What’s the Deal with Cash Balance Plans?
Cash balance plans seem to be getting a lot of attention recently. And for good reason. They can provide substantial benefits—both immediate and long-term—to employers. Plus, they offer employees a clearer picture of their retirement benefits than traditional defined benefit plans. Here we will take a quick journey into how cash balance plans work.
Cash Balance Plan Basics
A cash balance plan is a defined benefit plan. Defined benefit (DB) plans can be complicated. So, let’s start with a different kind of plan—the defined contribution (DC) plan—and then compare the two. Defined contribution plans include profit sharing plans and 401(k) plans. Federal rules dictate the maximum amount that employers and participants can contribute to these types of plans each year. Hence, the name: the maximum contribution is defined by statute. Once assets are contributed to the plan, the ultimate amount available to the participant is determined by the account’s investment growth. The participant typically directs the employer (or plan administrator) to invest the assets among the options made available in the plan, and the growth depends on how those assets perform over time.
On the other hand, defined benefit plan contributions are not nearly as limited on the front end. Rather, the employer can often contribute much, much more, as long as the amount contributed does not result in a projected benefit upon retirement that exceeds the annual limit. These limits are quite generous, so many employers find that they can contribute substantially more to a DB plan (especially to fund their own retirement benefits) compared with contributions to a DC plan.
Cash Balance Versus Traditional DB Plans
“Traditional” defined benefit pension plans must be funded to provide the benefit that is promised in the plan document. There are countless variations and many moving parts with DB plans. So, a simple illustration may help.
Example: Acme, Inc.’s DB plan provides the following benefit formula: participants will receive 1% of their pay for each year of service, up to 40 years (or 40%). This amount is based on the highest average pay over a certain period. One of Acme’s employees, Jenny, retires with 30 years of service and an average annual pay of $100,000. She is entitled to receive $30,000 per year during her retirement years, and Acme must contribute enough to the plan to ensure that there is enough in the plan to pay this benefit.
When Jenny was hired, Acme’s plan administrators didn’t know how long Jenny would work for Acme, how much she would be making at the end of her career, or how much the plan would earn from investments over the years. So sometimes complex actuarial calculations must be made to determine how much Acme must contribute each year to meet the plan’s promised benefits to employees. From Jenny’s perspective, it’s hard to know from year to year what she can expect from the plan. If she works for 30 years, she can reasonably expect to receive her promised benefit. But any variation in her work history with Acme, and the uncertainty of her future pay, makes it nearly impossible for her to understand what her current accrued benefit might be.
Cash Balance Plans Provide More Clarity
In addition to providing employers with the opportunity to contribute substantially more than with defined contribution plans, cash balance plans give plan participants a clearer understanding of their current benefits. 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 hypothetical in the sense that, unlike an individual account plan (e.g., most 401(k) plans), a defined benefit plan pools participants’ benefits into a single trust that is managed by the plan administrator and not split into separate accounts that are invested by each participant. So, the hypothetical balance is not imaginary or uncertain; it is real. It accurately represents the amount of benefit actually accrued by the participant. It’s simply not an “account” in the way that we are accustomed to in, say, an IRA or 401(k) plan.
Cash balance plans are clearly defined benefit plans. But they have some of the “look and feel” of a defined contribution plan because participants can point to their plan balance and track the growth of their “account.” For this reason (and others), cash balance plans are sometimes known as hybrid DB plans.
Other Cash Balance Benefits
In many ways, cash balance plans are like any other qualified retirement plan. The plan documents will define eligibility, the vesting schedule, forms and timing of distributions, the benefit formula, and so on. But the unique nature of defined benefit plans generally—and cash balance plans in particular—are worth exploring in more detail. In an upcoming installment on cash balance plans, we will do just that, highlighting more of what makes them highly attractive for certain employers.
The information, analyses and opinions set out herein are for general information only and are not intended to provide specific advice or recommendations for any individual or entity. Nothing herein constitutes or should be construed as a legal opinion or advice. You should consult your own attorney, accountant, financial or tax advisor or other planner or consultant with regard to your own situation or that of any entity which you represent or advise.