Advantages of a Cash Balance Plan
- Substantial benefits (read money) can be provided and accrued within a short time – even with early – retirement
- Employers may contribute (and deduct) more than is permissible under other retirement plans such as Defined Contribution Plans
- Plan provides a predictable and guaranteed benefit, and the benefits are not dependent on asset returns
- Plan can be used to promote certain business strategies by offering subsidized early retirement benefits
- The Cash Balance Pension Plan favors older participants as they are closer to retirement and need to accrue benefits at a faster rate than younger participants.
Disadvantages of a Cash Balance Pension Plan
- Administratively complex plan if there are multiple owners/partners in the business.
- Administration and compliance is expensive, though the cost benefits work out in favor of the sponsor.
- An excise tax may be applicable if the minimum contribution requirement is not satisfied. However, the risk of this can be mitigated by carefully monitoring the plan and the rate of accrual of benefits.
- An excise tax may be applicable if excess contributions are made to the plan resulting in over funding. Even this risk can be mitigated by adjusting the investment options periodically based on the investment returns.
Basic idea of a cash balance plan
There are two types of pension plans in the market, defined benefit plan and a defined contribution plan. In a defined benefit plan, the benefit is communicated as a monthly annuity at a future retirement age. In the defined contribution plan, the benefit is communicated as an account balance in today’s dollars. The cash balance plan is a hybrid plan where the benefit is communicated as a dollar amount in today’s dollars and the annuity calculations are done at the back end.
This makes it very easy to communicate benefits to the owner or participants.
Why was the concept of a cash balance plan created?
The answer is simple, to easily fix and communicate the benefits to the participants.
Most companies will have more than one participant in the pension plan. Each participant will also be of a different age and derive a different compensation. Hence, each participant will accrue benefits at a different rate and such situations typically lead to a conflict if it is a small business.
Assume a situation where a company has three partners who are 40, 50 and 60 years old with different compensation amounts. It will be almost impossible to generate the same allocation to each of them year after year. Such situations are easily resolved by utilizing the cash balance plan design.
The partners in the above situation can agree to make a contribution of 80,000 for each so that the amount is the same for each irrespective of their age.
The other possible scenario is that the partners can agree to allocate $80,000 to the youngest partner, and $150,000 and $200,000 to the other two partners based on their proximity to retirement age.
If you are interested in learning more, read our Comprehensive Guide for Cash Balance Plan.
Difference between cash balance plan and a 401(k) plan
- Contribution: In a cash balance plan, the contribution to the participants is made by the company. In a 401(k) the contribution is made by the participants themselves as a salary deferral.
- Investment and Asset Return Risks: Most 401(k) plans have participant directed investment accounts and they bear the risks of the investments. In a cash balance plan, the investment risk is borne by the employer or the company that is sponsoring the cash balance plan. Not just the investment risk, the cash balance plan promises an interest crediting rate and the company bears the risk of the investment rate of return.
- Contribution Limits: Contributions to a cash balance plan may be higher
Combination of cash balance plans with other plans
Cash Balance Plan Contribution Flexibility
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