A cash balance pension plan is a defined-benefit retirement plan with the option for a lifetime annuity. In this plan, the employer credits a participant’s account with a set percentage of their yearly compensation plus interest charges. The risk, funding limits, and funding requirements adhere to defined-benefit regulations, with the employer bearing full responsibility for profits and losses in the portfolio, ensuring stable retirement benefits regardless of market changes.
Key Takeaways
- Defined-Benefit Nature: A cash balance pension plan credits participants with a set percentage of their yearly compensation plus interest, resembling a defined-contribution plan.
- Age-Based Contribution Limits: Contribution limits may increase with age, providing a substantial retirement fund as one gets older.
- Employer-Funded: These plans do not have contribution limits for employees since the employer funds them to achieve a specific account balance at retirement.
Understanding Cash Balance Pension Plans
A cash balance pension plan functions similarly to a defined-contribution plan like a 401(k) in that each participant maintains an individual account. Despite market changes, participants receive the total account balance promised by the employer. Investments in these plans are managed professionally, ensuring participants are granted a specific retirement benefit.
For example, an employee might be promised 5% of their annual salary, plus 5% interest credit. If they earn $100,000 annually, they would receive a $5,000 pay credit plus 5% interest on the account balance. Over the years, the account balance grows to meet the employer-promised balance. Upon retirement, the employee can choose a lump-sum payout or monthly annuity payments.
Federal laws such as the Employee Retirement Income Security Act (ERISA) protect the benefits of participants in private-sector pension plans.
Cash Balance Pension Plan vs. Traditional Pension Plan
The primary distinction between a cash balance pension plan and a traditional plan is in benefits determination. Traditional plans base benefits on the highest compensation years’ earnings, while cash balance pension plans accrue benefits annually throughout employment aiming to reach a predetermined balance by retirement.
Cash Balance Pension Plan vs. 401(k)
The biggest difference between cash balance pension plans and 401(k) plans lies in investment risk. In cash balance plans, the employer bears the investment risk and ensures employees receive the promised amount at retirement. In 401(k) plans, employees choose investments and bear the risk, with retirement benefits hinging on the account balance.
Advantages and Disadvantages of a Cash Balance Pension Plan
Advantages
- Lump Sum Payouts: Allows payouts in lump sum, facilitating further investments or security purchases like government bonds.
- Rollover Options: Lump sum payouts can be rolled over into an IRA or another pension plan.
- Tax-Deferred Contributions: Contributions gain from tax-deferral until withdrawal, potentially lowering income tax if payouts fall into a lower tax bracket.
- No Contribution Limits: Contributions depend on salary, age, and the target fund balance, unlike IRAs and 401(k)s.
Disadvantages
- Taxable Distributions: Taxes apply when withdrawing retirement funds.
- No Employee Contributions: Only employers can contribute, limiting the employee’s capacity to bolster the fund via own income.
- High Maintenance Costs: Cash balance plans incur higher costs because they require actuary services for fund adequacy certification, increasing employer maintenance expenses.
Special Considerations
Combining a cash balance plan with a 401(k) plan can diversify your retirement portfolio, reducing tax liabilities and enhancing your nest egg. With contributions higher in cash balance plans, annual credits usually are significantly more substantial than those solely in a 401(k). Participants receive interest credits that can be either fixed or variable rates aligned to Treasury practices.
Nonetheless, properly administering cash balance plans can be more expensive for employers compared to traditional 401(k) plans due to certification requirements ensuring adequate funding.
Is a Cash Balance Pension Plan Better Than a 401(k)?
Both retirement plans have merit. The choice comes down to individual preference, specific financial goals, employment duration, and income levels.
What Can I Do With a Cash Balance Plan?
Cash balance plans offer flexibility in handling withdrawals. Employees can either make periodic withdrawals or opt for a lump sum payout, with the option to roll the latter into an IRA or another retirement scheme if applicable.
What Happens To My Cash Balance Pension if I Quit?
Cash balance pensions are portable. Employees can transfer the vested account balance into another retirement account if they resign from their job.
The Bottom Line
Cash balance pension plans provide another retirement savings avenue, similar to other accounts with tax-deferred growth on the principal and contributions. The employer shoulders the investment risk, allowing employees to invest their earnings concurrently into other retirement funds.
Given the unique structure of cash balance pension plans, it’s essential to compare them with other retirement options to determine which fits best with your financial needs and anticipated tax scenario at retirement.
Related Terms: 401(k), defined-benefit plan, investment risk, Employee Retirement Income Security Act (ERISA).
References
- U.S. Department of Labor. “Cash Balance Pension Plans”, Page 1.
- U.S. Department of Labor. “Cash Balance Pension Plans”, Page 2.
- U.S. Department of Labor. “Fact Sheet: Cash Balance Pension Plans”.
- FuturePlan. “2023 Contribution Limits Table”.
- Kravitz. “2018 National Cash Balance Research Report”, Page 7.
