To put together your estate plan, you need to understand all of your assets, especially your individual retirement accounts (IRAs) and qualified retirement plans, including your 401(k) plans. With that in mind, suppose your employer has just adopted a cash balance pension plan and told you that it is a lot like a 401(k). Is a cash balance pension plan similar to a 401(k) plan? Not sure? Then read on.

On the surface, cash balance pension plans appear similar to 401(k) plans. Under both types of plans, participants have accounts that show balances and are credited with interest. However, cash balance pension plans and 401(k) plans are fundamentally different. In a cash balance pension plan, you are credited with a retirement benefit, expressed as the current cash equivalent of the future benefit -- your employee account does not receive cash. Instead, a book entry is made where the employer agrees to pay you the benefit amount at a later date. In a 401(k) plan, you make your own before-tax contributions and may also receive an employer contribution. Consequently, cash balance pension plans are less secure than 401(k) plans because they are not fully funded, and they rely on the company’s continued performance.

Employee Investment Control and Vesting

One difference between 401(k) plans and cash balance plans relates to control. You typically can direct the investment of your 401(k) plan. You can also make withdrawals or take out loans from your 401(k) account, if needed. But, in a cash balance pension plan, you make no investment decisions. Instead, your employer sets an interest rate for benefits credited to employees under the plan and then invests the actuarial value of those benefits hoping to meet or exceed the stated interest rate. If your employer receives a larger interest rate than what was promised to the employees, the company can keep the difference or apply it to decrease its future contributions to the plan. Conversely, if the employer receives a lower interest rate than what was promised, the company will have to make up the difference.

Another difference between 401(k) plans and cash balance pension plans becomes evident when an employee leaves. Under a 401(k) plan you are always 100% vested in -- entitled to -- your contributions to your 401(k) plan account. However, employer matching contributions are subject to certain vesting rules. Most cash balance pension plans have a vesting requirement of five years of service before you are entitled to any portion of your account balance.

The Role of Interest Rates

From an employer’s perspective, cash balance pension plans are a great deal because they typically cost less to administer and fund than 401(k) plans. If an employer currently has a pension plan, it may save substantial money by converting the pension plan into a cash balance plan.

Cash balance pension plans can be highly sensitive to interest rate fluctuations. When most plans convert, the value of employees’ pensions earned up to the date of conversion is frozen. If interest rates go up, the value of the lump sum payout for the frozen benefit drops because it takes less money now to grow to the future benefit amount. Conversely, if interest rates drop, the value of the lump sum payout will increase. Some employers set the opening balances for employees lower than their accrued benefits under the old pension plan and guarantee the accrued benefits under the old pension plan. If you are close to retirement, this could have a significant impact on you and your estate plan.

For example, say your accrued benefit under a regular pension plan is $50,000 and your employer converts to a cash balance pension plan that gives you an opening balance of $45,000. Your employer has agreed to give you the greater of your balance under the old pension plan or your balance under the new pension plan. Assume that interest rates fall, causing the value of your benefit under the old pension plan to increase its present value to $60,000. Further, assume you work for a year after the conversion and receive $5,000 in pay and interest credits under the cash balance pension plan, bringing your balance to $50,000. If you then leave, you will receive $60,000 under the old pension plan. In effect, although the payout to you will be greater, you will not be earning any new pension benefits. To receive any benefits from the cash balance pension plan, your cash balance plan account in the above example first will have to grow to $60,000 from $45,000.

Examine All Investments Carefully

Like all investments affecting your retirement and estate plans, examine cash balance pension plans closely. As long as you understand that a cash balance pension plan is not the same as a 401(k) plan, you can make the most of it. Please call us if you have any questions about cash balance pension plans, 401(k) plans or any other estate planning issues. We would be glad to help you make the right decisions about your retirement plan.

Types of Vesting In a Cash Balance Pension Plan

You become vested in a cash balance pension plan in one of two ways:

1. Cliff vesting, which entitles you to employer matching contributions only after working for a number of years (such as 100% vested in employer matching contributions after three years of service); or