A cash-balance plan is a defined benefit plan that is a lot like a traditional pension, but with a few elements that closely resemble a 401(k).
Here’s what’s the same: You don’t invest any of your own money in the plan, nor do you have any responsibility for the investment choices.
Here’s what’s different: Instead of your benefit in retirement being based on a formula that takes into account how long you were on the job and your average salary during your last few years of employment, the cash-balance plan credits your account with a set percentage of your salary each year, typically 5%, plus a set interest rate that is applied to your balance.
Each year, you get a statement that shows the hypothetical value of your account, as well as what sort of monthly income payout (or lump sum) that will generate when you retire at 65.
Another key difference: If you leave the company before retirement age, you may take the contents of your cash-balance plan as a lump sum and roll it into an IRA. A traditional pension isn’t portable.
A cash-balance plan is great if you’re young and plan on job-hopping. But if you work for one company for a very long time – the total amount you’ll get from a traditional pension plan is typically bigger than what you’ll get from a cash-balance plan. That’s because the formula for a traditional pension gives heavy weight to your average salary over the last few years of employment. With a cash-balance plan, it’s a simple average of every year’s salary.
Cash-balance plans work just like traditional pensions. You just need to show up for work. You are automatically enrolled in the plan without having to opt in, though in some instances you need to be on the job for a year before you are officially enrolled in the plan. Keep in mind that just because you’re enrolled and the pension benefits are being credited to you, they aren’t 100% yours until you become fully vested.
The company that your employer hires to run the plan is responsible for all the investment decisions. There is absolutely no work required (or allowed) on your part in the management of the pension money.
About a decade ago, employers looked into the future, saw the massive size of their pension obligations, panicked – and came up with the idea of converting their existing pensions to the cash-balance model. No surprise why: Cash-balance plans typically result in smaller payouts to long-term employees.
That trend spurred a flurry of age-bias lawsuits by employees nearing retirement who were facing lower pension payouts. The 2006 Pension Protection Act calmed the waters a bit by ensuring that if you’re caught in a conversion, your employer can’t reduce your benefits below what you already were entitled to before the conversion.
Typically you need to wait until you reach retirement age to start taking money out of a cash-balance plan. However, unlike a traditional pension plan, a cash-balance plan is portable. That means that when you leave a job – whether voluntarily or not – you can take the vested portion of the money and roll it over into an IRA, just as you can with the contents of a 401(k). IRAs allow you to begin withdrawing without penalty at age 59½.
Many cash-balance plans offer a lump-sum payment only, so you may not have a choice.
If you do have a choice, there’s no one easy answer.
Monthly payments: If you opt for a monthly payout – known as a life annuity – you are assured of having a permanent steady income. That can be a lot less stressful than taking a big lump sum and assuming responsibility for how to invest the money. With a lump sum, there’s also the risk that you’ll spend too much today, then be left without enough money to cover your expenses later. By choosing a steady payout, you avoid tearing through your stash.
Lump sum: If you’re at all concerned your employer might run into trouble – say, you happen to work in the auto or airline industries – taking the lump sum means you don’t have the risk of facing reduced payouts down the line if your employer hits a wall. Even if your company is protected by the Pension Benefit Guarantee Corp., the PBGC does not guarantee it will cover 100% of the money you were told you were entitled to. The PBGC limits its payments to set monthly maximums.
By taking the lump sum, you also gain control of your money. You can roll it into an IRA and invest it. If you manage it well, you should be able to turn it into a stream of income that will stand up to inflation and last for life. Of course, pulling this off requires some planning and investing ability. So you have to decide if you’re up to it, or if you are up to finding an adviser who can handle the job.
You can roll the lump sum into an IRA, then use a portion of that IRA to buy an immediate annuity from an insurance company. Don’t confuse this type of annuity with the ones people use as tax-deferred investments. An immediate annuity is a vehicle designed to start paying you a guaranteed income as soon as you invest your money. In effect, you’ve created the same sort of monthly income stream that you would have with the lifetime annuity option on a pension.
The advantage to this arrangement is that you get the security of a monthly check, plus you have a stash of money that can keep pace with inflation and help out with occasional unexpected expenses.
Chances are, your plan will not produce enough income to fully cover all your retirement needs. So you need to be saving in other accounts too. Some employers that offer defined benefit plans also offer defined contribution plans, such as 401(k)s and 457 plans, which let you sock away more for retirement. If yours does, consider yourself lucky and sign up, especially if your boss agrees to throw in a matching contribution.
And if you are eligible for a Roth IRA, that is often an unbeatable way to save for retirement. In 2016, individuals with a modified adjusted gross income (MAGI) below $117,000 and couples filing a joint tax return with a MAGI under $184,000 can make a full $5,500 contribution to a Roth IRA; if you’re over 50, you can add another $1,000 to boost your annual contribution limit to $6,500.