Although 401(k) plans dominate the retirement plan marketplace today, defined benefit plans aren’t dead. In fact, 20 percent of U.S. private industry workers were still covered by defined benefit plans in 2006, nearly 25 years after the creation of the 401(k) plan. Defined benefit plans remain popular today primarily because they have much higher tax-deductible contribution limits than 401(k) plans.
The legacy of defined benefit plans, however, also owes much to the cash balance plan, an innovative plan design that combines the portability and simplicity of defined contribution plans with the high deduction limits of traditional pension plans. Most new defined benefit plans will be cash balance plans and nothing will likely change that trend. Occasionally, however, employers starting a new defined benefit plan still consider a traditional pension plan.
When is a cash balance plan or traditional pension plan the preferred fit for an employer? The answer lies in the very different benefit designs of these plans. In a traditional FAP pension plan, the accrued benefit is defined as a monthly benefit equal to a percentage of the participant’s terminal earnings (e.g., 1 percent of final average earnings in the last three years). In a cash balance plan, however, the accrued benefit is defined as a notional or “hypothetical” account that accumulates with annual allocations (“pay credits”) and earnings (“interest credits”).
These two very different designs drive very different outcomes in the areas of wealth accumulation, benefit portability, employee understanding, retirement readiness, and employer financing. We’ll look at how those differences can help guide an employer’s choice between a cash balance plan and a traditional pension plan. Note: a traditional plan can also be structured as a “true unit credit” formula that accrues annual annuity credits rather than the “pay credits” and “interest credits” of the cash balance plan. The typical true unit credit plan controls the cost of accruals relative to pay like the cash balance plan, but typically does not offer lump sum distribution options that are the cornerstone of portability advertised by a cash balance plan. In this article, our reference to “traditional pension plan” refers to the final average pay variety.
Wealth Accumulation
Retirement wealth accumulates over an employee’s career very differently in traditional FAP pension plans and cash balance plans. Traditional FAP pension plans favor long-term employees because much of the benefit value is accumulated in later years. Benefits grow slowly in early years while wages are low, but the benefit formula is highly leveraged. Each pay raise increases the entire accrued benefit because of the terminal earnings basis, so benefit accruals accelerate in later years.
Long-term employees can accrue larger benefits under a traditional FAP pension plan, but short-term employees can forgo substantial retirement wealth. For these reasons, some believe that traditional FAP pension plans can encourage employee retention.
According to the Employee Benefit Research Institute, however, only 9.5 percent of employees work in the same job for 20 years or longer, so traditional FAP pension plans aren’t as beneficial for most of the U.S. workforce. Cash balance plans, however, accrue benefits more evenly over an employee’s career so changing jobs has less of an impact.
An employee who changes jobs might receive roughly the same retirement wealth from multiple cash balance plans as an employee who remains in one plan (assuming similar benefit formulas among employers). In short, traditional FAP pension plans distribute proportionally more retirement wealth to long-term employees than they do to short-term employees; cash balance plans accrue more evenly, favoring short-term, mobile workers.
Benefit Portability
So how do termination benefits compare between the two designs? Benefits typically become fully vested and are accessible sooner in a cash balance plan than a traditional pension plan. In a traditional pension plan, benefits are often not vested until after five years of service and employees often must wait until age 55 or older to access their retirement income. Available optional forms of distribution typically do not include a lump sum option. For these reasons, traditional pension plan benefits aren’t viewed as portable.
In a cash balance plan, however, benefits are required to be vested after three years and terminating participants can usually receive their entire retirement benefit in a lump sum when they leave that can be rolled over to an IRA. A mobile workforce demands portable benefits, and cash balance plans are more responsive to that need than traditional pension plans are.
Employee Understanding
Employees have an easier time understanding cash balance plans because they have the simple look and feel of the highly popular 401(k) plan. A cash balance plan accumulates with deposits (“pay credits”) and investment earnings (“interest credits”) much like a 401(k) balance. Employees can easily add the value of their cash balance to their other retirement accounts to do high-level retirement planning. Contrast this with a traditional pension plan where employees are shown an accrued life annuity payable at age 65. Employees typically struggle to understand the “value” of an annuity without a financial advisor, which most employees don’t have, so traditional pension plans tend to be under-appreciated compared to cash balance plans. But it should be noted that ultimately employees face translating the “values” to an annual income stream in retirement. There the traditional plan shines.
