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©National Tax Association. Reprinted with Permission.
Abstract
The conversion of traditional defined benefit plans to cash balance plans is among the most controversial aspects of pension policy today. Because the controversy has focused on the treatment of older workers, however, the debate has generally ignored the long-term implications for retirement security. In fact, cash balance plans can often provide more retirement security than traditional defined benefit plans or defined contribution plans, especially for workers who change jobs frequently.
Introduction
The conversion of traditional defined benefit plans to cash balance plans and the rules governing these conversions are among the most controversial aspects of pension policy today. In recent years, several large employers have replaced their traditional defined benefit retirement plans, which typically pay guaranteed benefits that depend on years of service and salary earned near the end of the worker’s career, with cash balance plans, which provide benefits that depend on employer contributions to the plan made throughout the worker’s career and the amount of interest credited over time to these contributions. The controversy surrounding these conversions has focused on the treatment of older workers. Workers who spent many years in the old plan could fare worse under the transition because many traditional defined benefit plans provide generous benefits to long–tenured employees, especially those who choose to retire early. These concerns have led to age discrimination lawsuits and threats of Congressional action to prevent employers from converting to the cash balance design.
The focus on the impact of conversions on older workers has diverted attention from the long–term implications of cash balance plans for retirement security. Most retirement benefits in traditional defined benefit pension plans go to workers who spend much of their careers with a single employer, whereas those who change jobs frequently receive relatively few benefits from traditional plans. By contrast, workers in cash balance plans tend to accrue retirement benefits more evenly over the career and are not penalized much when they change jobs. As a result, cash balance plans may be better suited to the retirement needs of an increasingly mobile workforce than traditional defined benefit plans. Cash balance plans also offer a number of advantages over defined contribution plans, now the most common type of pension plan. Unlike defined contribution plans, cash balance plans provide some protection from investment risk, offer lifetime annuities that insulate retirees from the risk of spending all of their assets before they die, and provide benefits that are insured by the federal government.
The role of employer–sponsored retirement plans in retirement security is a crucial policy issue. As Social Security’s financial crisis grows, cutbacks in public retirement benefits are becoming increasingly likely, raising the importance of private sources of retirement savings. In addition, federal and state governments provide generous tax breaks to employer–sponsored retirement plans. These tax advantages will cost the federal government about $116 billion in lost tax revenue in 2004, according to projections by the Office of Management and Budget (2004). In light of these costs, it is important to understand how different plan designs operate and whether they effectively promote economic security at older ages.
In this article we examine the implications of cash balance plans for retirement security. After describing how different retirement plans work, we discuss the current controversy about cash balance plan conversions. We then examine the potential impact of cash balance plans on retirement security for workers who spend their entire careers in these plans, focusing on the implications for mobile workers, and the effects of payout options on retirement well–being. We also explore how cash balance plans might promote work at older ages, an increasingly important policy concern as the population ages.
(End of excerpt. The entire paper is available in PDF format. ©National Tax Association. Reprinted with Permission. )
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Disclaimer: The nonpartisan Urban Institute publishes studies, reports, and books on timely topics worthy of public consideration. The views expressed are those of the authors and should not be attributed to the Urban Institute, its trustees, or its funders.
