There are two primary types of pension plans: defined benefit plans and defined contribution plans. Defined benefit plans provide each eligible employee with a specific benefit at retirement, while defined contribution plans specify the amount of contributions to be made by the employer toward an eligible employee’s retirement account.
A cash balance plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. As recently as 2008, these “hybrid plans” represented only 10% of the overall defined benefit universe. However, research has shown that cash balance plans now make up approximately 20% of the retirement plan market.
Cash Balance Plan Basics
Cash balance plans are defined benefit plans with the look and feel of a defined contribution plan. In a typical cash balance plan, participant “hypothetical accounts” are credited each year with a “pay credits” (usually a percentage of compensation from the participant’s employer) and an “interest credit” which is either a fixed rate or a variable rate that is linked to a market index.
Increases and decreases in the value of the cash balance plan’s investments do not directly affect the benefit amounts promised to participants. Instead, the investment risks are borne solely by the employer. Thus, the employer tends to use conservative formulas to determine interest credits. Refinements to the basic cash balance model and the ability to offer participant-directed investments provide for risk-sharing between the sponsor and participants for the investment performance.
Participants in a cash balance plan have a few options when they retire or leave the company. They can annuitize their account balance, take a taxable distribution, or roll the distribution it into an IRA.
Why the Growth?
Most of the cash balance plan growth has been found in employers with fewer than 50 employees and less than $5 million in plan assets. The appeal of cash balance plans to some small employers is the ability of owner-employees to accumulate greater retirement savings than they can through defined contribution plans.
As with traditional defined benefit plans, cash balance plan annual contribution limits are based on an actuarial projection of how much needs to be contributed to fund the annual benefit by retirement age. The calculation incorporates the employee’s age and compensation as well as investment return projections.
A cash balance plan allows employers to benefit from an aggressive investment strategy, while still basing employees’ interest credit on a more modest rate of return. Additionally, a cash balance plan may better help employers attract and retain employees than a traditional defined benefit plan because employees can see their account grow.
However, it should be noted that cash balance plans are generally more expensive to operate administratively than a basic 401(k) plan.
Business owners can make more substantial contributions to a cash balance plan than to a 401(k) if they start funding the plan later in life. For 2014, the maximum annual retirement benefit a participant can accumulate is the lesser of the average of the participant’s highest earnings during a three-calendar-year consecutive period or $210,000. Additionally, the contribution must take into account the annual maximum compensation amount allowed for the purposes of calculation benefits, which is $260,000 for the 2014 plan year.
IRS nondiscrimination rules must still be met and participants must be 100% vested after three years of service. Cash balance plans are subject to minimum funding requirements and must be funded every year, with few exceptions.
Is a Cash Balance Plan Right for You?
The appropriateness of a cash balance plan generally depends on the particular employer’s objectives, ability to fund the plan annually, employee demographics and other factors.