What are Cash Balance Pension Plans?
Cash balance pension plans are defined benefit plans that promise to pay out a certain amount as retirement benefit each year. They incorporate elements of 401(k)s and traditional pension plans in that they provide individual accounts to employees and guarantee a fixed amount, annually or monthly. But their formula for calculating those benefits differs from traditional pension plans.
The advantages of cash balance pension plans are tax benefits, higher contribution limits, and more retirement savings. The disadvantages of cash balance pension plans are that they can be costly to implement for employers and can result in less payouts for employees.
Basics of Cash Balance Pension Plans
Cash balance plans are referred to as “hybrid” plans because they combine features of defined benefit plans and defined contribution plans. Like the former, they pay out defined benefits. But the amount of these benefits is spread out over the course of the individual’s employment history as opposed to his or her final years, as is usually the case for regular pension plans. Like 401(k)s, cash balance plans also allow employee to view their account balances over its lifetime. But these accounts are hypothetical and display hypothetical balances.
Cash balance pension plans are popular with small business owners and self-employed individuals because they have higher contribution limits. For example, the maximum contribution limits for certain cash balance pension plans can be as much as $3 million. In addition to providing tax benefits, such amounts can help reduce the overall tax liability of high net-worth individuals.
As it does with most defined benefit plans, the Pension Benefit Guaranty Corporation (PBGC) guarantees payouts for cash balance pension plans. Therefore, if the corporation fails for some reason, then the PBGC takes over management of the trust and makes sure that account holders are made whole.
In recent years, several employers have shifted to cash balance pension plans from traditional pension plans because the former reduces overall pension obligations for companies.
How Does a Cash Balance Pension Plan Work?
In a cash balance pension plan, the employer contributes to a pension fund that is divided into hypothetical individual accounts, one each for an employee. The percentage contributed varies between five percent to 7.5 percent. Contribution limits for employees increase with age. Therefore, the higher the age, the more an employee is allowed to contribute.
For example, a 40-year-old employee can contribute a maximum of $98,000 to a cash balance plan in 2021 while a 70-year-old can employee contribute a maximum of $343,000.
Cash balance accounts are credited each year with a balance that is calculated according to the following formula:
(Wage x Pay credit) + (Account balance X Credit Rate)
Pay Credit = Percentage of employee’s wage that is employer contribution to the account.
Interest Credit Rate = Growth percentage for investments set by the employers. It can be fixed or variable. In the latter case, it is indexed to a rate of return from an asset, such as 5-year treasury or an index fund.
Employers entrust management of the pension plan to investment managers to ensure that they can meet their pension-related obligations.
Withdrawals from a cash balance pension plan are taxed at regular income tax rates after the age of 59.5 years. There is a 10% penalty for withdrawals made before that age.
Entitled account holders can choose to take the benefits as a lump sum payment or an annuity that disburses fixed annual payments. Lump sum distributions can be rolled over to an IRA or to another employer plan.
Cash Balance Plans Vs. Traditional Pension Plans
While both are defined benefit plans, there are several points of difference between cash balance plans and traditional pension plans. Here are some of them:
- Cash balance plans allow employees to review their accruing retirement balances through hypothetical individual accounts but pension plans have no such mechanism.
- Pension plans define benefits in terms of monthly payment amounts while cash balance pension plans define them in terms of hypothetical account balances over a period of time.
- Pension plans are easier to setup for employers as compared to cash balance plans.
- The formula to calculate pension plan benefits emphasizes the last couple years of employment whereas cash balance pension plans place emphasis on all years of employment.
- Pension plans are adjusted for cost of living adjustments (COLA) and cash balance pension plans are not.
Cash Balance Plans Vs. 401(k)
Like 401(k)s, cash balance plans disburse benefits through individual accounts. Here are some points of difference between them:
- Cash balance plans are defined benefit plans and payout a specific amount at the end of the employment period whereas 401(k) plans are defined benefit contribution plans whose final payout varies based on investment choices.
- Employers take on investment risks in cash balance pension plans because they are responsible for managing investments whereas employees are responsible for managing investment risk in a 401(k) plan.
- Employees can contribute to 401(k) plans whereas employers are responsible for contributing to cash balance plans.
Pros and Cons of Cash Balance Pension Plans
Some of the advantages of cash balance pension plans are:
- Because contributions to such plans are pre-tax, cash balance pension plans can provide tax benefits.
- Cash balance pension plans have higher contribution limits as compared to traditional 401(k)s and IRA plans.
- Cash balance plans can provide significant benefits to self-employed individuals or senior executives because they have higher contribution limits.
- Cash balance plans provide tax deductions to employees and reduce overall pension payouts.
- Cash balance plans are portable and annualized over a person’s entire lifetime employment, making them suitable for young individuals who can build up a corpus over a lifetime.
Some of the disadvantages of cash balance pension plans:
- Cash balance pension plans are expensive to setup and maintain because they may have significant annuity fees and require actuarial certification on an annual basis.
- The formula to calculate cash balance pension plans emphasizes employment over a lifetime, making it a loss-making proposition for senior executives already locked into traditional pension plans.