Let's Make a (Bad) Deal

A traditional pension is based on your years of service to your employer and your last few years' salary. As a result, the value of pension benefits tends to zoom upward as employees near retirement. Under a cash-balance plan, though, your company allocates a percentage of your pay each year into a hypothetical account, which grows at a designated interest rate. And when you retire, your company will pay you the balance of the account.

From your employer's perspective, there's considerably less risk to crediting you with a set amount every year and being done with your retirement obligation the day you walk out the door than to budgeting for mailing you checks until you're a centenarian. That's one reason companies like cash-balance plans. And a lump-sum payment isn't necessarily a bad thing for you: There may be a psychological difference between getting biweekly paychecks and managing a big pile of money, but there doesn't have to be a mathematical difference. Any financial quantity, from the value of an apple tree to an inheritance from your aunt, can be expressed either as a single payment or as an annuity.

So everything about the cumulative value of a cash-balance pension depends on the assumptions your employer makes in setting it up: How much of a pay credit and an interest credit will you get? And the answers to those questions generally turn out to be, "not enough to equal the benefits you would have received from a traditional pension." According to an October 2005 Government Accountability Office report, when pension plans are converted, "more workers would have received greater benefits under the final average pay [pension] than under the typical cash-balance plan." A key reason: Companies contribute less. Indeed, companies are using cash-balance conversions to reduce their overall pension obligations. That's an even bigger reason why firms like cash-balance plans.

Most important, the "zooming" effect of traditional pensions disappears in a cash-balance plan. The value of a regular pension is determined both by the number of years you've worked and by increases in your salary, and can easily double in your last five to seven years on the job. A cash-balance benefit, on the other hand, simply grows by the compounded rate of your interest credit every year. "A cash-balance plan's age 65 lump-sum benefit for a long-service employee is dwarfed by the benefit earned under a traditional defined-benefit formula," writes Al Trezza, assistant director of research and analysis for Mellon Asset Management, in a recent report.

Companies eagerly began converting to cash-balance pensions in the late 1990s, and by 2003 cash-balance plans held 40% of all defined-benefit assets, according to Federal Reserve data. But when long-term employees at IBM, Xerox and other big firms woke up and found their pension benefits slashed (in some cases halved), they launched lawsuits and scored a few notable victories, which slowed the pace of conversions.

Last August, however, Congress passed the "Pension Protection Act of 2006," which essentially immunized future cash-balance plans against claims of age discrimination as long as employers apply the same interest-rate credit to workers of all ages. The following week the Seventh Circuit Court of Appeals held that the basic structure of cash-balance plans is legal, stating that "removing a feature that gave extra benefits to the old differs from discriminating against them." And on Jan. 16, the Supreme Court let that ruling stand.

Essentially, companies have found a way to reboot the process by which workers accrue retirement benefits. And the people who suffer most from cash-balance conversions are those who can do the least about it — employees who have spent many years at one company and are nearing retirement.

It's too late now to debate the inevitability of cash-balance plans, but the next time a similar scheme pops up, we would all do well to keep three things in mind.