How They Work
A cash balance plan defines the promised benefit to the participant in terms of a “hypothetical” account balance. Typically, each year the participant’s account is credited with:
- A “pay credit” – a specific percentage of the employee’s compensation, or a specific dollar amount
- An “interest credit” which is guaranteed – this can be based on either a fixed rate or a variable rate linked to an index such as the 30-year treasury bond rate
Employee accounts within the cash balance plan are not managed separately but pooled and professionally managed by the retirement plan. Fluctuations in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. The actuarial liabilities and the value of the accounts require calculation by a pension plan actuary, who will typically also send out annual statements to the plan sponsor for distribution to plan participants. The benefits in cash balance plans may be protected by federal insurance provided through the Pension Benefit Guarantee Corporation, assuming the plan sponsor is not a professional service corporation with less than 25 participants.
When a participant is eligible to receive the account balance of the cash balance plan, they can either take a lifetime annuity based on that balance or a lump sum. Lump sum distributions can generally be rolled over into an IRA or another employer’s plan if that plan accepts rollovers. When participants terminate employment they are eligible to receive the vested portion of their account balance, in this way a cash balance plan is portable like a defined contribution plan.
Types of Companies That May Benefit From Cash Balance Plans
Often established for the benefit of key executives, a cash balance plan may make sense in a variety of situations. Here are just a few:
- Highly profitable companies or sole proprietors – who are interested in a larger tax deduction, where its principals earn more than $260,000 (2014) a year.
- Family businesses – cash balance plans can be used as a component of succession planning.
- Closely held businesses – whose owners are looking for a greatly enhanced retirement plan
- Law firms, medical groups, and professional firms – CPAs engineers, architects, management consultants, financial services firms – tiered benefit levels are attractive for firms with varying levels of ownership and compensation.
- Firms looking to provide an enhanced benefit package to attract and retain high caliber employees.
The Benefits of Cash Balance Plans
There are a number of benefits that make cash balance plans attractive for these types of businesses including:
- Accelerated Retirement Savings and Larger Tax Deductions. Cash balance plans, which have much higher contribution levels that are age adjusted, can be a good way for owners and partners to increase contributions to their retirement accounts, especially if they need to catch up and have been unable to save for retirement while they have been growing their businesses. The older the participant, the faster they can catch up, as the more they are eligible to contribute. In addition, cash balance contributions may reduce both taxable income and adjusted gross income (AGI).
- Predictability. Cash balance plans can provide employers with a more predictable cost structure than traditional defined benefit plans by reducing the number of assumptions that need to be made to accurately project costs. The expected cost of a traditional defined benefit plan is based on a number of actuarial assumptions, including investment returns, salary increases, employee turnover, and life expectancy. Plan sponsors set aside funds for future benefits based on these assumptions and may incur unexpected liabilities if investment returns are lower than anticipated or life expectancy is longer than assumed. Cash balance plans however move the annuity calculation to the end of an employee’s career, rather than requiring an estimation of the cost of a lifetime benefit while the employee is still working. As the average U.S. life expectancy increases, this could make much more sense for employers.
- Attracting and Retaining Talent. A highly competitive retirement package helps to retain and attract talent and a cash balance plan may help to do that in a number of ways. Cash balance plan account balances can be easier to understand and more meaningful to participants compared to benefits under a traditional defined benefit pension plan. The guaranteed account value adds a comfort level for the participant who knows the value of the benefit they will receive. The ability to accelerate retirement savings enables the employee to ramp up their retirement plan as needed, while potentially reducing taxes on income. There is greater portability as compared with a traditional defined benefit plan
A 401(k) plan in combination with a cash balance plan can be the ideal plan design for many companies and partnerships. To learn more, contact your Alliance Benefit Group representative.