Ted Bauman: Traditional Pension vs Cash-Balance Plans

September 28, 2018 - By 
Ted Bauman explains Cash Balance Plans

A cash-balance plan may not mean very much to someone who has no concerns about retirement, but it provides an alternative to traditional pension plans. An international expert on money and the editor of three financial publications, Ted Bauman recommends a retirement plan review that may encourage employees to make a switch. From his perspective at Banyan Hill Publishing and as an authority on asset protection, he suggests that older workers and high wage earners may have a lot to lose by not considering retirement income alternatives. Employers may benefit as well.

Considering the Options

Bauman cites sobering statistics that may alarm anyone who has not considered the reality of savings habits in America. Only one-third of the population has saved money for retirement. Of the remaining 66 percent, about a fourth has accumulated only $10,000 or less. Ted Bauman estimates that “75 percent of Americans have inadequate retirement savings.” He recommends that employees evaluate the benefits of the two traditional types of savings plans and compare them with a third or “hybrid” type.

Traditional Pension

Companies have customarily offered “defined-benefit” plans that let employees know what to expect as monthly income. For many years, almost everyone thought that the traditional pension provided a secure source of funds for retirees. Bauman contends that it was a risky arrangement that relied on companies managing their plans professionally. However, Congresses that favored employers “watered down the system” so severely that companies in financial trouble often just stopped paying pensions.

401 (k) Plan

As an alternative to the traditional pension, the 401 (k) plan resulted from a format that resembled the individual retirement account and shifted the retirement savings risk to individuals. It placed the burden on each worker to make decisions about how much to put away. Simultaneously, it relieved the employer of any obligation other than deciding on how much it wanted to match. Smart Asset defines it as an option that allows an employee to make “contributions to a retirement plan” with participation by the employer who “may or may not make matching contributions.” The amount of savings and the movement of the stock market determine the value of a 401(k) account. All risk rests with the employee as an investor.

Cash-Balance Plan

Money considers a cash-balance program as a defined benefit plan that resembles a traditional pension that includes elements of a 401(k). Without a requirement for a cash investment, it relieves employees of “any responsibility for the investment choices.” Ted Bauman believes that the cash-balance option presents a combination of the best of the two types of retirement savings plans as a “hybrid” option. While the traditional pension allows the employer to provide the contributions, the investments reside under the management of finance professionals with a promise of benefits upon retirement. With a 401(k) plan, each employee receives an account balance instead of a guaranteed monthly income, and the fund’s performance rests with the stock market’s advances or declines and that of the fund manager.

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Understanding the Limitations of 401 (k) Plans

The benefits that employees get with a 401 (k) plan allow an employer to make contributions to a retirement program, but employers may or may not choose to contribute. The money that employees receive depends on how well the stock market performs and on the choice of funds that the manager selects to hold the contributions. A downturn in the market creates conditions that can wipe out a 401 (k). CNBC points to several reasons that make investing in a 401 (k) less than advisable in some cases. The plans require “revenue sharing” to pay the costs that a broker charges for selling the plan to an employer. The companies that hold the 401 (k) assets in custody require payment for record keeping. Operating expenses serve to reduce the returns that a plan may otherwise produce. Downsides include contract asset charges that can occur when plans offer “group variable annuities” to participants.

Advantages of Cash-balance Plan vs a Traditional Pension

A cash-balance pension plan resembles a traditional pension in several ways. The Balance points out that an employee does not invest any money in either and has no input into investment choices. Pensions may start paying out as soon as an employee reaches age 55 although most begin about 10 years later. Cash-balance plans use total years of service as well as salary in the years that lead to retirement to calculate account value. With them, companies base an annual credit of an “average of 5 percent“ of an employee’s salary, and it includes a “set interest rate” on the balance in an account. Cash-balance accounts allow portability that traditional pensions do not. The difference in methodology enables an employee to withdraw the funds from an account when leaving a job, but traditional pensions do not deliver a payout until an employee reaches retirement age.

Evaluating the Recommendations

Ted Bauman has spent a career across two continents in distilling and explaining financial facts that help people control their financial futures. His emigration from his childhood home on Maryland’s eastern shore to South Africa led to an education at the University of Cape Town and his postgraduate degrees in History and Economics. In his 25-years of experience there, he contributed his expertise through nonprofit sector executive leadership. Over the years, he has learned time management habits that he wishes he had acquired earlier. The benefits that Ted Bauman’s readers get to enjoy include his advice to “set aside the most productive part of the day” to work on the projects that matter the most.

Comparing the Pros and Cons of a Cash-balance Retirement Investment Strategy

The advantages and disadvantages of a cash-balance retirement plan may vary according to the point of view of participants. Older business owners who have limited retirement savings may see it as a “boon,” but a switch to it can “upend the retirement plans of long-term pension participants,” according to Kiplinger. Employees who have relied on a 401 (k) may like the addition of a cash balance plan that sharply reduces a tax bill and increases the value of a “sagging nest egg.”

However, those who anticipate the payout from a traditional pension plan may not like it as much. The traditional pension plan rewards longtime employees by increasing the benefits with contributions that companies base on the final years when salaries usually peak. Cash-balance plans may provide less lucrative results. Companies calculate contributions by using a base that represents an employee’s entire working career and includes the years when earnings did not equal those that came later. The advantages of a cash-balance plan to one employee may seem disadvantageous to another.

Choosing a Hybrid Retirement Plan Instead

The components of a well-designed hybrid plan include the elements that provide retirement security for all workers, according to Pew Charitable Trusts.

The basic requirements include these:

  • A commitment to fully fund retirement promises.
  • The combination of a benefit and savings rate that helps workers follow a path that ensures a secure retirement.
  • Access to income for life through annuities.
  • Professional management of a fund with low fees and pooled investments with “appropriate asset allocations.”

The IRS considers a cash-balance plan a hybrid that contains features of defined benefit options as well as defined contribution methods that allow sponsors and participants to benefit from both types of programs. Ted Bauman suggests that investors may need to consider it.

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