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MY COMPANY SHIFTED in the early 2000s from a traditional defined benefit pension plan, with a formula based on salary and years of service, to a cash-balance pension plan. All new employees would be put in the cash-balance plan. Existing employees had a choice to stay in the traditional plan or move to the new plan.
A generous transition credit for the cash-balance option was offered to current employees. The transition credit was based on a combination of current salary, years of service and age. Most employees who were in their 40s, which I was at the time, elected the cash-balance plan, which gave them instant ownership of a reasonably significant sum.
The cash-balance plan’s advantages over the traditional plan included its portability—you could take the money with you if you left the company—and its greater cash value for those early in their career, because you were 100% vested in your current balance. By contrast, the traditional plan was worth very little until you hit the magic age of 50. Starting at 50, there was a rapid, step-change increase in the monthly benefit. What if you left the company before 50? You got peanuts.
By contrast, there was no age-based step change with the cash-balance plan. The value grew steadily based on a combination of benefit credits, which were a percentage of an employee’s earnings, and investment credits, which were based on multiplying the existing balance by a percentage derived from a combination of the S&P 500’s total return for the year and a bond index. In no case would the annual investment credit be less than 4%. This protected employees during years when the S&P 500 had a negative return.
The election made in 2001 was irrevocable. Subsequently, the formula used for calculating the cash-balance investment credit changed twice. In 2008, the S&P 500 component was removed, which reduced the upside potential. Money accumulated prior to 2008 could still grow according to the original, more generous formula, but all benefit credits made in subsequent years could only grow according to a selected bond parameter.
Then, starting in 2017, the bond parameter was applied to the entire balance, completely eliminating any S&P 500-based growth potential. It was explained that these changes weren’t due to decisions made by the company, but were required based on recent legislation. To somewhat mitigate the impact, the benefit credit percentage was increased a little.
One of the results of these changes is that the few folks around my age who stayed with the traditional pension plan have ended up much better off in terms of pension income. True, they can’t take their pension as a lump sum—my employer doesn’t offer that option—but their monthly payouts are significantly higher than those of a similarly paid and tenured employee who elects to annuitize their accumulated cash balance upon retirement.
The annuity option for the cash-balance plan is based on a specific IRS rate that’s published monthly. For my company, the rate in August of a given year will be used for all cash-balance plan annuities taken in the following year. Say you have a $500,000 balance in the plan. If the applicable August rate is 5% when you retire, you get $25,000 a year for life. If that rate is 7%, you’ll get $35,000. If rates are going down rapidly, you could actually end up with a lower monthly payout as a “reward” for working an extra year. To be sure, the cash-balance lump sum value would still have increased and you always have the option of taking that full balance as a single sum rather than as monthly payouts.
Here’s where it gets personal. In a few months, I’m scheduled to retire and must make a pension decision. For many years, due to low interest rates, the monthly payout option wasn’t attractive. That changed in January 2023, when the effective annuitization rates jumped from around 6% to just under 7.5%. Whereas a $500,000 pension would have paid out around $30,000 annually if started in December 2022, that same pension would pay out around $37,500 a year if started in January 2023, an increase of 25%.
Last year, many workers with traditional pension plans scrambled to retire before the end of the year, so they could get a larger lump sum from their employer before the effect of higher interest rates kicked in. For traditional plans, rising interest rates reduce the actuarial present value of a traditional pension’s fixed monthly payout, making it less attractive to take the lump sum. By contrast, for cash-balance pension holders, higher interest rates don’t reduce the lump sum they receive. Still, as with beneficiaries of a traditional pension plan, higher rates do mean it makes sense to revisit the merits of taking the monthly payout.
For now, I’ve decided to punt. I’m deferring my pension until January 2024. The applicable interest rate has been trending higher, and I’ll know by September 2023 whether the rate applied throughout 2024 will be higher than the rate currently in force for 2023. Currently, I calculate the breakeven period for forgoing four months of pension payouts at the end of 2023 to be around six years. If, for some reason, the interest rate dives in the next couple of months, I can still elect to start my payments before the end of 2023.
Have any other HumbleDollar readers had to make similar decisions on a cash-balance pension? I’d love to read your thoughts.
Ken Cutler lives in Lancaster, Pennsylvania, and has worked as an electrical engineer in the nuclear power industry for more than 38 years. There, he has become an informal financial advisor for many of his coworkers. Ken is involved in his church, enjoys traveling and hiking with his wife Lisa, is a shortwave radio hobbyist, and has a soft spot for cats and dogs. His previous articles were Planting Bad Seeds and No Interest.
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Never use an annuity, you will earn 10% in the SP 500 or total market stock fund. The insurance company is taking 5% of your investments annually. This 5% fee costs you 5 million in your life. Anyone who argues this fact is an insurance employee. Read John Bogle for what fees cost us.
The problem with cash payouts replacing a pension is they don’t give you the 20X needed to make it work, they give us 10X .Example a pension of 50k needs 1 million in cash payout to equal that 50k pension, they give us 500,000 payout. With 1 million earning 10% ,you can withdraw 5% or 50k a year and your savings grows at 5%(10% return-5% withdrawals). Your 50k withdrawals will get a 5% raise annually. Inflation iin the 1900s was 3.1%.
