Pension plans fall into one of two categories: defined benefit plans or defined contribution plans. A cash balance plan has features of both. They can also be simpler to administer than some other plans. Is a cash balance plan right for your firm?
With a defined benefit plan, each eligible employee receives a specified benefit at retirement. A defined contribution plan, by contrast, specifies the amount of contributions the employer will make toward eligible employees’ retirement accounts. The actual amount of retirement benefits a defined contribution plan will provide to an employee depends on the amount of employer contributions, the amount of employee contributions, and the investment performance of the account.
Although considered a defined benefit plan, a cash balance plan defines the benefit the employee receives upon retirement in terms of a stated account balance, making it similar to a defined contribution plan in that respect.
How Do Cash Balance Plans Work?
In a typical cash balance plan, each participant’s account receives an annual “pay credit” (such as 5 percent of compensation from the employer) and an “interest credit” (either a fixed rate or a variable rate linked to an index). Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks are borne solely by the employer.
When a participant becomes entitled to receive benefits under a cash balance plan, the benefits will be defined in terms of an account balance. For example, assume that a participant has an account balance of $100,000 when he or she reaches age 65. If the participant decides to retire at that time, he or she would have the right to an annuity based on that account balance. Such an annuity might be approximately $8,500 per year for life. In many cash balance plans, however, the participant could instead choose (with consent from his or her spouse) to take a lump sum benefit equal to the $100,000 account balance.
If a participant receives a lump sum distribution, that distribution generally can be rolled over into an IRA or to another employer’s plan if that plan accepts rollovers.
The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, with certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation.
Cash Balance Plans vs. Traditional Pension Plans
Both traditional defined benefit plans and cash balance plans must offer payment of an employee’s benefit in the form of a series of payments for life. However, traditional defined benefit plans define an employee’s benefit as a series of monthly payments for life to begin at retirement, while cash balance plans define the benefit in terms of a stated account balance. These accounts are often referred to as “hypothetical accounts” because they do not reflect actual contributions to an account or actual gains and losses allocable to the account.
Cash Balance Plans vs. 401(k) Plans
There are four major differences between typical cash balance plans and 401(k) plans:
Participation — Participation in typical cash balance plans generally does not depend on the workers contributing part of their compensation to the plan; however, participation in a 401(k) plan does depend, in whole or in part, on an employee choosing to contribute to the plan.
Investment Risks — The employer or its appointed investment manager handles cash balance plan investments, and the employer bears the risk. Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. By contrast, 401(k) plans often permit participants to direct their own investments within certain categories. Under 401(k) plans, participants bear the risks and rewards of investment choices.
Life Annuities — Unlike 401(k) plans, cash balance plans must offer employees the ability to receive their benefits in the form of lifetime annuities.
Federal Guarantee — Since they are defined benefit plans, the benefits promised by cash balance plans are usually insured by a federal agency, 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 begin to pay pension benefits up to the limits set by law. Defined contribution plans, including 401(k) plans, are not insured by the PBGC.
Pros and Cons of Cash Balance Plans
Pros: Cash balance plans can simplify plan administration for the employer. In a typical plan, the employer credits each participant’s account with a percentage of his/her pay (such as 5 percent) and an interest credit.
Cash balance plans also allow rollovers before age 65, so vested workers can take their benefit in a lump sum payment when they go. That makes cash balance plans attractive to today’s more mobile employees. Employers report having adopted the plans to improve their competitive edge in hiring.
Converting a traditional defined benefit plan to a cash balance plan eliminates the early retirement subsidy of traditional plans.
Cons: Cash balance plans do not guarantee savings for employers. Because the retirement benefit is predefined, the employer must deal with any shortfall that results from poor investment performance, just as it may benefit from any gain. Contributions to the plan are determined actuarially and are not strictly up to the employer. You can terminate or amend the plan, but you cannot reduce the benefit that plan participants have already earned.
For more information on cash balance plans, Rhodes-Warden Insurance,Lebanon(541) 258-2131,Albany(541) 967-8062 or Stayton (503) 769-7105.
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