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10-26-15 Opinion re Pension Commission Cash Balance Plan v. 401k

Star Ledger - Pension Commission's cash balance plan offers more value for public employees than 401(k) | Opinion

By Star-Ledger Guest Columnist 
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on October 24, 2015 at 10:00 AM, updated October 24, 2015 at 10:06 AM

Some public employees have expressed concerns with the New Jersey Pension and Health Benefit Study Commission's proposal to provide future retirement benefits through "cash balance" plans because "a 401(k) cannot fund retirement for an average worker." The cash balance plans recommended by the commission, however, are not 401(k) plans. While the two plan types have some similarities, the distinguishing characteristics of the proposed cash balance plans address many of the public employees' concerns with 401(k) plans.By Larry Sher

A cash balance plan, like a 401(k) plan, expresses its benefits in terms of an account balance. Both plans allow public sector employees to make pre-tax contributions and both provide transparent benefits. That is, it is easy for employees to understand what their total benefits are worth at any time and how they grow over time. It is also easy to identify the portions of an employee's total plan benefit provided by his or her own contributions and by the employer's contributions. Like a 401(k), employer funding of the proposed cash balance benefits will tend to be highly predictable and stable.

But the similarities end there. A cash balance plan, being a type of defined benefit plan, can provide benefit guarantees and other special features that cannot be provided in a 401(k). The proposed cash balance plans provide valuable benefit guarantees. Employees' accounts will be no less than their salary-based employer "pay credits" plus their own contributions. In addition to this guarantee of principal, employees' accounts would receive "interest credits" over a given period at a rate no less than that guaranteed in the plan. If market returns exceed the guaranteed rate, employees would share in this upside. Thus, under the proposed cash balance plans, investment risks (and opportunities) would be shared between employers and employees, rather than being borne entirely by the employees as in a 401(k), or entirely by the employers as in the current pension plans.

The principal and interest credit guarantees mitigate two common risks of 401(k) plans – widely disparate results among participants due to their differing investment elections, and large losses in account balances shortly before retirement. The risk of disparate results is also mitigated because any interest credited above the guaranteed rate would be based on investment returns on assets selected by professionals and uniformly applied, rather than the individual-directed investments in typical 401(k) plans.

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Furthermore, the commission's proposal contemplates that in-service withdrawals (or loans) would not be permitted, alleviating another potential reason for 401(k) account shortfalls: diversion of retirement funds to other uses. Similarly, a 401(k) typically offers only lump sum distributions, which forces employees to invest the proceeds and determine how much they can withdraw each year, thus introducing the risk that employees will outlive their assets. The proposed cash balance plan would offer lifetime guaranteed annuities payable directly from the plan's assets, determined from account balances, and likely based on more favorable terms than would be available to an individual trying to annuitize his or her 401(k) balance with an insurance company.

All of foregoing distinctions render the proposed cash balance plan far more suitable as a primary retirement vehicle than a 401(k).

Funding of the cash balance plans will also be far more predictable, stable and responsible than pension funding has proven to be in New Jersey. The current pension benefits are defined as a percentage of final average salary, regardless of what salaries turn out to be or the actual performance of the plan's investments. The need to take into account uncertain future salaries and investment returns inevitably injects subjectivity into pension funding. Over the years, both employers and employees have taken advantage of this subjectivity to excuse underfunding or justify benefit enhancements, or even worse, as happened with 2001's 9 percent pension increase, to excuse underfunding while enhancing benefits.

In contrast, the risk of underfunding is greatly diminished under the proposed cash balance plans. Cash balance funding is based primarily on a percentage of current salary paid during the current year. While the guarantees built into the cash balance benefits and the provision for life annuities impose some contingent funding risk on taxpayers, this risk pales in comparison with the huge and uncertain contingent obligations assumed under the current pension plans.

Cash balance plans have increasingly replaced traditional pensions in the private sector for many of the same reasons that make a cash balance plan attractive in the public sector, particularly where financial volatility is a major concern but shifting all risks to employees is unacceptable. The centerpiece is predictability – a critical element for employees, employers and the public at large.

Larry Sher is a member of the New Jersey Pension and Health Benefit Study Commission.

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