A Deeper Dive into Cash Balance Plans
In previous articles, we explored some of the basics of cash balance plans. Now we’ll go into more detail on one of the surest ways for certain businesses to ensure substantial retirement benefits for their employees.
A Primer on Defined Contribution Plans Versus Defined Benefit Plans
Simply stated, a defined contribution (DC) plan, such as a 401(k) plan, is limited by how much can be contributed on behalf of plan participants each year. By contrast, a defined benefit (DB) plan is limited by how much benefit can be distributed to a participant upon retirement. In other words, the plan sponsor (employer) is allowed to fund a DB plan with larger annual contributions than would be allowed under a DC plan—as long as all the contributions and earnings don’t result in benefits for participants that exceed a certain annual amount. The annual threshold for 2024 is $275,000, which means that plan sponsors cannot fund their DB plans in such a way that provides for retirement benefits that exceed this annual amount. As we will see, this approach gives certain employers an especially ripe opportunity for annual contributions that far exceed those for defined contribution plans.
Important differences between DB and DC plans
According to a Department of Labor (DOL) Fact Sheet, there are four major differences between a cash balance plan, which is a type of DB plan, and a 401(k) plan, which is the most prevalent type of DC plan.
- Participation – Participation in typical cash balance plans generally does not depend on the participants contributing part of their compensation to the plan; all contributions are made by the plan sponsor. Participation in a 401(k) plan, however, normally depends on an employee contributing to the plan.
- Investment Risks – The investments of cash balance plans are managed by the plan sponsor or an investment manager appointed by the plan sponsor. The employer bears the risks of the investments. 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 are required to offer participants the option 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. Of course, PBGC insurance comes with a cost, and plans (or plan sponsors themselves) must pay annual premiums for this required coverage.
The essential difference: contributions versus benefits
There are many differences between defined contribution plans and defined benefit plans. The two plan types differ in complexity, in cost, and in some fundamental concepts. And while these differences are important, you need not understand them all in order to grasp this bedrock principle: in certain situations, DB plans can dramatically outperform DC plans—and may well be worth considering, despite any added expense and complexity.
A bit more background may help set the groundwork for an example. For 2024, the maximum 401(k) deferral amount for a participant who has reached age 50 is $30,500 (the regular deferral limit of $23,000 plus an additional $7,500 catch-up contribution). In addition, the plan sponsor may make contributions through a profit-sharing feature, as long as the total contribution for this participant does not exceed $76,500 (the annual additions limit of $69,000 plus the $7,500 catch-up contribution). But, keep in mind that the plan must also pass rigorous nondiscrimination testing requirements, which may further limit the total amount of employee and employer contributions.
In contrast, the focus with a defined benefit plan is on the total amount accrued by the plan on behalf of each participant in order to satisfy the plan’s promised benefit upon retirement. Conceptually, if a plan sponsor establishes a new DB plan and promises a certain benefit at retirement age, an executive who is 55 years old and earning a salary on the high end of the scale may require a much higher contribution to the plan than an entry-level employee who is only 25 years old. This is true for several reasons. First, let’s assume that the executive has only 10 years until normal retirement age under the plan; the other worker has 40 years until reaching age 65. So there is a much longer time horizon for the plan to accumulate the earnings necessary to meet the younger employee’s promised retirement benefit.
Second, assume that the executive is earning much more than the younger employee. If the promised retirement benefit is one-half of the participant’s annual earnings after, say, 30 years of service, the executive may be entitled to many more times the benefit that a rank-and-file worker would be, merely because of the executive’s greater annual earnings. Third, many complex actuarial calculations may affect the actual amount that the plan sponsor must contribute to the defined benefit pension plan. Factors such as employee turnover, compensation (including salary increases), employee mortality rates, and investment returns will dictate the plan sponsor’s annual contribution obligation. A simple illustration may help.
Example: Cami is 55 and the CEO of Zenith Inc. making $500,000 per year; Dan is a 25-year-old dock worker who makes $50,000 per year. Zenith’s DB plan promises to pay 1% of the average of the five highest consecutive years of pay for each year of employment, up to 40% (after 40 years). Cami already has 30 years of service and expects to retire at the plan’s normal retirement age of 65, so she will be entitled to about $200,000 per year in retirement. Dan has been at Zenith for about one year and expects to get regular, incremental raises based on cost-of-living adjustments. Depending on how much Zenith has already contributed on behalf of Cami to meet its funding obligations, it seems likely that the company will have to contribute substantially more for Cami than for Dan, considering many actuarial factors such as attrition, years until retirement, differences in employee compensation, and plan investment returns.
