Cash balance plans offer an intriguing pension possibility

Pension plans have become the dinosaurs of the retirement-planning world. For years now, employers have been moving away from defined benefit plans (pensions) to defined contribution plans, such as 401(k)s; but like the hardiest of species, a different type of pension plan has evolved. It’s a sort of hybrid pension plan, and it remains relatively popular. This is the cash balance plan.

Examining the concept

With a cash balance plan, the employer commits to adding a fixed percentage of participants’ compensation to an “account” that’s, strictly speaking, more of an accounting device than an actual account, as used in 401(k) plans. In addition, the sponsor credits earnings to those accounts. The interest crediting formula can be fixed, linked to an index, or a combination of the two.

In recent years, regulations have given sponsors more flexibility with respect to interest crediting rates. Previously, most plans pegged their rate to rates on long-term Treasury bonds. Sponsors have more recently been using an “actual rate of return” crediting formula (subject to certain floors).

Most employers offer cash balance plans in conjunction with 401(k) plans and not on a stand-alone basis. How does this benefit you, as a small business owner? And will this plan be attractive to your employees? Don’t worry! Fiducial can help you figure all of that out.

Benefiting participants and sponsors

When cash benefit plan participants retire, the plan must offer them a lifetime annuity whose monthly benefits are determined by the size of the “account” balance. But vested participants also have the option of taking a lump sum distribution or IRA rollover of the accumulated “account” balance—even before retirement. Another plus for participants is the ability to more easily understand the accrued value of their benefit, compared to a standard defined benefit plan. There is security in knowing, as a retiree, that you will have a steady income for your lifetime, and this aspect of the cash benefit plan will be very attractive to some workers.

Cash balance plans appeal to sponsors because they give them a clearer view of the liabilities they’re accruing over a standard defined benefit plan. Although cash balance plan sponsors cannot back away from setting aside funds on behalf of participants as set by the plan formula, they have two fewer areas of exposure than traditional defined benefit plan sponsors:

1. Less vulnerable to market swings. By linking the crediting rate on the account balance to an index, sponsors become less vulnerable to market swings. This assumes the sponsor invests plan assets consistently with the chosen index.
2. Monthly payment set. The size of the monthly lifetime payments at retirement is determined when the participant retires. This means, for example, that, if the cost of an annuity has risen sharply at the time a participant retires (such as because of a drop in interest rates), the sponsor isn’t obliged to cover the difference between the monthly benefit that a participant might have received when annuity costs were lower, and the higher cost at the participant’s retirement age. That risk is borne by the plan participant.

Another perk for small business owners (plan sponsors) is the expanded limits on contributions (that increase with age) that come with cash balance plans vs. the contribution limits on traditional 401(k)s. In traditional 401(k) plans, total employer and employee contributions for those 50 and older cannot exceed $57,500 per year. Those 60 and older can put away over $200,000 annually in pre-tax contributions with cash balance plans. For business owners who have invested assets into the growth of their business over the years, rather than into their own retirement plans, the ability to sock away higher amounts in the years leading up to retirement, when their business is well-established, is a boon.

Fiducial can help you look ahead

Because you can design cash balance plans with different pay credits for distinct groups, these plans suit employers wanting to make significantly higher contributions for their key executives as compared to the rest of the staff, as well. But the IRS rules are complex, and the administrative burden may be heavy. Need help deciding which retirement plan (or plan combinations) may be right for you and your employees? Fiducial can help you keep up with the latest trends in retirement planning and decide which plan(s) make the most sense for your situation. Contact us for more information.