What is a Cash Balance Plan?
A cash balance plan is an excellent way to save extra money on a tax-deferred basis for your retirement. In simple terms, cash balance plans are defined benefit plans that maintain hypothetical individual employee accounts similar to a defined contribution or 401(k) plan. Legally speaking, these plans are defined benefit plans, but in reality they’re more of a hybrid plan.
In a typical plan, your account would be credited yearly with a “pay credit” (a certain percentage of compensation from your employer) and an “interest credit” (either a fixed or variable rate linked to an index like the treasury.) The benefit of this setup means liabilities change modestly when interest rates change, as opposed to a traditional defined benefit plan where liabilities can fluctuate dramatically. This does mean a more modest growth rate for accounts, but also helps lessen your risk of underperformance, and since as an employer you are liable for annual contributions to the plan this is a major plus.
What makes a company a good candidate for cash balance plans?
If any of these criteria sound like your company, a cash balance plan may be a good option for you
- Partners and owners wish to contribute more than $50K/year to their accounts
- Traditional 401(k) plans severely limit contributions, and depending on your age, you can contribute up to an additional $225K/year or more in a cash balance plan
- Companies already or willing to contribute 3%-4% of pay to employees
- Cash balance plans normally provide a minimum contribution between 5%-7.5% of pay for staff so it is key that you already have a record of contributing
- Companies with consistent profit patterns
- There are required annual contributions so it is important that you have consistent cash flow to meet these obligations
- Partners and owners over the age of 40 who wish to catch up on their savings
- Maximum contributions are age dependent, so you can really accelerate your savings the older you are
Additionally, if you are wishing to improve benefits for key employees or want to attract and retain high-ranking employees this is a great way to do so.
What are the differences between cash balance and traditional 401(k) plans?
• Participation in cash balance plans typically doesn’t depend on employees contributing part of their compensation to the plan, whereas participation in a traditional 401(k) plan generally depends on an employee choosing to contribute to the plan
• Investments in cash balance plans are managed by the employer, which means that the employer bears the risks of these investments. In traditional 401(k) plans, participants manage their own investments, meaning that the participants bear all risk from their investment choices
• Cash balance plans are required to offer employees the choice to receive their benefits in the form of lifetime annuities, while 401(k) plans are not required to do so.
• As cash balance plans are defined benefit plans, they may be subject to insurance by a federal agency, usually the Pension Benefit Guaranty Corporation.
• Employers with less than 25 employees, owner only plans and certain professions are exempt from such coverage. Defined contribution plans such as 401(k) plans are not required to be insured.