MY COMPANY SHIFTED in the early 2000s from a traditional defined benefit pension plan, with a formula based on salary and years of service, to a cash-balance pension plan. All new employees would be put in the cash-balance plan. Existing employees had a choice to stay in the traditional plan or move to the new plan.
A generous transition credit for the cash-balance option was offered to current employees. The transition credit was based on a combination of current salary, years of service and age. Most employees who were in their 40s, which I was at the time, elected the cash-balance plan, which gave them instant ownership of a reasonably significant sum.
The cash-balance plan’s advantages over the traditional plan included its portability—you could take the money with you if you left the company—and its greater cash value for those early in their career, because you were 100% vested in your current balance. By contrast, the traditional plan was worth very little until you hit the magic age of 50. Starting at 50, there was a rapid, step-change increase in the monthly benefit. What if you left the company before 50? You got peanuts.
By contrast, there was no age-based step change with the cash-balance plan. The value grew steadily based on a combination of benefit credits, which were a percentage of an employee’s earnings, and investment credits, which were based on multiplying the existing balance by a percentage derived from a combination of the S&P 500’s total return for the year and a bond index. In no case would the annual investment credit be less than 4%. This protected employees during years when the S&P 500 had a negative return.
The election made in 2001 was irrevocable. Subsequently, the formula used for calculating the cash-balance investment credit changed twice. In 2008, the S&P 500 component was removed, which reduced the upside potential. Money accumulated prior to 2008 could still grow according to the original, more generous formula, but all benefit credits made in subsequent years could only grow according to a selected bond parameter.
Then, starting in 2017, the bond parameter was applied to the entire balance, completely eliminating any S&P 500-based growth potential. It was explained that these changes weren’t due to decisions made by the company, but were required based on recent legislation. To somewhat mitigate the impact, the benefit credit percentage was increased a little.
One of the results of these changes is that the few folks around my age who stayed with the traditional pension plan have ended up much better off in terms of pension income. True, they can’t take their pension as a lump sum—my employer doesn’t offer that option—but their monthly payouts are significantly higher than those of a similarly paid and tenured employee who elects to annuitize their accumulated cash balance upon retirement.
The annuity option for the cash-balance plan is based on a specific IRS rate that’s published monthly. For my company, the rate in August of a given year will be used for all cash-balance plan annuities taken in the following year. Say you have a $500,000 balance in the plan. If the applicable August rate is 5% when you retire, you get $25,000 a year for life. If that rate is 7%, you’ll get $35,000. If rates are going down rapidly, you could actually end up with a lower monthly payout as a “reward” for working an extra year. To be sure, the cash-balance lump sum value would still have increased and you always have the option of taking that full balance as a single sum rather than as monthly payouts.
Here’s where it gets personal. In a few months, I’m scheduled to retire and must make a pension decision. For many years, due to low interest rates, the monthly payout option wasn’t attractive. That changed in January 2023, when the effective annuitization rates jumped from around 6% to just under 7.5%. Whereas a $500,000 pension would have paid out around $30,000 annually if started in December 2022, that same pension would pay out around $37,500 a year if started in January 2023, an increase of 25%.
Last year, many workers with traditional pension plans scrambled to retire before the end of the year, so they could get a larger lump sum from their employer before the effect of higher interest rates kicked in. For traditional plans, rising interest rates reduce the actuarial present value of a traditional pension’s fixed monthly payout, making it less attractive to take the lump sum. By contrast, for cash-balance pension holders, higher interest rates don’t reduce the lump sum they receive. Still, as with beneficiaries of a traditional pension plan, higher rates do mean it makes sense to revisit the merits of taking the monthly payout.
For now, I’ve decided to punt. I’m deferring my pension until January 2024. The applicable interest rate has been trending higher, and I’ll know by September 2023 whether the rate applied throughout 2024 will be higher than the rate currently in force for 2023. Currently, I calculate the breakeven period for forgoing four months of pension payouts at the end of 2023 to be around six years. If, for some reason, the interest rate dives in the next couple of months, I can still elect to start my payments before the end of 2023.
Have any other HumbleDollar readers had to make similar decisions on a cash-balance pension? I’d love to read your thoughts.
Ken Cutler lives in Lancaster, Pennsylvania, and has worked as an electrical engineer in the nuclear power industry for more than 38 years. There, he has become an informal financial advisor for many of his coworkers. Ken is involved in his church, enjoys traveling and hiking with his wife Lisa, is a shortwave radio hobbyist, and has a soft spot for cats and dogs. His previous articles were Planting Bad Seeds and No Interest.