Cash Balance Plans: A Different Type of Defined Benefit Plan
Cash balance plans are defined benefit pension plans, so the concepts discussed above generally apply to these plans. But cash balance plans also have some of the look and feel of a defined contribution plan. This is achieved by supplying participants with an annual “hypothetical account balance,” which shows them both the contributions made on their behalf and the earnings that accrue based on a guaranteed interest rate. The account balance is considered hypothetical because defined benefit plans pool participants’ benefits into a single trust that is managed by the plan administrator and that is not split into separate accounts that are invested by each participant. So while the hypothetical account balance accurately represents the amount of benefit accrued by the participant, it is not an “account” in the way that we are accustomed to in an IRA or 401(k) plan.
When participants know what their plan balance is—that is, they know what they are entitled to from the time they enter the plan until they retire—much of the mystery of defined benefit plans simply disappears. So rather than participants speculating about their currently accrued retirement benefits, with a cash balance plan they will be able to see their benefit expressed as a lump sum amount available today. To further take the mystery out of cash balance plans, here are a few other responses to common questions.
Which type of employers benefit most from cash balance plans?
Cash balance plans can be suited to a variety of businesses based on size, profitability, and overall retirement plan objectives, but the following businesses tend to land in the cash balance plan sweet spot:
- Businesses with consistently strong profits (historically and forward-looking)
- Smaller firms, such as closely held family enterprises or professional service businesses (doctors, lawyers, CPAs, etc.), typically with under 100 employees
- Employers who want to (and can afford to) contribute more than the amounts allowed by a current 401(k) or similar plan
- Businesses with older, more highly compensated employees in leadership positions
Which employees benefit most?
All participants can enjoy significant retirement benefits from cash balance plans. But the typical cash balance calculations allow a greater share of employer contributions to be allocated to those with higher compensation. (Generally, if certain threshold contributions are made to rank-and-file employees, a defined benefit plan will pass nondiscrimination tests and will maintain compliance with applicable IRS and DOL rules.)
What is a common cash balance plan benefit formula?
One of the main distinguishing features of a cash balance plan is the predictability of employer contributions versus a traditional defined benefit plan. Without discussing all the actuarial details, traditional DB plans can be subject to substantial swings in funding obligations depending on factors such as interest rate fluctuations. This can cause DB plans to become underfunded, which may require additional employer contributions to meet plan liabilities.
Cash balance plans are different from traditional defined benefit plans. Although they are indeed defined benefit plans, they are also considered “hybrid plans” because of their similarity to defined contribution plans. Remember, this similarity comes from the hypothetical account balance, which looks much like the balance on a profit-sharing plan statement. An example of a common cash balance contribution formula may help.
Example: Using Cami and Dan from our example above, let’s assume that the cash balance plan dictates a 7% employer contribution for each eligible employee. This means that Cami will receive a $35,000 contribution (based on her $500,000 compensation) while Dan gets $3,500 (based on his $50,000 pay). In addition, participants’ credited amounts will grow according to a guaranteed annual interest rate.
How is interest credited?
In addition to the employee contribution—either a percentage of pay or a flat-dollar amount—the cash balance plan must specify a guaranteed rate of return on the participants’ balances. This rate is most often equal to the 30-year Treasury bond yield, which has been approximately 5% recently. This Treasury bond yield fluctuates, but it has been a fairly steady rate that is not subject to the sometimes wild swings of the securities markets. As a type of defined benefit plan, the cash balance plan guarantees that all participants will receive both the contributions made on their behalf and the rate of return stated in the plan document. The plan sponsor, or the investment manager appointed by the plan sponsor, is free to invest the plan trust assets in various ways, provided they are prudent and in line with the investment objectives of the plan. But irrespective of how the trust investments perform, the plan must pay the promised amounts. So if the trust investment returns do not keep pace with the rate of return promised by the plan, the plan sponsor may need to make additional plan contributions to satisfy the plan’s financial obligations.
How are benefits paid?
Defined benefit plans, including cash balance plans, typically default to a monthly annuity payment to the participant upon reaching the plan’s normal retirement age. But most plans also allow for a lump sum distribution (with spousal consent, if applicable). This lump sum is the total of employer contributions plus all guaranteed interest, subject to any vesting requirements that the plan imposes. Taking a lump sum distribution allows the participant to invest the assets in any way desired—or to roll over the assets into another eligible retirement plan. Especially with the frequency of job changes nowadays, cash balance plan participants love knowing that the account balance statements that they have been receiving accurately reflect the amount to which they are entitled upon separation from the employer.
Cash Balance Plans – Are They a Good Fit for You?
For those businesses with the financial resources to contribute more than is allowed under the defined contribution rules and that fit the profile described above, cash balance plans can be a boon. What’s more, businesses can operate their defined contribution and defined benefit plans side by side. Because the contributions limits are independent of one another, businesses can maintain both plans, thereby dramatically increasing their retirement plan savings.
To begin the conversation about whether a cash balance plan may be right for your business, reach out to Pentegra’s retirement plan experts at solutions@pentegra.com or 855-549-6689.