The Fall of Pensions
Traditional defined benefit plans are quickly becoming a thing of the past. Throughout the 20th century pensions were the most important part of retirement income outside social security. Despite recent buzz about their resurgence, statistics show a decline in use; the decline has only slowed recently due to low interest rates and funding, which make terminating pensions costly. As market conditions improve, the rate of termination will accelerate again.
Initially, pension plans were attractive to employers and employees. Employers could set aside substantial amounts of cash on a tax-favorable basis and provide retirement income for employees. Markets were advantageous, interest rates were attractive, profitability was strong and life expectancy was shorter.
The complex dynamics of pension plans now make them unattractive to many companies. They require substantial resources—riddling budgets and squeezing profitability. There is little control over variables embedded into the plan design, such as interest rates, market volatility, annual funding, liability, increased life expectancy, PBGC (Pension Benefit Guaranty Corp.) premiums, plan complexity and administration.
The Rise of the Cash Balance Plan
The fall of pensions gave rise to a new type of plan design: the cash balance plan. Introduced in 1985, the first cash balance plan was adopted by Bank of America. It gained more traction after the Pension Protection Act of 2006. Cash balance plans have since experienced double digit growth every year, rising by 500% over the last decade.
These plans are hybrid retirement plans, offering the governance of a defined benefit plan with the look and feel of a defined contribution plan. Contributions are now commonly a percent of compensation, but can also be a specific dollar amount, hence the feel of a defined contribution plan.
Although still relatively novel, cash balance plans could be a significant resource for organizations wanting to maximize retirement savings in a tax-favorable manner. They also complement the defined contribution plans used today. Cash balance plans can stand alone or be used in combination with current 401(k) or profit sharing plans. When used concurrently with existing plans, the total retirement contribution could provide significant savings per employee, per year.
Plan Advantages
Cash balance plans make benefit calculations simple for employees. Participants receive an annual statement of their accumulated balance, which is the total of employer annual contributions and credited growth rate. Each year, contributions and benefits are credited with a rate of growth based on a chosen benchmark. The most common benchmark is the 30-year Treasury Bond, which provides four to five percent credit annually.
Cash balance plans don’t require individuals to be investment experts; assets are pooled and invested based on the direction of the plan trustee. It remains the employer’s responsibility to ensure monies are available to pay benefits and growth. Because rates can be more modest and palatable, investments need not assume high levels of risk and can be invested conservatively to temper volatility.
Another advantage is that cash balance accounts are portable, so employees can take it with them when they go. There is still a vesting requirement, but once an employee has accrued vested status and separates service, they may roll the account value into another employer’s sponsored plan. Additionally, retirement income payments are no longer an employers’ lifetime obligation; participant balances are paid in lump sum or used to purchase an annuity for the beneficiary upon retirement.
Concerns that retirement plans are struggling are warranted. Employees don’t save enough on their own, and defined contribution plans can be favorably biased toward owners and highly compensated employees. However, cash balance plans level that playing field and provide everyone with a suitable vehicle for retirement income. Their momentum will continue to rise as traditional pensions fade away.