What is a Cash Balance Plan?
A cash balance plan is a type of defined benefit pension plan that has some characteristics of a defined contribution plan.
Here’s a breakdown of key features in a cash balance plan:
Defined Benefit Plan
Like traditional pension plans, a cash balance plan provides employees with a guaranteed benefit at retirement.
However, the way the benefit is calculated and communicated is different.
Account Balance Illustration
Each participant has a hypothetical account that grows annually in two ways:
- a pay credit, which is usually a percentage of the employee’s annual compensation or a flat dollar amount, and
- an interest credit, which is either a fixed rate or a variable rate tied to an index.
Benefits of Cash Balance Plans
For Employers
Employers can contribute more to a cash balance plan than to a traditional defined contribution plan, which can be beneficial for tax purposes.
Plan sponsors also have control over the investment of plan assets.
For Employees
Employees see a simplified, account-like statement, which can be easier to understand than traditional pension benefit formulas.
The plan also offers portability; if an employee leaves the company, they can roll over their balance into an IRA or another employer’s plan.
Risks and Management
Investment risks and the responsibility to fund the plan lie with the employer, not the employees.
This is different from defined contribution plans like 401(k)s, where employees bear the investment risk.
Popular Among Small Business Owners
Cash balance plans are particularly popular among small business owners and professionals (e.g. sole proprietors) who are looking for larger tax deductions and accelerated retirement savings.
Legal Requirements
These plans are subject to the Employee Retirement Income Security Act (ERISA) and require annual filings with the IRS.
They must also meet certain funding requirements to ensure they can provide promised benefits.
