A cash balance plan is a much like the traditional pension plan. Just like a traditional pension plan, a cash balance plan affords employees the opportunity of a lifetime annuity.
Traditional pension plans do not create individual account for workers but Cash balance creates such account complete with a lump sum. Setting up a cash balance plan can help employers save money.
What Is a Cash Balance Plan?
When participating in a cash balance plan, an employee is informed that he or she will have unrestricted access to a certain amount of money upon retirement. Let’s assume the lump sum is $300,000. To reach the lump sum of $300,000, an employer will make contributions with interest compounding overtime.
Upon retirement, the employee can cash out the $300,000 as a lump sum, or commit the $300,000 to an annuity that pays a portion of the $300,000 in a series of regular payments.
When an employee receives a benefit from a business each year, the employee earns the benefits based on the formula below:
Annual benefit = (Salary x Pay Credit Rate) + (Account Balance x Loan Interest Rate).
Let’s simplify these terms:
- AN EMPLOYEE’S SALARY is the amount of money he or she earns in a given working period.
- THE PAY CREDIT RATE is a certain percentage of the worker’s salary that the employer contributes to the employee’s cash balance. The pay credit rate is usually between 5%-8%.
- THE ACCOUNT BALANCE is the amount of money the employee accrues from benefits and earnings.
- THE INTEREST CREDIT RATE is a percentage the employer earmarks for the growth of his contributions over time. This interest could either be fixed (e.g. 5%) or varying (e.g., the interest rate on 30-year Treasury bonds).
Cash balance versus Traditional Pension
There are a few differences between these two plan types.
- The benefits you have accrued are safe: Companies can freeze or substitute a pension plan for another but they can’t withdraw the benefits their employees have earned already. Worst still, if the terms of your employer-sponsored pension plan changes that it so becomes unfavorable to you, you’ll still have unfettered access to the benefits you earned under the initial pension plan. Additionally, most of the funds in the majority of defined benefit plans are insured by the Federal Government through the Pension Benefit Guaranty Corporation, a government agency.
- A traditional pension plan converted to a cash balance plan is very favorable to younger employees: A traditional pension will calculate your retirement benefits using a formula based on the time you spent working for the company and your earnings (wages) in your last few years of service. While cash balance plans unlike the traditional pension plans, offer benefits that are more evenly spread over the duration of an employee’s career and that grow at the same rate over time. Money contributed early in an employee’s career has more time to compound, and therefore becoming more valuable.
How does it compare to a 401(k) plan?
A 401(k) is nothing less than a Defined Contribution (DC) plan, while a cash balance plan can be a Defined Benefit (DB) only plan or a combination of both DB and DC depending on whom you ask. In 401(k), contributions are made to a retirement plan by an employee while the employer sponsoring the 401(k) chooses to make matching contributions or not.
Major difference between a 401(k) and a cash balance plan: With a 401(k), the amount of money an employee will have in retirement is not “defined” as the employee’s retirement benefits depend on the performance of the funds that hold the 401(k) contributions and the market. The risk that the market will take a nosedive and all funds will be wiped out is borne by the employee.
While operating a cash balance plan leaves the employee with the knowledge of the amount of money he or she will receive i.e. the retirement money is “fixed/defined”. In this plan, the employer and not the employee, bears the risk of fluctuations in the market. As a result of its Defined Benefit status, cash balance plans are secured and the plans must offer the choice of a lifetime annuity. 401(k) lacks these features/benefits.
CASH BALANCE OPTIONS
If your employer helps you with a cash balance plan, you have the choice of receiving your benefits as a lump sum or throwing it into a lifetime annuity. If you decide to go with an annuity, your cash balance will be paid out to you in series of payments following the years after your retirement. But if you feel taking the whole benefits as a lump sum is the right choice to make, you can decide to take the lump sum and put it into an IRA or a new employer’s plan.
Cash Balance Plans for Business Owners
As a business owner, here is how you can benefit from establishing a cash balance pan for yourself and your employees:
Setting up a cash balance for yourself and your employees affords you much higher contribution limits that you would get with a 401(k). This can really be helpful if you or (your employees) need to make substantial contributions towards retirement.
The contribution limit for cash balance plans is based on age (e.g., workers in the age bracket 58 and above. The contribution limit for ages 58 and above is $200,000.
As an added bonus, as a business owner, when you make contributions to your business’s cash balance plan, your taxable income will reduce. You can also even set up a 401(k) and a cash balance plan if you really want to get things moving. Just be prepared to pay higher administrative fee for the cash balance plan as it requires actuarial certification every year.
One of the perks in participating in a cash balance plan is that you will receive regular statements explaining the hypothetical value of your retirement account, and the amount of money you can expect to have in retirement. The decision to take the money in a lump sum or invest it into lifetime is completely yours to make.
Annuity gives you less control over your money but you enjoy peace of mind that comes from knowing you can’t spend foolishly and leave yourself with nothing in your advance years.
However, your benefits could be reduced if your company runs into trouble. This is one reason why some employees take their benefits as a lump sum and roll them into an IRA while they can.
If you however choose a rollover bear in mind that you are responsible for making your benefits suffice you for the rest of your life. It’s therefore important to plan with that knowledge in mind!