When setting up a cash balance plan, employers can use a number of different methods. The most popular is the New Comparability approach, which assigns different percentages of pay to different employee groups.
This approach is meant to maximize the benefits for owners, while providing meaningful benefits for non-owners. This approach has several advantages, including flexibility in benefit cost and easy communication with employees. While the pay formula for each employee group should be comparable, it does not mean that they are equal.
The most common method for setting up a cash balance plan is to use a New Comparability Cash Balance Plan (NCCP). This plan is similar to the traditional final average pay DB plan, except that it uses a uniform benefit formula.
What is the Pay Formula Used in a Cash Balance Plan?
A census is used to illustrate how much a hypothetical account balance can be distributed in the first year. Afterward, the participant receives a benefit statement each year.
The maximum compensation allowed under a cash balance plan is $280,000 for 2019 and $275,000 for 2018. The IRS final regulations set the rules for the “market rate of return” requirement. The formula for determining an annual compensation can vary from company to company.
Annual compensation credits are deposited into the participant’s account prior to the filing of their business taxes. The annual pay credits are either level for all age groups or graduated, with younger workers earning more and older employees receiving higher credits.
The annual fund-balance formula can be different for each employee, depending on the demographics of the employees. You can model these different options using a cash balance illustration.
Pay Credit Formula
The pay formula in a cash balance plan varies from company to company. For example, a cash balance plan can have a lower salary limit than an IRA, but the same amount of money can be credited to both accounts.
Similarly, a cash balance plan can have varying interest credits. A good company will provide the employee with an option to change the formula according to their personal circumstances.
In a cash balance plan, the employer contributes a certain percentage of their employee’s compensation to the account. The employer also bears the risk of the investment, so there is no guarantee the plan will make a profit.
However, the cash balance plan should offer more than enough benefits to meet the needs of its participants. The employer should also be able to match the employee’s income and expenses.
The pay formula for a cash balance plan is based on the employee’s salary. This is usually expressed in terms of a fixed percentage of pay, or as a fixed dollar amount. The interest credit is based on a fixed percentage of the employee’s pay, and it is not the same as the employer’s contribution. Nevertheless, the company cannot rely on the percentage as the sole basis for allocating interest credits.
The interest crediting rate in a Cash Balance Plan is 51% of compensation. The employer must meet annual non-discrimination requirements. A typical example is an employee earning $200,000 per year and receiving 2% of the employee’s salary.
With these assumptions, the cash balance plan would provide a benefit of $102,000 per year, or $158,403 over ten years. The formula may be different for the employee or employer.
Bottom line
The funding formula used in a Cash Balance Plan is quite simple. Its funding requirement is 51% of the employee’s compensation. It is based on a four percent interest crediting rate and a normal retirement age of 65.
This would mean that a hypothetical participant earning $200,000 per year would receive an allocation of $102,000 per year, which would equal $158,403 over ten years.