We’ve mentioned cash balance pension plans a few times on this blog. The Pew Research Center and the Arnold Foundation have been actively pushing cash balance plans in Kansas, Kentucky, Alabama, and Virginia. They tout cash balance plans as a solution to the problem of pension underfunding, as some magic combination of defined benefit pension plans and defined contribution 401(k)-style plans. In reality, cash balance plans are a failure for public employees and taxpayers.
Traditional defined benefit pension plans calculate the pension benefits that an employee earns using a formula:
The employee then knows how much she will earn in monthly retirement income. For a defined contribution 401(k)-style plan, the employee and, typically, the employer contribute a certain amount- usually a percentage of salary- to an account each month during the worker’s employment. The amount the employee will have in retirement income, however, depends on the investment returns of the money in that account. A sudden downturn in the financial market could completely wipe out years worth of savings. A cash balance pension plan tries to have it both ways by combining elements of defined benefit plans and defined contribution plans.
Cash balance pension plans are still relatively rare and their design varies widely. Instead of a defined benefit amount that they earn, in a cash balance plan, employees are given “accounts.” They accrue benefits in these “accounts” through “pay credits”- often a fixed percentage of salary- then use these “pay credits” to earn “interest credits”, which ultimately determines how much the employee will have in retirement income. The “interest credits” can be fixed or variable; fixed is much better for the employee because it means they will earn at least a certain amount. If the interest credit is variable, the employee could end up earning very little if the financial market does not perform well.
Cash balance plans offer the false promise of a more “fair” retirement plan for public employees. Traditional defined benefit pensions are better than cash balance plans at pooling and managing risk since cash balance plans shift more of the risk to the employee, just like 401(k)-style plans. In a cash balance plan, it is harder for a worker to know how much retirement income she is earning. The complicated formulas and variable interest credits make it less transparent how much an employee is actually saving for retirement. Finally, cash balance plans reward short-term employees over long-term employees who remain in one profession for their career. In public service jobs like teaching or firefighting, employees gain skills the longer they remain in the profession, which benefits the people they serve. Encouraging people to remain in the profession is one of the strengths of traditional defined benefit pensions.
People like John Arnold and the Pew Research Center like cash balance plans because they open the door to defined contribution 401(k)-style plans and they weaken the retirement security of public employees. States that are currently considering cash balance plans, like Alabama, should avoid buying their snake oil and stick with their traditional defined benefit pension plans.