Why Would We Want a Cash Balance Plan? by Ilene Ferenczy, J.D., CPC, APA, Ferenczy Benefits Law Center
All qualified retirement plans – profit sharing plans, 401(k) plans, defined benefit plans, and cash balance plans – offer a way to save pre-tax dollars for employees’ retirement. The difference between these plans is how the amount deposited to the plan is determined for each employee, and the different rules among the plans for how the money may be distributed. Cash balance plans can be a very effective way to save more for retirement for company owners and their most valuable employees.
Defined Benefit Plans: Different from Defined Contribution Plans
Cash balance plans are a type of “defined benefit plan.” These plans are different from defined contribution plans (i.e., profit sharing and 401(k) plans) in two critical ways: First, the benefit at retirement—rather than the contribution amount—is defined within the defined benefit plan. An enrolled actuary, who is authorized by the Internal Revenue Service (IRS), must determine and certify the amount that must be contributed to the plan each year to ensure that there is sufficient money in the plan to deliver the promised benefits. Second, as the benefit is guaranteed under the plan, the risk of poor investment performance is borne by the employer. If the plan’s investments do not perform as well as anticipated, the employer must contribute additional funds to make up the shortfall. This is the opposite of the situation in a 401(k) or profit sharing plan, where better investment returns mean higher benefits for the participant, and lower returns mean smaller benefits.
But Viva La Difference!
Pension plans promise a benefit at retirement. The funding of pension plans is akin to paying off a loan – the longer the payoff period, the lower the payment. The plan has only 10 years to accumulate the cost of a benefit for someone who is currently age 55, whereas the plan has 30 years for someone who is currently 35.
In a company where owners and managers are older than the other employees, this means that the company can contribute more for them than for the rank-and-file: in many cases, this is exactly what the owners want.
However, in a “classic” defined benefit plan, this also means that employees of different ages earning the same salary and doing the same job will have different contributions made into the plan on their behalf and different lump sum distributions at termination. This can be hard for employees to understand and may be considered by the younger employees to be unfair.
Cash Balance Plans: A Better Mousetrap
This problem is solved in cash balance plans. In these plans, the contribution rates and benefits for similarly situated employees may be constant, despite differences in ages. But, the creative designs available in these plans still permit significant weighting in favor of the older owners and executives, allowing the company to direct more dollars to the people it most wants to benefit. For example, it is possible that contributions for owners who are age 50 or older will exceed $200,000, while the cost for other employees will be between eight and ten percent of payroll. Depending on the actual demographics, it is not unusual for the cost for the rank-and-file employees to be covered by the tax savings experienced by the owners.
Cash balance plans are also used by larger companies to provide more significant retirement benefits to their employees. These plans often replaced the classic defined benefit plans from years past. The costs for cash balance plans may be more controllable than old defined benefit plans. Furthermore, the ability to treat similarly situated employees equally has made these plans much more attractive than their predecessors. As larger companies strive to help their workers to plan for retirement, cash balance plans are likely to increase in popularity.
Cash balance plans are often adopted in combination with 401(k) plans, not as a replacement. This maximizes the flexibility of design and the contributions made on behalf of the owners and executives, while providing all employees with an opportunity to add to their retirement nest egg through pre-tax savings.
But Isn’t This Really Complex?
It is true that pension plans can be more complex than profit sharing and 401(k) plans. However, with the right actuary and other professionals helping you, this complexity can be managed. And, the better results under these plans for owners and executives makes it all worthwhile.
Conclusion
Both closely held companies and larger companies can experience significant advantages by adopting a cash balance plan. This includes richer benefits for the employees, much larger tax deductions for the business, better targeting to the owners and executives, and more predictable and controllable costs than were available in the classic defined benefit pension plan. This is an option that is worth checking out!
