Cash balance plan

A cash balance plan is a type of Retirement Planning vehicle that combines characteristics of both traditional Defined Benefit Plans and Defined Contribution Plans. Within the broader category of employee benefits, it is fundamentally a defined benefit plan, but it defines the promised benefit in terms of a stated account balance for each participant, mimicking the appearance of a defined contribution account.⁴⁷,⁴⁶ This hybrid structure means that while employees see a growing "hypothetical account," the employer bears the Investment Risk associated with the plan's underlying assets.⁴⁵

History and Origin

The first cash balance plan was introduced in 1985 at Bank of America.⁴⁴ These plans gained significant momentum in the small-plan market, particularly after the Pension Protection Act of 2006 provided clearer guidance on their legality and administrative issues.⁴³ Prior to this, their status was sometimes ambiguous, especially concerning conversions from traditional defined benefit plans. The hybrid nature of cash balance plans appealed to employers seeking to offer a predictable benefit while also managing some of the volatility and long-term liabilities associated with traditional pensions.⁴²,⁴¹ The number of cash balance plans has seen substantial growth, increasing fifteen-fold from 2001 to 2020, now accounting for nearly 50% of all defined benefit plans, with assets exceeding $1.2 trillion.⁴⁰

Key Takeaways

• A cash balance plan is a hybrid retirement plan, legally classified as a defined benefit plan but structured with individual hypothetical accounts.³⁹,³⁸
• Employer contributions and an annual Interest Rate credit grow the hypothetical account balance.³⁷
• The employer, not the employee, assumes the investment risk of the plan's assets.³⁶
• Benefits can often be taken as a Lump Sum Distribution or converted into an Annuity at retirement.³⁵
• These plans can allow for significant Tax-Deferred savings, especially appealing to high-income business owners.³⁴,³³

Formula and Calculation

In a cash balance plan, a participant's hypothetical account grows annually through two main components: a "pay credit" and an "interest credit."³²

The formula can be expressed as:

Where:

• Beginning Account Balance: The hypothetical balance from the prior year.
• Pay Credit: An Employer Contributions amount, typically a percentage of the participant's compensation for the year (e.g., 5% of salary).³¹
• Interest Credit: A guaranteed rate of return applied to the beginning account balance, which can be a fixed rate or a variable rate tied to an index (e.g., the one-year Treasury bill rate).³⁰

This calculation determines the hypothetical value of a participant's benefit.

Interpreting the Cash Balance Plan

A cash balance plan offers a clear, understandable benefit to employees because it presents retirement savings as an account balance, similar to a 401(k) Plan-plan).²⁹ This provides employees with a tangible, growing figure, which can be less abstract than the complex Actuarial formulas used in traditional Pension Plans. For employers, this structure allows for more predictable funding requirements compared to traditional defined benefit plans, as the benefits are tied to hypothetical account balances rather than projected future salaries and years of service. The transparency of the cash balance plan can be a significant advantage in attracting and retaining talent.

Hypothetical Example

Consider Sarah, a 40-year-old marketing manager whose employer offers a cash balance plan. The plan provides a 7% pay credit based on her annual compensation and a guaranteed 4% annual interest credit.

1. Year 1: Sarah earns $100,000.

   • Pay Credit: $100,000 * 0.07 = $7,000
   • Beginning Account Balance: $0 (first year)
   • Interest Credit: $0 (no prior balance)
   • Ending Account Balance (Year 1): $0 + $7,000 + $0 = $7,000

2. Year 2: Sarah receives a raise, now earning $105,000.

   • Beginning Account Balance: $7,000
   • Pay Credit: $105,000 * 0.07 = $7,350
   • Interest Credit: $7,000 * 0.04 = $280
   • Ending Account Balance (Year 2): $7,000 + $7,350 + $280 = $14,630

This hypothetical account balance continues to grow each year with new pay credits and interest credits, illustrating the consistent accumulation of benefits in a cash balance plan. The actual investments made by the employer may perform differently, but Sarah's promised benefit grows according to the plan's defined formula.

Practical Applications

Cash balance plans are increasingly popular, particularly among small and mid-sized businesses, including professional service firms like law and medical practices.²⁸,²⁷ These plans are often established alongside a 401(k) Plan-plan) to allow business owners and highly compensated employees to significantly increase their tax-deferred retirement savings beyond the limits of a 401(k) alone.²⁶,²⁵ The design flexibility of a cash balance plan allows employers to customize contribution levels for different employee groups, subject to non-discrimination rules set by the Internal Revenue Service (IRS).²⁴,²³ This can serve as a powerful tool for attracting and retaining key talent by providing a robust and predictable retirement benefit. Assets in cash balance plans, like other qualified retirement plans, are typically protected from creditors, offering a layer of asset protection.²²

Limitations and Criticisms

Despite their popularity, cash balance plans have faced criticism, particularly concerning their transparency and the impact of plan conversions on older workers. Early controversies arose when traditional defined benefit plans were converted to cash balance plans. Critics argued that in some conversions, older, long-tenured employees could experience a "wear-away" period where their accrued benefits under the new plan were initially lower than what they would have received under the traditional plan. While the Pension Protection Act of 2006 aimed to clarify and address some of these concerns, the fundamental difference remains that traditional defined benefit plans often had benefits that accrued more rapidly in later career stages, while cash balance plans accrue benefits more evenly over an employee's career. Additionally, although the employee sees a hypothetical account, they do not direct the investments, which can be a perceived limitation for those who prefer control over their retirement assets.²¹ Employers, while mitigating some long-term liability volatility compared to traditional pensions, still bear the ultimate investment risk to ensure the guaranteed interest credits are met.²⁰ The administrative complexity and associated Actuarial and compliance costs are generally higher for cash balance plans than for defined contribution plans, requiring annual filings with agencies like the Department of Labor.¹⁹,¹⁸

Cash Balance Plan vs. Defined Contribution Plan

The primary distinction between a cash balance plan and a Defined Contribution Plan lies in who bears the investment risk and how the benefit is determined.

While a cash balance plan presents benefits as an account balance, similar to a defined contribution plan, its underlying nature as a defined benefit plan means the employer is ultimately responsible for ensuring the promised benefits are paid, regardless of the actual investment performance of the plan's assets.⁷

FAQs

What happens if the plan's investments underperform the guaranteed interest credit?

If the plan's actual investments underperform the guaranteed interest credit, the employer is responsible for making up the difference to ensure participants receive their promised benefit. The Investment Risk rests with the employer, not the employee.⁶

Are cash balance plans protected by federal insurance?

Yes, like most traditional Defined Benefit Plans, the benefits in a cash balance plan are generally protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC).⁵

Can I take my cash balance as a lump sum when I leave my job?

In many cases, yes. When a participant becomes entitled to receive benefits, they often have the option to take their cash balance as a Lump Sum Distribution or convert it into an Annuity for monthly payments, often with spousal consent.⁴,³

How do cash balance plans impact an employer's taxes?

Employer Contributions to a cash balance plan are generally tax-deductible for the business, and the plan assets grow on a Tax-Deferred basis until distribution to the employee.²,¹ This can provide significant tax advantages for employers, especially business owners.