Defined benefit retirement plans cost employers a sizable amount of money to fund, especially for older employees nearing retirement age. Enter a new hybrid, a plan growing in popularity called a cash-balance plan. It’s designed to save employers significant sums of money, but the cost still may be high.
Cash-balance plans allow employers to set up employee savings accounts at a certain balance and contribute a percentage of their yearly pay, usually 4 percent, plus 5 percent interest. Sounds simple enough, but it doesn’t take long for problems to surface.
First, cash-balance plans may have a serious adverse effect on older employees’ pensions. Their defined benefit pension balance cash values could be cut anywhere from 20 percent to 50 percent. In a traditional defined benefit pension plan, which many larger companies offer, an employee’s benefit increases dramatically as he or she nears retirement, because contribution amounts are generally determined by multiplying the number of years of service with the employee’s highest final average pay.
Consequently, many employees earn half or more of their pension during the last five to 10 years on the job. When these older employees are switched to a cash-balance plan, they receive a starting balance in their account, which could be significantly less than the lump-sum balance in their defined benefit pension plan accounts. They will not earn additional pension benefits until their new cash balance accounts reach what their old balances were in their traditional plans.
Is this legal? Yes, since the employees don’t lose that old balance and can receive it if they quit. They just won’t earn any more toward their pensions until their old balances are achieved. This is known as plateauing. In other words, there isn’t any progress made.
Many companies that have switched over to cash-balance plans have met resistance from older employees. To “soften the blow,” some companies have instituted a grandfather clause allowing older employees who meet certain age and years-of-service requirements to stay in their traditional plans.
Some employers have chosen another option, giving older employees a larger annual pay credit. For instance, a worker in his 20s may receive 2 percent, while a worker in his 50s may receive 8 percent.
In addition to creating poor employee relations, another problem with cash-balance plans is that the IRS has never approved of some aspects of these plans. Employers adopting them therefore could find themselves in trouble with the IRS and be forced to spend more money repairing the problem.
Who benefits from a cash-balance plan? Employers? Perhaps, if the IRS doesn’t find a problem with their plans. Employers can save a significant amount of money on pension funding. How about younger employees? On the surface, that appears to be the case.
Many employees in their 20s and 30s don’t stay in jobs long enough to see a pension benefit. Many younger employees believe that, through a cash-balance plan, they can earn thousands of dollars toward retirement and take the money with them when they start a new job.
The problem is that many cash-balance plans have a five-year vesting period before an employee can receive a full benefit.
Louis P. Stanasolovich, CFP, named one of the best financial advisers in America the last three years by Worth magazine, is founder and president of Legend Financial Advisors, Inc., a fee-only Securities and Exchange Commission registered investment advisory firm in the North Hills. Reach him at (412) 635-9210. The firm’s Web site is www.legend-financial.com.
