Choosing Between Pension Plans

If you have access to a traditional pension plan at work, it can be an excellent benefit for retirement. However, newer pension designs like cash balance plans differ greatly. Understanding how to evaluate pension plans is key to making the right choice. This blog will compare the pros and cons of different pension plan types to help inform your decision.

Overview of Pension Plans

A pension plan is an employer-sponsored retirement account that promises to pay employees a fixed, regular retirement income for life after they retire. Pensions provide a predictable income stream without requiring workers to actively manage investments.

The main types of pension plans include:

  • Traditional/Defined Benefit – Employer guarantees a monthly income for life based on tenure and salary.
  • Cash Balance – Employer credits worker’s account annually with interest for retirement income.
  • Hybrid – Combines traditional plan and 401(k) with employer contributions.

Now let’s dive deeper into how traditional and cash balance pensions differ.

Choosing Between Pension Plans

Traditional Pensions

Traditional defined-benefit pensions pay a monthly retirement income based on your years of employment and earnings. Key features include:

  • Monthly income is fixed and continues for your lifetime along with a survivor’s benefit.
  • Benefit accrual is backloaded – income replaces a higher % of income as tenure increases.
  • The employer bears risks and must fully fund the plans.
  • Benefits are insured by the Pension Benefit Guaranty Corporation (PBGC) up to limits if underfunded.
  • No employee contributions are required in most plans.
  • Benefits do not accrue evenly each year but spike toward retirement.
  • Income typically begins at the normal retirement age as defined in the plan.

While traditional pensions provide reliable lifetime income, some downsides exist as well.

Drawbacks of Traditional Pensions

Some drawbacks of traditional defined-benefit pension plans include:

  • Benefits are not portable if you change employers prior to vesting.
  • Benefits are not personalized based on individual factors like lifespan.
  • Income is not adjusted for inflation leaving purchasing power at risk.
  • Employers bear funding risks which may lead to benefit reductions.
  • PBGC limits leave extremely high benefits vulnerable.
  • The lack of lump sum payout options reduces flexibility.

This is where the newer cash balance design aims to make improvements.

Choosing Between Pension Plans

Cash Balance Pension Plans

Cash balance plans are a type of defined benefit plan that combines features of traditional pensions and defined contribution plans like 401(k)s. Key characteristics include:

  • Employer annually credits a retirement account for you with interest.
  • The account balance accrues evenly each year.
  • The balance is portable between employers.
  • You choose a lump sum or annuity at retirement.
  • Payouts can start prior to the normal retirement age.
  • Accounts earn a fixed interest rate specified in the plan.
  • Benefits take the form of an account balance.

Cash balance plans provide increased transparency and predictability over traditional pensions. Next, let’s examine the pros.

Advantages of Cash Balance Pensions

Some of the main Advantages of cash balance pension plans include:

  • Portable account balances make them ideal for mobile employees.
  • Regular accruals avoid backloading issues of traditional pensions.
  • The lump sum payout option provides more flexibility.
  • Participants understand the benefits since they resemble a 401(k) balance.
  • Allows retirement prior to normal pension age.
  • Accounts can be split for divorce more easily.
  • Participants can model future balance projections.
  • Accounts earn market interest rates making them competitive.

Disadvantages of Cash Balance Plans

Some Disadvantages to consider with cash balance pensions include:

  • The employer still bears funding risks.
  • PBGC protections may be lower than traditional pensions.
  • Market fluctuations can impact interest crediting rates.
  • Early retirement subsidies common under traditional pensions usually don’t exist.
  • Annuitizing balances to get lifetime income reduces flexibility.
  • Participants may outlive lump sum distributions.
  • Income is not inflation-adjusted like some traditional plans.

Overall, cash balance plans offer increased transparency and individual control over retirement assets compared to traditional pensions.

Choosing Between Pension Plans

Key Considerations When Evaluating Pension Plans

Here are some important factors to weigh when assessing pension plans:

  • Will benefits vest before you may leave the employer?
  • How financially healthy is the employer to meet funding obligations?
  • What lump sum payment options exist if you don’t want lifetime income?
  • Does the plan provide cost-of-living increases to protect against inflation?
  • Do benefits allow phased retirement or early retirement if desired?
  • Can you comfortably manage investing in a lump sum distribution?
  • How much income would each plan type realistically replace for you?

Working closely with your employer’s benefits team and qualified financial professionals can provide guidance to make the pension choice fit your needs.

Conclusion:

While traditional pensions offer guaranteed lifetime income, portability issues exist. Cash balance plans provide increased transparency and control for more mobile employees. When choosing between pension plan types, evaluate how well each aligns with your financial situation, retirement timeline, longevity, and desire for flexibility. This will steer you toward the optimal pension design.

The most common pension plan types are traditional/defined benefit plans, cash balance plans, and hybrid plans that combine aspects of defined benefit and defined contribution accounts.

FAQs About Pension Plans

What are the main types of pension plans?

The most common pension plan types are traditional/defined benefit plans, cash balance plans, and hybrid plans that combine aspects of defined benefit and defined contribution accounts.

What are the key differences between traditional and cash-balance pensions?

Traditional pensions backload benefits and provide lifetime income, while cash balance plans accrue evenly with account-style balances. Cash balance plans offer more portability and flexibility.

What happens if you leave a traditional pension early?

With traditional pensions, leaving a job prior to vesting results in forfeiture of accrued benefits. This lack of portability is an issue if changing employers.

What are the funding risks with pensions?

The employer bears risks of adequately funding defined benefit pensions. Underfunding may result in reduced benefits. PBGC insurance protects a portion of benefits if terminated.

What pension options exist for withdrawing benefits?

Traditional pensions pay lifetime income, while cash balance can pay lifetime annuities or lump sums. Hybrid plans offer options like installment payments, annuities, or lump sums depending on the design.

A Ahmad
A Ahmad

A Ahmad, a certified financial planner, Retirement Step was created to share over two decades of retirement planning experience with readers looking to take control of their financial futures.

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