Pension plans are not as popular as they used to be. For years now, employers have been moving from defined benefit plans (pensions) to defined contribution plans such as 401(k)s. But one type of hybrid pension that remains relatively popular 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 is, 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.
Benefiting participants & 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 Individual Retirement Account 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. Cash balance plans appeal to sponsors in that they give them a clearer view of the liabilities they are 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:
- 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.
- 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 is not 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.
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. But the IRS rules are complex, and the administrative burden may be heavy. Contact us for more information.