benefit.
If you want to know exactly how much your own pension benefit will change under a cash-balance plan, you'll have to contact your benefits department. By law, once the cash-balance plan has been implemented, your employer must provide a personalized statement showing your new balance and old balance within 60 days of your request.
But 60 days is a long time. If you want to estimate the effect of your plan change right away, try our Cash-Balance Calculator above. We've got hints on how to supplement your cash-balance plan on the next page (it's a good idea for employees both old and young). But to really understand who wins and loses with these plans, you need a little background. Sorry if it gets a little arcane.
Cash-Balance Plans 101
In a cash-balance plan, employers make annual contributions to an account in your name, which typically earns interest at close to the rate of long-term Treasury bonds. This so-called defined contribution method 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% but it's unlikely interest rates would ever fall so low that the employer would have to pitch in to cover the shortfall. You have no control over your account.
The reason these plans favor younger employees is because you start building your retirement benefit early -- usually right away -- whereas in a traditional pension most of your benefit is earned in your 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.
For this reason, some companies grandfather older employees who might be penalized by the transition to cash balance. At Citigroup, for instance, employees over age 45 will still be eligible for the old plan. (As will those who meet the following criteria: They have at least five years of service and the sum of their age and years of service is 60.)
Keep in mind that the biggest controversy regarding cash-balance plans lies in how a company handles the conversion. The best companies, like Eastman Kodak, give all employees a choice of rolling over their pension or not. If that's the case with your conversion, then it's up to you to make the right decision. Unfortunately, most companies only give their oldest employees a choice, which can leave middle-aged workers in the lurch.
One thing's for sure: a cash-balance plan -- even a good one -- is usually still a far cry from a decent 401(k). Sure, with a generous cash-balance plan your employer could contribute, say, 10% of your salary into your account. 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 6% returns. And you aren't able to supplement your employer's contribution with pretax contributions of your own. The good news is 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.
Confused? A few scenarios should help you see how these plans work:
The Scenarios
Before we begin, bear in mind that many cash-balance plans do not exist on their own. Companies generally offer other retirement benefits that may be sweetened during the switch to a cash-balance plan. So make sure you factor in any other benefits when considering the impact of your pension conversion.
Young Employee
So you're 28, and you've worked at your company for a year or two. Things are going well, but it's not like you're going to spend the rest of your life here. For you, a cash-balance plan is probably an improvement.
Right away, your employer's contributions toward your retirement will increase from next to nothing to something like 5% 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 picnics for the past 25 years. That's because it will dramatically reduce your employer's annual contributions toward your retirement benefit. And it may freeze the growth of your benefit for years to come. 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?
Of course, your employer can't take away what you've already earned. That is converted into an account with your name on it. But here's the bad news. Your employer can essentially freeze your current balance, explains Ron Gebhardtsbauer, senior pension fellow at the American Academy of Actuaries in Washington, D.C.
Fortunately, some companies try to cushion the blow for employees that fall into this category. (After all, many of the big guys making these decisions fall into this category themselves.) Some, like Kodak, allow all of their employees to choose between the new cash-balance plan and the old pension. Others give an additional lump-sum contribution to longtime employees. But quite frankly, some companies will simply hang you out to dry.
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.
Hopefully this decision will become easier in the future. Legislation has been introduced into Congress by Senator Daniel Patrick Moynihan (D., N.Y.) that would require employers to fully disclose to all employees how their personal benefits would be affected by a pension plan switch. He's got our vote.