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Cash-Balance Pension Plans: Who Benefits, Who Doesn't

© Ronald J. Rakowski, CELS, SPHR

Cash-balance pension plans are classified as defined-benefit plans by federal government regulatory authorities, even though those plans share many of the characteristics of defined-contribution pension arrangements like 401(k) and profit-sharing plans. Other defined-contribution deals include target benefit, money-purchase, stock bonus, and employee stock ownership plans.

Under a typical 401(k) plan, an employer may match a certain percentage of an employee's pre-tax contribution up to a specified maximum. For example, if an employee contributes six percent of his or her current compensation to a 401(k), an employer may then add three percent. Some employers are more generous with matching contributions and some employers are more conservative. While employees may have a wide range of investment vehicles to choose from, employers often require that company contributions be invested in company stock. Some defined-contribution plans do not require employee contributions. A profit-sharing plan is just one example.

Unlike defined-benefit pension plan sponsorship, an employer's defined-contribution pension plan non-administrative and non-fiduciary responsibility ends when it makes its contribution to employee accounts. Participating employees then win or lose as a result of the investment performance of the assets held in their individual acounts. When an employee leaves the company or retires, the distribution they receive is the sum of their contributions and the contributions made on their behalf by their employer plus investment earning/loss experience.

Under a "traditional" defined-benefit pension plan, the employer establishes a pension benefit payable when an employee attains a certain age. A defined-benefit pension "promise" is typically based on a combination of years of plan participation, compensation, age at benefit commencement, and the survivor option selected. Some defined-benefit pension plans allow for a lump-sum distribution, and some do not. It is the employer's responsibility to fund the plan, although some defined-benefit plans require employee contributions, and it is the employer, not the employee, who benefits if plan trust investment earnings are higher than expected and suffers if earnings are lower than expected.

A "traditional" defined-benefit pension plan covering salaried employees typically provides a pension benefit calculated using the retiring employee's average compensation over the highest five consecutive years of service during the ten years preceding retirement. Unlike a defined-contribution plan, a "final average" defined-benefit plan calculation benefits older and longer service employees as the formula, which uses late-career compensation, positively affects all years of employment equally.

A distinct disadvantage of a "traditional" defined-benefit pension plan is that vested benefits are frozen if termination occurs before the employee meets the minimum age requirement for retirement. Consider the case of a 30-year-old employee who leaves a company after five years of employment and is in receipt of a vested pension benefit of $300 per month payable at age 65. That vested benefit won't increase in value over the next 35 years and will therefore be worth a fraction of what it's worth today as a result of inflation.

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