Is a Floor Offset Plan better than a Cash Balance Plan?
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.
The defined benefit and profit-sharing plans are aggregated and tested together to satisfy nondiscrimination 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.
