5 Things to Know about Cash Balance Plans

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You know about IRAs, 401(k)s, and traditional pension plans. You probably aren’t familiar with cash balance plans, but you should be. They could well be the solution you’re looking for when it comes to maximizing your retirement savings without being wholly dependent on the whims of Wall Street. Statistics in the recently issued Kravitz National Cash Balance Plan Research Report 2011 demonstrate the advantages of these plans. Here's what you need to know about them.

Not Your Grandfather’s Pension Plan

Pension plans are defined benefit plans that promise to pay participants a fixed sum upon retirement. The promise is based on a participant’s earnings and is not dependent on the investment performance of the plan. Cash balance plans, in contrast, are a type of pension plan that define the promise to pay in terms of a participant’s account (they are also called “hybrid plans”). Essentially, a cash balance plan transforms the retirement payment promise into something more akin to a defined contribution plan, such as a profit-sharing and 401(k) plan.

For example, instead of promising a monthly pension of $5,000 upon retirement as a pension plan does, the cash balance plan instead says the participant’s account balance is $90,000 at retirement. The account balance can then be taken as a monthly payment (which may be the same $5,000 per month as in the case of the pension plan). Or the participant can receive a lump-sum payment of $90,000 – something that usually isn’t possible with a pension plan.

The lump-sum distribution can be rolled over on a tax-deferred basis into an IRA, allowing the participant more flexibility in tailoring distributions to meet retirement income needs. This “portability” feature – being able to make a rollover – also distinguishes traditional pension plans from cash balance plans.

In contrast to traditional pension plans, cash balance plans are easier for participants to understand because benefits are stated as individual account balances rather than as “accrued benefits” or some other obscure formula.

Cash Balance Plans aren’t Just for Large Corporations

Just because the first cash balance plan was established by Bank of America (in 1985) doesn’t mean that cash balance plans are limited to large corporations. Small and mid-sized companies are now using them in greater numbers. In fact, according to the Kravitz Report, 82% of plans in place are with firms with fewer than 100 employees. Further,

• Companies in the fields of finance and manufacturing account for a large percentage of plans;
• Medical and dental groups account for 37% of all plans;
• A diverse range of other companies (astrologers, auctioneers, animal groomers, bars, bagel shops, religious institutions, museums, and ski reports) account for 11% of all plans.

Advantages over 401(k)s

Cash balance plans can be better for certain business owners and their staff. Here are four advantages to participants:

1. Contributions are made entirely by the company, thus providing more retirement benefits for participants, which isn’t dependent in whole or in part on contributions by employees. This may seem burdensome to small businesses, but many of them are family-owned, with few “outside” participants, so the contributions primarily ensure to the benefit of owners and their families. Also, plan contributions are tax deductible, reducing the profits that will be taxed.
2. The company, rather than the participants, manages the investments in cash balance plans. Increases (and decreases) do not affect the promised benefit to participants. In contrast, with 401(k)s, participants at retirement have only as much as their (and the company's) contributions have earned. Retirement benefits are more stable in cash balance plans because investments usually are tied to a benchmark such as the 30-year Treasury rate and are conservatively invested.
3. At retirement, a guaranteed payment for life must be offered in a cash balance account. In contrast, a 401(k) may offer a similar payout option but this isn’t mandatory.
4. Participants in cash balance plans are guaranteed to receive a pension for life because, as a defined benefit plan, cash balance plans are insured by the Pension Benefit Guaranty Corporation (PBGC), a federal agency that protects participants in the event their pension plans don’t have enough funds to pay the promised benefits. There is no such protection for 401(k) participants.

Cash Balance Plans are No Longer Questionable in the Eyes of the IRS

In the past, there were uncertainties when it came to cash balance plans, and the IRS turned its nose up. However, some of these questions were answered by the Pension Protection Act of 2006. Last October, final and new proposed regulations, clarified more mysteries about these plans to enable benefits experts to craft plans that comply with legal requirements and avoid IRS challenges. The regulations, for example, clarify how plans can transfer from traditional pension plans into cash balance plans.

These regulations generally apply to plan years beginning on or after January 1, 2011.

Cash Balance Plans Can Be Combined with 401(k) Plans

Instead of a stand-alone pension plan, the cash balance plan can be combined with 401(k) plans to maximize retirement savings without increasing company costs. The Kravitz Report shows that 89% of cash balance plans are combined with a profit-sharing or 401(k) plan. Remember, the participants are the ones funding the 401(k).

Final Word

Be sure to discuss your retirement plan options with a knowledgeable benefits advisor to determine whether a cash balance plan is a good fit for your company.

To learn more, you’ll find general information about cash balance plans from the Department of Labor. You can find tax-related information from the IRS.