Don’t throw out that DB plan yet. Here’s an alternative to just define contributions that can help you to attract more employees while minimizing risk and liability.
Recent actions by the courts have given cash-balance plans a new lease on life. Almost simultaneously, the Pension Protection Act blessed hybrid plans and provided guidelines on making conversions and ongoing design decisions. These developments reestablish the cash-balance plan as a viable alternative. Let’s look at a cash-balance plan as part of the total retirement picture from four key perspectives: value, cost, risk and administration.
• Value. One measure of value for almost any retirement plan is its ability to help attract and retain talent. Most companies measure the plan’s attraction and retention impact through surveys. Do employees understand and value the benefits they receive? In contrast to participants in traditional defined benefit (DB) plans, cash-balance plan participants at all service levels and ages can answer this question affirmatively.
It’s true that both cash-balance and 401(k) plans are easy for employees to understand because both communicate benefits as an account balance that grows tax deferred with interest and employer contributions or credits. However, cash-balance plans typically are totally employer funded, a significant selling point for recruiters. A cash-balance plan also allows employees maxing out their 401(k) to accumulate additional wealth.
Finally, the fact that many lower-paid employees cannot afford to contribute much to a 401(k) plan often prevents them from receiving the full employer match. Companies in industries such as retail depend on a large, lower-paid workforce and must manage this issue.
• Cost. The return on plan assets has a direct impact on any retirement plan’s long-term cost. When comparing a cash-balance plan to a 401(k), the relationship of return and benefit levels becomes clear. A cash-balance plan sponsor with a large pool of assets to invest can assume more risk—and reap more reward—than most individual 401(k) participants can tolerate. In addition, sponsors can take advantage of lower investment management fees available to institutionally managed funds. These investment advantages enable employers to provide a higher level of benefit at a lower ultimate cost. Plan sponsors should weigh the implications of this risk and reward balance, both for the company and the employees.
Finally, compared with traditional final average pay plans, several cash-balance plan features generally result in less cost volatility.
• Risk. In a cash-balance plan, the employer bears the risk of volatile or underperforming assets. Although cash-balance plan participants avoid this risk, many argue that they also miss out on the long-term market gains a 401(k) plan can provide. This is true for the minority of plan participants who are savvy about managing their 401(k) investments. Therefore, participants benefit from a cash-balance retirement plan that provides a stable (risk-free) floor on which to build the variable and more risky 401(k) account.
An added risk to participants is the possibility of outliving their retirement assets. Cash-balance plans are required to provide annuity options to participants, thus lessening a participant’s longevity risk. While 401(k) participants can purchase an insured life annuity, DB plans facilitate and encourage annuity payments.
• Administration. In today’s lean environments, few companies have the resources or inclination to take on a plan that is difficult or costly to administer. True, the administration of either a cash-balance or 401(k) plan can be easily outsourced, but cash-balance plan administration allows for slightly more flexibility regardless of who is administering it. For one thing, cash-balance accounts are generally valued quarterly or annually rather than daily using a set interest rate. Therefore, it is easier to reconstruct the participant’s account balance if an administrative error occurs. Contributions occur quarterly or annually, which may provide more flexibility.
WHY OFFER A CASH-BALANCE PLAN?
The cash-balance plan retains some of a traditional DB plan’s best features while recognizing the needs of today’s more mobile workforce. However, when employers offer a cash-balance and a 401(k) plan, the whole for employers and employees alike is often more than the sum of its parts. That combination provides employees a level of benefit security a 401(k) plan alone does not, while moderating the employer’s financial risks of a traditional DB plan.