Cash Balance Plans: The Best of Two Retirement Plan Worlds

Cash Balance Plans: The Best of Two Retirement Plan Worlds

Have you, like many other Americans, seen a substantial decrease in your retirement savings? Are you nearing retirement with less retirement savings than you expected? Would you like to contribute larger amounts to a retirement plan? If so, a Cash Balance Plan may be your “saving” grace.

Cash Balance Plans are a hybrid type of retirement plan, combining elements of both of the two typical types of retirement plans. Those two types of retirement plans are defined contribution and defined benefit plans. In general, defined contribution plans (i.e., 401(k)s and profit sharing plans) specify the amount an employer contributes to the plan.

The amount of an employee’s retirement account is dependent upon employer contributions, employee contributions (or salary deferrals) and gains or losses on those contributions. Defined benefit plans, however, provide a promised benefit to each eligible employee at retirement, without regard to investment gains or losses.

A Cash Balance Plan is a defined benefit plan that incorporates attributes of a defined contribution plan. Cash Balance Plans have gained increasing popularity in recent years. Cash Balance Plans typically allow larger contributions than may be achieved through defined contribution plans where a participant generally may not contribute more than $40,000 per year. The hybrid quality of Cash Balance Plans allows employers to take advantage of higher contribution amounts, while at the same time mitigating potential disadvantages that can be associated with traditional defined benefit plans.

The following table illustrates contribution levels for a hypothetical owner and four employees after adoption of a defined benefit plan:

TRADITIONAL DEFINED BENEFIT PLAN

The Owner is able to contribute more than $100,000 to the plan on his own behalf (well in excess of the $40,000 limit applicable with defined contribution plans), but there are two drawbacks that limit the appeal of the plan.

First, the Owner would be required to make a very large contribution on behalf of the 55-year old employee (i.e., Employee 1). A traditional defined benefit plan requires that a larger amount be funded for an older employee than is funded for a younger employee. The rationale is that the amount funded for a younger employee has a longer period to “grow” through investment returns than the amount funded for an older employee.

Second, because a traditional defined benefit plan bases contributions upon relative age, the contributions on behalf of employees are quite different. The amounts the Owner must contribute for Employees 2, 3, and 4 differ drastically with the amount the Owner must contribute for Employee 1.

A Cash Balance Plan may allow employers to address both of these drawbacks. First, the Owner may be able reduce the amount contributed on behalf of Employee 1. The following is an example of what funding levels may look like if the Owner adopted a Cash Balance Plan:

CASH BALANCE PLAN

The contribution amount for Employee 1 has been reduced dramatically, but the Owner is able to make more equivalent contributions on behalf of the Employees. The discrepancy between the amounts contributed on behalf of Employees 2, 3, and 4 and the amount contributed on behalf of Employee 1 has been reduced. An employer who previously rejected a traditional defined benefit plan due to disparate contribution levels may find Cash Balance Plans to be more appealing.

Cash Balance Plans also tend to be more understandable to participants than traditional defined benefit plans. Traditional defined benefit plans provide participants with a promised benefit at retirement, typically stated as a percentage of their average pay, multiplied by their years of service. Moreover, traditional defined benefit plans usually provide that a participant will receive a retirement annuity based upon this benefit formula. At any given time, a participant’s portion of the defined benefit plan is the present value of the expected future benefits.

Cash Balance Plans, however, are more similar to defined contribution plans. The Employer sets aside a given percentage of salary for each employee and credits interest to those contributions at a predetermined rate. These benefits are then expressed to each participant as an “account balance.“ Employees who terminate employment can then rollover their account balances to a new employer’s plan or an IRA, rather than wait for benefits to commence once they reach retirement age.

For some employers, a Cash Balance Plan allows them to experience the best of both the defined contribution and defined benefit plan worlds. While providing their employees with equivalent and meaningful benefits, they are also able to make larger contributions on behalf of themselves and/or their key employees. To determine whether you could benefit from the establishment of a Cash Balance Plan, please contact our office.