Retirement Readiness
Employees are financially prepared for retirement when they’ve accumulated enough funds from Social Security, personal savings, and employer-sponsored retirement plans to replace a targeted percent of pre-retirement earnings. Cash balance plans are based on the employee’s entire career of earnings. Benefits typically accumulate with variable interest credits, so they don’t consistently replace a fixed percentage of pre-retirement earnings.
Traditional FAP pension plans, however, are based on terminal earnings and they’ll aim to replace a fixed percentage of pre-retirement earnings. More importantly, traditional pension plans emphasize annual lifetime income options over single-sum payouts, so they provide greater protection against employees outliving their retirement assets. Even with growing emphasis on creating pension plans seem to better prepare employees for retirement than cash balance plans through targeted income replacement and emphasis on lifetime income options.
Employer Financing
A cash balance plan and a traditional FAP pension plan can be designed to cost roughly the same on paper, but an employer can contribute to a cash balance plan with less financial risk to the company than a traditional pension plan.
In defined benefit plans, by definition, the employer must fund the promised benefits no matter how the investments perform. However, more investment risk can be present in a typical investment policy for a traditional FAP pension plan than in a cash balance plan. Traditional FAP pensions are more likely to be invested heavily in equity securities, while cash balance plans are often invested conservatively, favoring more fixed income securities to closely match the interest crediting rate.
Another difference is how each plan’s liabilities respond to salary increases. In a cash balance plan, a single year’s pay increase will only increase the current year’s benefit accrual or pay credit. In a traditional FAP pension plan, one year’s pay increase affects the entire accrued benefit liability because the benefit is so highly leveraged on terminal earnings. As a result, traditional FAP pension plans can have more volatile cash contribution requirements than cash balance plans. Furthermore, employers who must account for their pension obligations under U.S. GAAP can see more balance-sheet and expense volatility with a traditional pension plan than a cash balance plan.
There is also a difference in the extent to which the plan sponsor must bear or finance the plan’s mortality risk—the risk that participants will outlive actuarial estimates. In a cash balance plan, employees typically receive their benefits in a single sum, so there’s no mortality risk to the employer once the employee retires. But in a traditional pension plan employees often receive lifetime annuities and the employer will need to fund that annual payout no matter how long the employee actually lives. As a result, a mature traditional pension plan can have long-term liabilities and it may be prohibitively expensive to terminate the plan depending on annuity purchase rates. Employers find it easier to predict the resulting cost of a cash balance plan because the cost is typically limited to the sum of the current cash balances
.
Many financial risks are present in defined benefit plans, but the level of concern over those risks will vary among employers. Some large companies have terminated their traditional FAP pension plans or converted them to true unit credit traditional plans or cash balance plans in the past 10 years to reduce the financial risks, regardless of any design advantages. In addition, the majority of costs in a large company’s traditional pension plan will go to providing benefits to rank-and-file employees, not the key stakeholders (i.e., C-suite executives). Smaller organizations, however, may be more willing to accept the risks of a traditional pension plan because most costs go to provide benefits to the owners or shareholders.
Summary
Employers who want to increase their tax-deductible retirement contributions beyond a 401(k)-type plan typically consider adding one of two defined benefit plan types: a cash balance plan or a traditional FAP pension plan.
The cash balance plan is the more popular option because it looks similar to a 401(k) plan and provides highly portable benefits, all while carrying less financial risk to the employer than a traditional pension plan.
But traditional pension plans still have their place in the retirement marketplace. Many small business and professional service firms are willing to accept the additional financial risks of a traditional pension plan to attain the benefits they provide in helping retain employees for the long-term and enhancing employees’ overall retirement security.
Deloitte disclaimer: This publication contains general information only and is based on the experiences and research of Deloitte practitioners. Deloitte is not, by means of this publication, rendering business, financial, investment, or other professional advice or services. This publication is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte, its affiliates, and related entities shall not be responsible for any loss sustained by any person who relies on this publication.
David A. Pitts, FSA, MSPA, EA, MAAA, is a manager with Deloitte Consulting LLP in Minneapolis. He has been consulting with plan sponsors for more than 14 years in the areas of plan design, funding, and compliance.
