A cash balance plan is a twist on the traditional pension plan. Like a traditional pension, a cash balance plan provides workers with the option of a lifetime annuity. However, unlike pensions, cash balance plans create an individual account for each covered employee, complete with a specified lump sum. Establishing a cash balance plan offers potential savings for employers.
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What Is a Cash Balance Plan?
In a cash balance plan, a participating employee is told that he or she will have access to a certain sum upon reaching retirement. Let’s say that sum is $400,000. To get to $400,000, the plan assumes a combination of employer contributions and compound interest over time. When the employee retires, she can either take the $400,000 as a lump sum, or commit to an annuity that pays a portion of the $400,000 in regular checks.
For each year that an employee earns benefits with a company, she accrues benefits according to the following formula:
annual benefit = (wage x pay credit rate) + (account balance x interest credit rate).
Let’s break down those terms. An employee’s wage is his or her salary. The pay credit rate is the percentage of the employee’s wage that the employer provides in contributions. This is often between 5 and 8 percent.
The account balance is what the employee has already accrued in benefits and earnings. The interest credit rate is a percentage the employer sets for growth of contributions over time. This could either be a fixed rate (5%, say), or a variable rate that’s tied to something else, like the interest rate on 30-year Treasury bonds.
Cash Balance vs. Traditional Pension
Cash balance plans gained popularity when some companies and state governments began converting their traditional pension plans to cash balance plans as an alternative to freezing struggling pensions. If you’ve just received news that your pension is becoming a cash balance plan, here’s what you need to know:
The benefits you’ve already earned are (probably) safe: While companies stay afloat, they can change or freeze a pension plan but they can’t renege on benefits their employees have already earned. Even if the terms of your employer-sponsored plan change for the worse, you’ll still have access to the benefits you accrued under the original plan. Plus, most of the funds in the majority of defined benefit plans are federally insured through the Pension Benefit Guaranty Corporation, a government agency.
Conversion to a cash balance plan is more favorable to younger employees: A traditional pension calculates your retirement benefits using a formula based on your time with the company and you salary in your last few years of employment. If you’re an experienced worker who has climbed the ranks and is now earning well, it’s probably in your interest to have a pension that reflects that wage growth. Cash balance plans, on the other hand, offer benefits that are more evenly spaced over the length of a worker’s career and that grow at the same rate over time. Dollars contributed early in a worker’s career have more time to compound, and therefore are more valuable.
Cash Balance vs. 401(k)
A 401(k) is strictly a Defined Contribution (DC) plan, whereas a cash balance plan is considered, depending on whom you ask, to be either a Defined Benefit (DB) plan or a hybrid DB-DC plan. With a 401(k), an employee makes contributions to a retirement plan. The employer sponsoring the 401(k) may or may not make matching contributions.
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Here’s the big difference between a 401(k) and a cash balance plan: With a 401(k), the money that the employee will have in retirement is not “defined.” Instead, the employee’s retirement benefits depend on the performance of the market and of the funds that hold the 401(k) contributions. The employee bears the risk that a market downturn will wipe out her 401(k).
With a cash balance plan, on the other hand, the amount of money an employee can expect in retirement is “defined.” That’s what makes it a Defined Benefit plan. The employer, not the employee, bears the risk of market fluctuations. By virtue of their Defined Benefit status, cash balance plans are insured and must offer the option of a lifetime annuity, neither of which holds true for 401(k)s.
Cash Balance Options
If you have a cash balance plan through your employer, you have the choice between annuitizing your benefits and receiving your benefits as a lump sum. If you choose an annuity, your cash balance will be paid out to you in smaller portions in the years after you retire. If you decide to take a lump sum payment, you can choose to take all the money at once and roll it over, either to an IRA or to a new employer’s plan.
Cash Balance Plans for Business Owners
State governments and large firms get lots of media attention when they decide to convert from a traditional pension plan to a cash balance plan. Small and medium-sized businesses, though, can also benefit from using a cash balance plan.
If you’re a business owner, establishing a cash balance plan for yourself and your employees leaves you with much higher contribution limits than you’d get with a 401(k). This can be a real lifesaver if you (or any of your employees) need to make sizable catch-up contributions to prepare for retirement. The contribution limits for cash balance plans are based on age and top $200,000 for workers 58 and over.
Plus, contributions to your business’s cash balance plan reduce your taxable income. You could even set up a 401(k) and a cash balance plan if you really want to kick things into gear. Just expect to pay higher administrative costs for the cash balance plan because it requires actuarial certification each year.
Related Article: Getting Started with Retirement Planning
If you’re a participant in a cash balance plan, you’ll get regular statements explaining the hypothetical value of your retirement account, plus the money you can expect to have in retirement. Whether you choose to take that money as an annuity or in one lump sum is up to you.
With an annuity, you have less control, but enjoy the peace of mind that comes from knowing you can’t overspend and leave yourself with nothing in old age. On the other hand, you could face reduced benefits if your company runs into trouble down the road. That’s one reason some employees choose to take their benefits as a lump sum and roll them over into an IRA while they can. If you choose a rollover, remember that you’re taking on the responsibility for making your benefits last the rest of your life. It’s important to plan accordingly!
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