Tuesday, November 16, 2010

For Employers, What is a Risky Retirement Plan?

Since the late 80s, the private sector in the US has seen a gradual migration away from defined benefit pension plans (including, but to a lesser extent, hybrid plans such as cash balance plans). The most popular plan now is the 401(k) plan -- virtually every employer with more than 25 employees seems to have one and most provide an employer matching contribution.

In these times where corporate cash flow is king for many, isn't this a risky design? Matching contributions are not limitless, but most companies encourage their employees to increase their participation in the 401(k) plan, and with that increased participation comes an increase in company cost.

Some of the largest companies perform sophisticated forecasting of their 401(k) costs, but most don't. And, even those who do could be off by a material amount.

Further, 401(k) plans do not promote employee retention (unless they are extremely generous) beyond the vesting period (usually 3 years or less). In fact, in the current economy, where many employees are cash-strapped, a meaningful number have left their jobs for the primary purpose of taking a distribution from their 401(k) plan despite the adverse tax consequences. Isn't excessive turnover a significant business risk?

Where can employers turn? With the latest round of cash balance regulations, this may be the much less risky answer. Plan sponsors can now offer a rate of return equal to the rate of return on the trust's investments (or a  fraction thereof) with a lifetime floor. So, to the extent that a plan invests in a well-diversified relatively low-volatility portfolio and properly hedges against interest rate deviations, required cash flow may be more predictable than in a 401(k) plan. And, as long as you are willing to cover your low-paid, there are no refunds that must be given to your high-paid.

No, cash balance plans are not nirvana, but with the recently proposed regulations, they may now be the closest thing in a qualified retirement plan that the US private sector has to offer.

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