Your pension plan is the subject of today’s post – but first, a pop quiz:
What do rotary phones, the #2 pencil, and defined benefit pension plans have in common?
They are relics of our parent’s generation – things that are going the way of the dinosaur!
There’s more than one type of pension – with some being better than others. Unfortunately, your current pension plan is not the sort of pension that our parent’s generation have come to enjoy. Before I get into what makes your pension plan so different, let’s take a bit of time to talk about the old school pension plan: the defined benefit pension plan.
The Defined Benefit Pension Plan
Before 401(k)s became the main option for retirement savings, employers gave their staff traditional defined benefit pension plans. And this was (and still is) a very big deal; a traditional defined benefit pension is an amazing employee benefit! With a defined benefit pension plan, an employee can count on receiving a guaranteed payment in retirement. The amount of this guaranteed payment increases with one’s salary and years of service – the higher one’s salary and the more years they work at a company, the greater the guaranteed payment. With enough years of service, employees can sometimes expect a very big benefit – something large enough to cover their basic living expenses and then some!
To illustrate how a traditional defined benefit pension plan works, let’s refer to a fictional employee of EY, Richie Rich:
Richie has been an employee at Ernst & Young (EY) for some time now – roughly 30 years! When Richie first joined EY, he qualified for EY’s defined benefit pension plan. For each year he worked, Richie earned credits, entitling him to higher and higher guaranteed payouts. Having worked for EY for over 30 years, Richie could expect a monthly benefit of $10,000 a month from EY’s pension plan. What a deal!
What makes the traditional defined benefit pension plan so special is that the employer is on the hook for providing the employee with a guaranteed payout – a payment that could have been promised 30 years ago!
How A Defined Benefit Pension Plan is Different from a 401(k) Retirement Plan
Unlike EY’s traditional defined benefit pension plan, your 401(k) account is only as valuable as the balance of the account – which depends on:
• the amount of contributions, and
• the growth available from the investments
Let’s use an example with our favorite fictional employee, Joe Danger CPA, to illustrate this point:
Joe Danger defers 6% of his salary into his 401(k) account. For his $3,000 contribution, the company kicks in 25%, or $750. Over the next 30 years, the $3,750 in Joe’s 401(k) account earns a 7% return. This $3,750 grows to $28,545.96.
The amount of money that Joe will have in retirement is unknown. The account balance depends on both the amount of money going into the account, and the investment return he earns.
It’s a different story for Richie at EY. The amount of money that Richie can expect in retirement from EY’s defined benefit pension plan is not only known, but guaranteed by his employer. Richie knows exactly how much money he can expect from his pension in retirement.
Your Defined Benefit Pension is Probably a Cash Balance Plan
The traditional defined benefit pension offered by EY is just one type of pension. So, if you find yourself a new participant in your employer’s pension plan, that pension plan is more likely a defined contribution pension plan than a defined benefit pension plan. (Or it could be a defined benefit pension plan using a cash balance formula, such as Deloitte’s pension plan.) This means that instead of expecting a guaranteed amount in retirement, you can expect a guaranteed contribution in the investment account. And just like your 401(k) account, the value of a defined contribution pension plan (or a cash balance plan) is only as valuable as the amount of the contributions and the growth of the account.
|Company||Plan Type||Payment Determined By|
|EY||Defined Benefit Pension Plan||Employer Guarantee|
|Deloitte||Defined Benefit Pension Plan – Cash Balance||Account Contributions & Account Growth|
|–||401(k)||Account Contributions & Investment Return|
What is a Cash Balance Pension Plan?
As mentioned, a traditional defined benefit pension plan guarantees a certain dollar amount in retirement – such as $10,000/month for the rest of your life. With a cash balance pension plan, you are guaranteed a benefit, but the amount of the benefit is unknowable. Of course, an estimate of the benefit amount that your cash balance plan entitles you to is always available on your pension statement. However, this estimate assumes a rate of investment return on the account – and you can rest assured that whatever investment return estimate is used to calculate your benefit will be different than the average interest rate going forward – for the simple reason that no one can predict the future.
This is part of the reason your cash balance pension is so much like your 401(k) plan. Like your 401(k), no one knows the investment return you’ll be able to get over the next 30 years. (Of course, we can make estimates.) Moreover, a cash balance plan only provides a contribution by your employer (much like the contribution your employer makes when they match your 401(k) contribution).
To illustrate this, let’s return to our favorite fictional employee, Joe Danger, CPA, and his fictional pension plan:
Having worked at his employer just long enough, Joe is now able to participate in his company’s pension plan. Joe gets $1,500 put into his cash balance pension plan in the first year. The next year, he gets a little bit more, with the original $1,500 earning a bit of interest over the year. After 30 years, Joe is sitting on over $150,000 in his cash balance pension plan.
Ready to enter retirement, Joe has a choice in front of him, annuitize the amount or take it as a lump-sum. The lump-sum option means Joe is entitled to $150,000. Annuitization will get Joe an annual payment of $10,000 a year for the rest of his life.
What Do I Need to Know About My Pension Plan?
Employers are moving from traditional defined benefit pension plans to 401(k) offerings and cash balance plans because these new options are less expensive for the employer. And usually when an employer spends less money on an employee benefit, it means less value for the employee. The switch to the cash balance pension plan is no exception.
Looking at the anecdotes above, its easy to note that Richie can live a pretty good life on $120,000 a year, while Joe – on the other hand – will likely need other income than the $10,000 annually he can expect from his pension plan. The catch for Richie is that sometimes employers run out of money in their pension plans! So, while he has a “guaranteed” benefit, he may actually not get that entire benefit. But that’s the subject for another blog post.
Young employees take note: pension plans are not what they once were. You cannot expect to fund the total of your living expenses from your pension plan payout alone. You will need to supplement your income in retirement from your 401(k) plan, your IRA, and your taxable investment accounts.
And Now for the Good News
The good news is multifold: firstly, you can count your employer’s pension plan to help you save for retirement – if only just a little bit. Secondly, you now know not to count on your employer’s pension plan to completely cover you in retirement. This gives you the opportunity to plan your savings for retirement with plenty of time to spare.