What Is a Cash Balance Pension Plan?
A cash balance pension plan is a defined-benefit pension plan with the option of a lifetime annuity. The employer credits a participant's account with a set percentage of their yearly compensation plus interest charges for a cash balance plan. The funding limits, funding requirements, and investment risk are based on defined-benefit requirements. Changes in the portfolio do not affect the final benefits received by the participant upon retirement or termination, and the company bears all ownership of profits and losses in the portfolio.
- A cash balance pension plan is one in which participants receive a set percentage of their yearly compensation plus interest charges.
- This type of plan is maintained on an individual account basis, much like a defined-contribution plan.
- The benefit of such plans is that contribution limits increase with age.
- Cash balance pension plans do not have contribution limits because the employer funds them to meet a specific account balance at an employee's planned retirement date.
Understanding Cash Balance Pension Plans
A cash balance plan (CBP) is maintained on an individual account basis, much like a defined-contribution plan. This means it isn't like the regular defined-benefit plan. Instead, the cash balance pension plan acts just like a defined-contribution plan because changes in the value of the participant's portfolio do not affect the account balance promised by the employer.
The features of cash balance pension plans resemble those of 401(k) plans. Investments are managed professionally, and participants are promised a specific benefit at retirement. However, the benefits are stated in terms of a 401(k)-style account balance rather than the terms of a monthly income stream.
For instance, an employee on a cash balance pension plan might receive a promise of 5% of their salary with a 5% interest credit. If they made $100,000 annually, they would receive a pay credit of $5,000 plus 5% interest paid on the account balance. As the number of years at the employer increases, the account balance grows to meet the balance promised by the company. At retirement, the employee can choose a lump sum or monthly annuity payment.
The benefits of individuals participating in private-sector pension plans are protected by federal laws, such as the Employee Retirement Income Security Act (ERISA).
Cash Balance Pension Plan vs. Traditional Pension Plan
The most significant difference between a cash balance pension and a traditional pension plan is that the traditional plan generally uses the last few years of your highest compensation to determine your monthly benefit.
A cash benefit pension plan uses the total number of years you're with the company and is designed to have a predetermined amount in the account by retirement.
Cash Balance Pension Plan vs. 401(k)
Besides the contribution limits, the most significant difference between the cash balance pension and a 401(k) is that the employer bears the investment risk in a CBP. The employer is responsible for ensuring the employee receives the amount promised, so no matter what happens, it must ensure the employee gets that amount. People 60 years and older can sock away well over $300,000 annually in pretax contributions.
In a 401(k), the employee bears the investment risk because they are the ones that choose the way the plan invests. The employer has no investment risk because they give employees money to invest as they see fit. Additionally, the retirement benefit amount depends on the balance of the account.
Advantages and Disadvantages of a Cash Balance Pension Plan
While this type of plan does have several benefits, there are some disadvantages to consider as well.
Lump sum payouts
No contribution limit
No employee contributions
High cost to maintain
- Lump sum payouts: A cash balance pension can pay out in a lump sum. This can benefit someone who still has time to invest or wants to place the capital in a traditional preservation instrument like government bonds or money market funds.
- Rollover: You can roll a lump sum payout into an IRA or another pension plan.
- Tax-deferred: Contributions are tax-deferred. This means you don't pay taxes on your distributions until you make withdrawals or take a lump sum payment. If you're in a higher tax bracket when you're contributing than when you make withdrawals, you pay less in income tax.
- No contribution limit: The annual limit for a cash balance pension depends on how much you make, how old you are, and the target date and balance of the fund. IRAs and 401(k)s have limits.
- Taxable distributions: While the tax-deferred treatment is a benefit, you will have to pay taxes when you withdraw money.
- No employee contributions: Only the employer contributes, so you can't add capital from your wages.
- High costs to maintain: The costs to maintain the plans are higher because an actuary is needed to ensure it performs well enough to meet the balance requirements. This translates into higher coss for employers.
Combining a cash balance and a 401(k) pension plan can help you slash your tax bills and bolster your nest egg because you legally have two retirement plans.
When combined with a 401(k) plan, cash balance employer contributions for rank-and-file employees usually amount to roughly 6.9% of pay compared with the 4.7% contributions that are typical of 401(k) plans only.
Participants receive an annual interest credit. This credit may be set at a fixed rate, such as 5%, or a variable rate, such as the 30-year Treasury rate. At retirement, participants can take an annuity based on their account balance or a lump sum, which can then be rolled into an IRA or another employer's plan.
Cash balance pension plans are often more expensive (for the employer) to administer than traditional employer-sponsored retirement savings plans like the 401(k). That's because these pension plans require certification to ensure they're adequately funded. The types of fees and amounts for each can vary, but cash plans tend to have higher startup costs, annual administration charges, and relatively high management fees.
Is a Cash Balance Pension Plan Better Than a 401(k)?
Both can be excellent retirement plans. Which one is better depends on your preferences, goals, how long you might be with an employer, and current income.
What Can I Do With a Cash Balance Plan?
You can choose to make withdrawals or a lump sum payout. If you choose a lump sum, you can roll it into an IRA or other retirement plan if allowed.
What Happens To My Cash Balance Pension if I Quit?
Your cash balance pension is portable, so you can take the vested portion with you when you quit and roll it into another retirement account.
The Bottom Line
A cash balance pension plan is similar to other retirement accounts. The contributions are tax-deferred for the employee, and the principal grows with compounding interest and capital gains. The employer takes on all the investment risk, and the employee can use their wages to invest in another retirement fund of their choice.
While a cash balance pension is an excellent retirement plan option, you should choose one with caution. Compare it to other accounts and the tax treatment you expect to receive when you retire to see if it or another plan will work better for your financial situation.