All about cash balance plans

All about cash balance plans

Since the onset of employer-sponsored 401(k) plans, traditional pension plans have mostly disappeared from the private sector. The 401(k) alleviated the expense of funding a pension plan for companies struggling to pay larger benefits to retirees who were living longer, yet provided a way for employees to contribute to their own retirement.

Now another shift is occurring in the world of retirement plans, one that is providing some of the lifetime guaranteed income of a traditional pension with cost and tax benefits for employers. Cash balance plans are a fast-growing segment in the retirement plan market and may become as numerous as 401(k) plans in the next few years.

What are cash balance plans?

Cash balance plans are defined benefit pension plans. How they differ from traditional pension plans is the way in which the employee benefit is defined.

A traditional pension pays a benefit based on how long you worked for the employer and your average salary during the last few years of employment. You never have an individual pension account that grows over time.

A cash-balance plan, on the other hand, creates a hypothetical account that grows in value based on your annual compensation and a set annual interest rate. The individual accounts are considered hypothetical because they do not reflect actual contributions to an account or actual gains and losses allocable to the account.

The typical cash balance plan has a two-part credit mechanism:

  • The pay credit, which is a percentage of the recipient’s annual compensation.
  • The interest credit, which is a fixed rate or a variable rate linked to an index, such as the 30-year Treasury. This rate must not exceed a “market rate.” It is established during the plan design and normally does not change.

How they compare with 401(k)s and traditional pensions

Another major difference between the two types of pensions is that cash balance plans are portable. If you leave employment with the plan sponsor, you are entitled to the amount credited to your plan account. What’s more, you can typically roll those funds over into an IRA.

One of the key similarities between traditional pensions and cash balance plans is that both are insured by the Pension Benefit Guaranty Corporation (PBGC). If a defined benefit plan is terminated with insufficient funds to pay all promised benefits, the PBGC has authority to assume trusteeship of the plan and to pay pension benefits up to limits set by law. Defined contribution plans, including 401(k) plans, are not insured by the PBGC.

Although they have some characteristics of a 401(k), there are several distinct differences. With cash balance plans, the employee typically:

  • Does not contribute to the account.
  • Does not bear any of the investment risk nor makes any investment decisions.
  • Will receive, at retirement, the account balance as a lifetime stream of annuity income payments. Like an annuity, the amount of lifetime payouts will be based on actuarial formulas.

Some plans, but not all, will allow you take the account value as a lump sum at retirement, which you can then keep as cash, roll into an IRA or purchase an annuity.

Unless you are the business owner or a highly compensated employee, a cash balance plan probably won’t cover your full retirement needs. Because the plan has to guarantee an annual rate of interest, the funds will be invested fairly conservatively. Unlike a 401(k) or IRA, you won’t have the ability to invest aggressively, nor can you contribute your own money to your account.

But as with a traditional pension, you can maintain a 401(k) or IRA in addition to being enrolled in a cash balance plan.

Why so popular?

Cash balance plans have become popular in the last few years for several reasons.

First, many small and medium sized business owners, especially those who are approaching retirement and behind on their own retirement savings, are establishing these plans in their companies to take advantage of higher contribution limits. Cash-balance plans have generous contribution limits that increase with age; at older ages the limit can be $200,000 a year or more.

Also, business owners who have been hit with higher tax bills since tax rates increased a few years ago are decreasing their taxable income because the contributions to cash balance plans are tax deductible. They are especially popular with family businesses, sole proprietors with significant cash flow, and professional practices such as attorneys and physicians.

Some companies and state governments that have seen their traditional pension liabilities grow too large are switching to cash balance plans to save on pension costs. When a company switches from a traditional pension to a cash balance plan, employees will likely receive lower payouts at retirement. That’s because traditional pension benefits tend to be based on a participant’s final working years while cash balance benefits are based on all working years.