I have a government cash balance plan that promises 7.5% for the duration of the payouts. It’s never changed. It’s always been very well funded and managed. I will opt for the annuity only because it’s not the bulk of my needed funds in retirement. I can let it ride (earning min. 5%) annual until I decide to annuitize. i think of it as just another bucket in the life of diversification.
A hospital that I worked 10 years for had a cash benefit pension plan with a guaranteed 5% annual return until one turned 65. Because no other investment that I had included this guarantee I left the account alone for the 10 years until I turned 65. Just prior to turning 65 I researched annuities from insurance companies but the income from them did not come close to that available from the pension plan. That information, the hospital’s annuity being guaranteed by the PBGC, and them doing all the legwork to set up the pension convinced me to go with the hospital’s insurer. I also chose the 100% survivor benefit as my mother in law just passed the 101 1/2 milestone, and my mother in law’s aunt lived to 103 1/2. Our break even point is less than 12 years so the odds are we potentially will have a huge total payout even without a COLA clause.
It definitely sounds like you made a great choice to keep the cash balance pension annuity.
Thanks Ken. Best wishes in making a wise decision. You have a good grasp on your options.
I retired with 28 years in the NC state pension system at the end of 2010. The only COLAs we get are the results of earnings by the pension system, and the system has done poorly with its investments. I have received less than 2% of COLAs in 13 years. As a consequence, the purchasing power of my pension has eroded considerably.
CPI has increased 40% during that time. I never relied solely on my pension and SS for retirement. I saved and invested along the way, so we still have a comfortable retirement.
Before I retired, I asked the State how well the pension system had done with COLAs vs inflation. They showed COLAs for past 20 years that had done slightly better than inflation. Since that time there have been less than 2% total COLAs. The silver lining for NC is their pension system is one of the best funded public pensions. So it is safer, yet our pensions erode slowly.
Do not underestimate the power of COLAs. Of course, if you have the money invested by yourself, your investment choices can help you hedge inflation. Many people do not have the discipline or knowledge to do that, but for those that do, I believe it is a better way. Our pension system did not have that option or I would have taken it.
Best wishes.
You are lucky to get 2% I get 1/10 of 1% maximum, a year
Thanks for commenting, Jerry. My pension does not have a COLA so I expect the purchasing power to erode considerably over time. It should, however, keep me from having to tap other assets that can continue to grow over the long term and hopefully outpace inflation.
Having any kind of pension these days is quite a blessing. You are fortunate that the NC system is so well funded, as many public pensions are not. I appreciate your input.
Ken, thanks for the interesting and well-written article. Also, thanks for linking to my article about pensions and ump sum decisions. I lived through the drama when my employer converted the defined-benefit plan to a cash balance plan. The decision was sold as necessary to secure the long term viability if the plan. The CFO told us it would make the plan solid for “as far as the eye could see”. About two years after they changed the pan, it was frozen. Apparently the eye couldn’t see very far.
Our traditional defined-benefit was frozen at the time of transition. Luckily I had 31 years in the plan at the time. When our employer transitioned to a CB plan they also added a lump sum option, which was new for all of us. We had options to take both benefits as monthly payments, or both as lump sums. We did not have the option to take one as an annuity and one as a lump sum. The
Have you considered or researched how generous an annuity the lump sum would purchase from a commercial insurance company? If you took the hybrid approach (old defined-benefit monthly benefit & partial CB lump sum) the benefit of that would be two sources of guaranteed income, but not tied to the same source. As dick Quinn states below, sources of guaranteed income in retirement are quite valuable.
The other thought I had was how do the various options work from a survivor perspective? These types of decisions are more complicated when you have to consider two lifetimes.
Rick, I have to give credit to Jonathan for including the link to your fine article. I am a relatively new Humble Dollar reader and was not aware of it. Thank you for commenting on my article.
I have looked a little bit into the value of the company annuity versus something I could purchase, using immediateannuities.com. The company annuity is a slightly better deal, presumably because they don’t need to make a profit. I like that the company pension is guaranteed by PBGC and is currently funded well. My company is large and thriving financially. But I do see your point.
I have a large variety of survivor options available. My wife has longevity in her genes (grandma lived until 99, mom is currently a very healthy and independent 89), so I am going to pick the 100% survivor option for the non-frozen portion.
In my thinking the decision to pick the 100% survivor option by the older, higher earning spouse is one of the best financial gifts you can make to a spouse. Years ago I previously helped a widow with her taxes after she had been air evacuated to my town after Katrina flooded her skilled nursing facility in New Orleans. Over the years her investments and savings became depleted by the years of uninsured costs at skilled nursing facilities. Her remaining financial income consisted of her earned social security benefit and the inherited 100% survivor pension benefit from her husband’s employment.
