The term “defined-benefit” has been traditionally used as a synonym for “pension.” Increasingly, the term is being used to describe hybrid cash balance plans. While not wholly inaccurate, as we’ll explain, it is certainly misleading for employees and lawmakers to use the terms interchangeably as there are several major distinctions between hybrid cash balance plans and defined-benefit pension (DB) plans. Today, we break down the differences between cash balance, DB pension, and defined-contribution (DC) plans and why DB plans are the best way to provide a secure retirement for dedicated public employees.
What are DB plans?
DB pension plans have been a part of America since the beginning of the republic when the U.S. colonies first offered pensions to soldiers injured during the Revolutionary War. A half-century later, in 1857, New York City introduced the first public pension plan in the country for the city’s public safety officers harmed in the line of duty.
Now, most public employees will have access to a DB plan. According to the U.S. Bureau of Labor Statistics, in 2018, 86% of state and local public employees had access to a DB plan, and 77% participated in one.
When a worker in a DB plan retires, they will receive a guaranteed monthly benefit for life that is based on a formula that includes the employee’s years of service, final average salary, and a benefit multiplier (calculated as a percentage to help determine the size of the monthly benefit).
DB plans earn revenue from three primary sources: employer contributions, employee contributions, and investment earnings. According to the National Association of State Retirement Administrators (NASRA), taxpayers contribute little to the funding of DB plans, as the national average of state and local government spending on pensions is 5.2%. NASRA has also found that, since 1990, investment earnings have accounted for 61% of DB plans’ revenue.
DB plans are different from other plans because they pool risk collectively and are specifically designed to be invested for the long term. Because DB plans have a mixture of high and low-risk investments spread out over a prolonged period of time, this enables them to weather the ups and downs of the financial market better than DC or hybrid cash balance plans.
Defined-contribution plans (aka the 401(k)).
With the passage of the Revenue Act in 1978 came the creation of the modern-day DC plan known as the 401(k). The 401(k), which was never intended to be the primary retirement savings vehicle for most Americans, took off in the private-sector when major corporations realized they could save money by offering a cheaper retirement plan for their employees.
DC plans are different from DB plans because they offer a less secure retirement benefit for participating workers. First, unlike pensions, workers are given a lump sum of money when they retire. The amount of money saved is made up of employee contributions, plus any employer-matched contributions (if offered), and any interest accrued. Rather than offering a defined monthly benefit they can count on for the rest of their lives, retirees are dependent on making this lump sum last, leaving them vulnerable to running out of money in their golden years. Retirees’ savings are also subject to the whims of the stock market, leaving them economically vulnerable if there is a downturn.
The widespread adoption of the 401(k) has not led to a corresponding rise in retirement security for America’s workers, as a combination of stagnant wages and a rising cost of living makes it difficult for workers to save on their own for retirement. According to the Economic Policy Institute, the median DC account balance is $1,000 for families headed by people in their mid-30s and is $21,000 for households near-retirement. That is not nearly enough to retire with security.
Hybrid cash balance plans
Hybrid cash balance plans try to combine elements of DB and DC plans. While on paper these plans may sound appealing because of this combination, in reality, they often fail to meet retirees’ needs.
Depending on how they are structured, some cash balance plans are set up so participants have individual retirement accounts consisting of pay credits and service credits. At the end of an employee’s career, the sum of these credits will determine how much income the worker will earn for retirement, which can be withdrawn either as a lump sum or as an annuity. Other hybrid plans offer a guaranteed rate of return on the account balance in the plan.
Too often now, opponents and lawmakers have taken to using the term “defined-benefit” to describe these cash balance plans. This is severely misleading because of the common understanding of what a “defined-benefit” plan typically offers employees, i.e. a structured formula that offers a modest monthly benefit.
Finally, cash balance plans also differ because they weaken the retirement security of newly hired public employees by cutting their benefits. In Kentucky, for example, the state legislature switched newly hired public employees to a cash balance plan in 2013. Under the plan, “an employee hired at age 24 who retires at age 65 will see a 13% cut in their retirement benefit compared to what the traditional pension plan provided.” The state’s unfunded liabilities also increased as a result of the switch, contrary to the claims of supporters who argued that it would decrease following the change.
Because of their benefit formula, risk pooling among members, and long-term investment outlook, DB plans offer the strongest pathway for a secure and dignified retirement compared to other types of retirement plans. According to the National Institute on Retirement Security (NIRS), the number of poor households aged 60 and older would have increased by 19% in 2013 if their income from DB pensions was eliminated, making them a critical resource in reducing poverty.
Lawmakers should avoid using DB to describe cash balance plans because that does not accurately reflect what a cash balance plan is in comparison to a DB plan, as they do not provide the same levels of security in retirement.