Cash balance retirement plan needs close study

Personal Finance

August 27, 2006|By Eileen Ambrose | Eileen Ambrose,Sun Columnist

Employers now have more reasons to feel comfortable about ditching their traditional pension plans for so-called cash balance plans.

For years, there have been questions about whether switching to a cash balance plan discriminated against older workers, because conversions often have reduced the projected benefits for those workers. But the new federal pension bill signed into law this month essentially says newly created cash balance plans won't be age discriminatory if they meet certain criteria.

And a federal appeals court in Chicago recently ruled that International Business Machines Corp.'s plan isn't discriminatory - a favorable sign for existing plans. (IBM workers last week asked the court to re-hear their case.)

Even with the green lights, though, it's unclear how many companies will embrace cash balance plans.

"The legal cloud has been lifted," said David Certner, AARP's legislative policy director. "Whether there is a trickle or flood of cash balance plans, we just don't know."

Some employers may hesitate to adopt a cash balance plan because of new, stricter pension fund requirements and coming accounting rule changes that will affect the plans, said Cheryl Tillman, a senior vice president with Aon Consulting in Baltimore.

IBM has already announced it is freezing its cash balance plan in 2008 and offering workers a beefed-up 401(k) instead.

Still, if your employer decides to convert its traditional pension to a cash balance plan, you need to do some homework. First you must understand how the plan works and its terms.

A cash balance plan combines features of a traditional pension and 401(k).

As with a traditional pension, the employer bears all financial responsibility. Each year, the employer credits a worker with a percentage of pay and guarantees a rate of interest on that money.

Formulas are all over the map, said Larry Sher, director of retirement policy at Buck Consultants in New York. Some employers might credit a worker with 5 percent of pay annually, while others might start at 3 percent and gradually raise the rate based on a worker's age or years of service, Sher said. The interest earned might be tied to the 30-year Treasury bond or some other index.

And like traditional pensions, cash balance plans are insured by the federal Pension Benefit Guaranty Corp.

As for the 401(k) features, cash balance plans provide regular statements to workers showing the lump-sum value of their benefits. These are easier for workers to understand than projections of pension benefits in retirement, experts said.

And like the 401(k), the cash balance account is portable. Workers leaving the job after being vested can roll their lump-sum payout into an individual retirement account or possibly a new employer's 401(k). They can cash out, and pay any early withdrawal penalties or income taxes due. Or, they may be able to leave their account with their old employer and continue to earn interest.

When workers retire, they typically can choose a lump sum or an annuity that gives them a monthly check for life.

Once you understand how your cash balance plan works, the next step will be to compare how you would fare under the old plan versus the new one. This isn't always easy to figure and workers should ask employers for the details, said J. Mark Iwry, a senior fellow at the Brookings Institution.

Generally, cash balance plans benefit younger workers who are more likely to job hop and have more years for their accounts to compound. Traditional pensions favor older workers who spend a career with the same employer. That's because they earn the bulk of their benefits in the few years before retirement.

Conversions

Companies began converting regular pensions to cash balance plans in the 1980s and there are now more than 1,000 plans. Among the reasons for conversions, companies said that old-fashioned pensions no longer fit today's mobile employees who don't stick around long enough to earn a significant benefit.

In some of the early conversions, however, older workers saw their projected benefits under the old pension cut by up to half under the cash balance plan, Iwry said. Workers also sometimes experienced "wear-away," where they didn't earn additional benefits for a period that could last for years, he said.

The new pension law prohibits wear-away in conversions made after mid-2005. It also requires that workers be vested in the plan in three years, instead of the usual five.

Older workers at companies doing conversions should ask if there are any transition protections that would lessen the impact of the switch.

"More recent conversions have typically given older workers more of a softer landing by providing some degree of grandfathering under the old formula or a choice of the old or new formula," Iwry said.

The whole package

Look at the whole package. Often employers making a conversion will sweeten other benefits, such as raising the 401(k) match, experts said.

If you still come up short in the conversion, lobby your employer for more relief, Iwry said.

This exercise also might reveal that you might have to change your behavior, said Jack VanDerhei, a Temple University professor. "It could mean you have to save more on your own in a 401(k) and an IRA."

To suggest a topic, contact Eileen Ambrose at 410-332-6984 or by e-mail at eileen.ambrose@baltsun.com.

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