The answer to the above question varies based on circumstances of the plan sponsor, ownership structure, demographics, and the amount of liability the sponsoring company wants to assume. Let us address these issues one by one:
Ownership structure: A traditional defined benefit plan is based on the age, compensation, and the years of service for individual participants. If there are multiple owners in the firm, then each individual will receive a different allocation in the defined benefit plan because of the age difference. This may not be desirable, and in a situation like this, a cash balance plan would be preferred since it is possible to equalize the allocations to individual participants in a defined benefit plan. However, if the ownership resides with only one or two individuals, then the advantage of equal benefits is insignificant in comparison to other things.
Liability: The second issue is the amount of liability and this is of paramount importance to a small to medium sized business enterprise.
In a cash balance plan, a participant’s account is credited each year with a ‘pay credit’ and an ‘interest credit’. The pay credit is defined as a percentage of the participant’s compensation while the interest credit is defined in the plan document and could be a fixed rate of interest (say 5%). This virtually means the plan sponsor is guaranteeing a return to each participant irrespective of the performance of the plan assets. Any negative performance of the plan investments will have to be made good by the sponsor, and topped up with the interest credit! This can be a major liability which is something that the owners of small to medium sized businesses do not prefer.
For a business with employees, the preferred plan design is the floor offset design which mitigates the issue of liability to a large extent.
A floor-offset design is made up of a defined benefit plan and a profit sharing plan. The owners receive maximum benefits in the defined benefit plan, typically 100% of their compensation, while a floor is set for the employees by allocating only meaningful benefits, typically around 0.5% of the compensation. Next, the benefits in the defined benefit plan are actuarially offset by the allocations in the profit sharing plan. In most situations, the entire benefits received by the employees in the defined benefit plan are offset thus absolving the sponsor of any future liability. The sponsor may have to compensate the employee only up to the floor level in an unlikely scenario where the entire profit sharing contribution is wiped out due to investment losses.
The defined benefit and profit sharing plans are aggregated and tested together to satisfy non-discrimination testing prescribed by the IRS.
Traditional defined benefit and cash balance plans have been around for years, but the floor offset design is the most complicated of all pension designs. They are also becoming more popular because of the cutting edge software that is now available in the mass market that can perform plan aggregation and testing, which is manually impossible.
Thus in the debate between a cash balance and defined benefit plan, the real winner turns out to be a floor offset plan.