I am grateful that when she fully exhausted all her savings the facility where she came to, and died at, compassionately reduced the facility charges to her net ongoing benefit amounts for the remainder of her life. As she was limited in performing most activities of daily living the cost of facility qualified as a medical expense that reduced her taxable income to the point where she did not have any taxable income. I am further grateful the CPA firm I worked for at the time helped her with the preparation of her return without charge to her after the point her savings were gone.
I have wondered if she would have even been admitted in the first place to the skilled nursing facilities if she had not had the pension benefit. The pension did not have a COLA feature. I doubt that a COLA would have kept up with the increased medical costs.
Hi William,
I am a little confused regarding your person’s skilled nursing home financing. Usually after one’s assets reach a minimal level Medicaid covers the cost. Here in NH the maximum asset level for the patient is $2,500. For a living spouse the asset amount is higher and includes an amount for the value of their home. Unless this facility did not have Medicaid beds, they were receiving some income from the state and was not altruistic.
BTW I was the DPOA for finance for brother that became disabled who left his wife due to abuse. She refused to cooperate in providing financial information and the state refused Medicaid benefits for my brother. Well established Federal law states that a state can not deny benefits due to “spousal refusal”. How do I know this? I utilized $20K of my brother’s assets to retain a lawyer to fight the state and won. That was money that could have been used to defray the cost of his care going to a lawyer instead.
What’s the saying? Oh yeah penny wise pound foolish!
Good morning David,
I am glad you stepped up and were able to help your brother. My client had no family to advocate for her which likely could have helped her getting assistance through the Medicaid program and with all the other needs she had.
I did not hold a general or medical POA, only the IRS 2848 limited authority for my tax client which allowed me, as a then active CPA, to help her with complying with her annual tax filing obligations.
What I can say is the Medicaid safety net did not work as intended in a timely manner and the facility was compassionate in allowing her to remain in the small single room she occupied at a reduced rate.
An advocate, like you were for your brother, with the appropriate general and medical POA seems vital to better outcomes when the one counting on us needs us the most. Having a pot of money available to meet the financial aspects of filling those needs makes the task easier for all.
Best, Bill
A survivor annuity is a must in my opinion, but not necessarily a 100% J&S. That depends on the age difference, total assets and amount of life insurance.
I selected a 50% survivor annuity for my qualified plan and 75% for a smaller non-qualified pension, but my wife is four years older than I am and there is enough group life insurance to cover several years expenses plus investments.
I agree that the factors you cite are important considerations in the decision to be made regarding a survivor pension. I would add that I think another major consideration is income taxes when the filing status of the survivor changes to single.
For those survivors who have lived below their means and have accumulated “enough” and leave assets after death the pension decision may not be as crucial. Not knowing the unknowns of future life events makes me want to build a reasonable margin of safety, to the extent possible, into my decisions.
My wife is a bit older than me as well, which actually provides even more incentive to go with the 100%. The reduction on the monthly payout going from 50% to 100% is not that bad and is much less than if she were four or five years younger than me. I’d rather forgo a relatively insignificant amount of money each month in exchange for the knowledge that she would get the full enchilada were I to pass away first.
Thank you for your comments, William. The story you shared provides another helpful perspective. In addition, I also think about the advantages of having a pension in the event one’s financial judgement erodes in later years.
Any pension plan, including a cash balance plan is intended to be paid as an annuity, that’s why they are pensions. However, very few people in cash balance plans take the annuity as opposed to a lump sum.
I installed a CB plan at my old employer back in 1995 for new hires. I just learned that in 2023 there are 23 people on a CB annuity. The lump sum is too tempting.
Needless to say, each situation is different, but to me the more guaranteed income streams in retirement, the better.
We hear a lot today about the lack of pensions and yet we find that most people will give one up for the appearance of big bucks up front given the chance.
I make 10% a year investing, an annuity is a big money maker for insurance companies. If I was in a balanced portfolio 1/2 in (10% return) stocks and 1/2 of it in CDs making 4% .I will earn 7% .One doesn’t need 50% in cash, You should never withdraw more than 5% ,so 3-5 yrs in cash is fine for recessions ,this means 15-25% of your portfolio in cash .If you have 90% in stocks 10% in CDs you will make 9.5% .
My pension was frozen around 5 years ago. Though the payout will not be huge, around $900 a month, I’ll still choose the annuity. That will pay some bills and give me a minimum guaranteed income.
Thanks Dick, I was hoping you would chime in. I am pretty sure I am going to buck the trend and take my pension as an annuity since the interest rates are the most favorable in over a decade. Another option I have that I didn’t get into in the article (it was wonky enough already) is that I could take a combination of my frozen pre-conversion annuity along with the bulk of the benefit as a lump sum. The lump sum in that case would be about 75% of my total account balance, but I would get a modest lifetime pension as well. That had been my plan for years and is what most of my peers took when they retired. It is only this year that the full annuity option started looking more attractive.
I’ve known a few people who took the lump sum and it was gone in five years. They had to move in with their children ,and in one case their ex wife.
We had employees who took lump sums and blew it all in a year or so. One guy lost it in AC and was living in his car.
Well, we can be sure that guy was not a reader of Humble Dollar.