Cash_balance

What Is Cash Balance?

A cash balance plan is a specific type of defined benefit plan that structures an employee's retirement benefits to resemble an individual account, similar to a defined contribution plan. Within the broader category of retirement planning and employee benefits, these plans offer a hybrid approach to saving for retirement. Unlike traditional defined benefit plans that promise a specific monthly payment at retirement, a cash balance plan defines the promised benefit in terms of a stated account balance. The employer credits each participant's hypothetical account annually with "pay credits," typically a percentage of compensation, and "interest credits," which are guaranteed earnings based on a fixed or variable rate. Increases and decreases in the plan's actual investments do not directly affect the benefit amounts promised to participants; the employer bears the investment risk.³¹, ³²

History and Origin

Cash balance plans emerged as a response to the evolving nature of the workforce, particularly the shift away from employees spending their entire careers at a single company. Traditional defined benefit plans, which primarily benefited long-tenured employees, were becoming less suitable for a more mobile workforce.³⁰ The design of the cash balance plan, with its account-like structure, allows employees to accrue more substantial benefits earlier in their careers, offering portability that was less common with older pension structures.²⁹

Despite their advantages, cash balance plans faced legal challenges, particularly concerning age discrimination, as some conversions from traditional pension plans were perceived to disadvantage older workers.²⁸ A significant turning point came with the passage of the Pension Protection Act of 2006 (PPA 2006). This legislation provided clarity and certainty regarding the legality of cash balance plans by clarifying that cash balance accruals are not inherently age discriminatory.²⁶, ²⁷ The PPA 2006 also introduced new rules for benefit determinations and funding requirements, offering greater stability to these plans.²⁴, ²⁵

Key Takeaways

• A cash balance plan is a hybrid retirement plan, combining features of defined benefit and defined contribution plans.
• It provides participants with a hypothetical individual account balance that grows with employer contributions (pay credit) and guaranteed earnings (interest credit).
• The employer bears the investment risk, not the employee.²², ²³
• Benefits are typically insured by the Pension Benefit Guaranty Corporation (PBGC) up to certain limits.²⁰, ²¹
• Upon termination of employment, participants can usually choose to receive their benefit as a lump sum or convert it into an annuity.¹⁹

Formula and Calculation

The hypothetical account balance in a cash balance plan is calculated annually by adding pay credits and interest credits to the previous year's balance. While the exact formula varies by plan, the core components are:

Where:

• (\text{Account Balance}_{\text{Current}}) is the hypothetical balance at the end of the current plan year.
• (\text{Account Balance}_{\text{Previous}}) is the hypothetical balance from the end of the prior plan year.
• (\text{Pay Credit}) is the amount credited by the employer, often a percentage of the employee's compensation.
• (\text{Interest Credit Rate}) is the guaranteed annual rate of return credited to the account. This can be a fixed rate or linked to an external index, such as Treasury bill rates.¹⁷, ¹⁸

This calculation ensures the tax-deferred growth of the participant's hypothetical account.

Interpreting the Cash Balance

The cash balance shown on an employee's statement represents their accrued benefit, expressed as a single, understandable dollar amount. This differs from traditional defined benefit plans where the benefit is typically expressed as a future monthly annuity payment. The clarity of the cash balance makes it easier for employees to understand the value of their retirement savings and facilitates portability when changing jobs.

When evaluating a cash balance, it is important to understand the plan's specific pay credit and interest credit rates, as these determine the growth trajectory. The stated balance is a hypothetical figure, and the underlying assets of the plan are pooled and managed by the employer or an appointed investment manager. The employer guarantees the interest credit, meaning the participant's account grows at the promised rate regardless of the actual investment performance of the plan's assets. This provides a level of security for the employee.

Hypothetical Example

Consider an employee, Sarah, who participates in a cash balance plan. Her employer's plan provides a 5% pay credit based on her annual compensation and a 4% interest credit on her account balance.

• Year 1: Sarah's starting compensation is $70,000.

  • Pay Credit: (5% \times $70,000 = $3,500)
  • Interest Credit: (4% \times $0 = $0) (assuming start from zero)
  • End of Year 1 Balance: ($3,500)

• Year 2: Sarah's compensation remains $70,000.

  • Pay Credit: (5% \times $70,000 = $3,500)
  • Interest Credit: (4% \times $3,500 = $140)
  • End of Year 2 Balance: ($3,500 + $3,500 + $140 = $7,140)

This simplified example demonstrates how the hypothetical account balance accumulates over time through regular credits and compounded interest. If Sarah leaves her employer after Year 2, her vested benefit would be based on this $7,140 balance, which she could potentially roll over or take as a distribution, depending on the plan's rules and her vesting schedule.

Practical Applications

Cash balance plans serve as a significant component of retirement savings strategies for many employers and employees.

• Employer-Sponsored Retirement: They are a popular choice for businesses seeking to offer a robust retirement benefit that is easier for employees to understand than traditional pensions. Small and professional practices, in particular, often utilize cash balance plans to maximize tax-deferred contributions for owner-employees.¹⁶
• Portability: The account-like structure makes cash balance plans highly portable. When an employee changes jobs, they can typically take their vested cash balance benefit as a lump sum or roll it over into an Individual Retirement Account (IRA) or another employer's plan that accepts rollovers.¹⁵ This contrasts with traditional defined benefit plans, which often require longer tenure for full benefits.¹⁴
• Defined Benefit Security: Despite their resemblance to defined contribution plans, cash balance plans retain the key security feature of being defined benefit plans. They are typically insured by the Pension Benefit Guaranty Corporation (PBGC), a federal agency that protects pension benefits up to certain limits in the event a plan terminates with insufficient funds.¹², ¹³
• Regulatory Framework: These plans operate under federal regulations, including the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code, overseen by agencies like the U.S. Department of Labor and the Internal Revenue Service. These regulations cover aspects such as fiduciary responsibility, participation, vesting, and funding.¹¹ The U.S. Department of the Treasury also issues guidance on cash balance plans.¹⁰

Limitations and Criticisms

While offering many advantages, cash balance plans do have potential limitations and have faced criticisms.

• Investment Risk for Employer: The employer, not the employee, bears the investment risk of the plan's assets. If the actual investment returns fall short of the guaranteed interest credit rate, the employer must make up the difference to ensure the promised benefit is met.⁸, ⁹ This can create significant funding obligations for the employer, especially during periods of market downturns or low interest rates.
• Complexity and Administration: Despite their simplified appearance to employees, cash balance plans are complex to administer from an employer's perspective. They require actuarial valuations to determine appropriate funding levels, which can incur ongoing administrative costs.⁷ Compliance with ERISA and the Internal Revenue Code is also intricate, requiring specialized expertise.
• Historical Age Discrimination Concerns: In the past, conversions from traditional defined benefit plans to cash balance plans sometimes led to controversies and lawsuits regarding age discrimination.⁶ Older workers, who might have accrued significant benefits under the old plan's formula, sometimes perceived a "wear away" effect where their benefit accrual slowed or appeared to stagnate under the new cash balance formula until the new benefit surpassed the previously accrued one. The Pension Protection Act of 2006 (PPA 2006) largely addressed these concerns by providing specific anti-age discrimination rules for cash balance plans.⁵

Cash Balance vs. Defined Contribution Plan

The primary distinction between a cash balance plan and a defined contribution plan (such as a 401(k)) lies in who bears the investment risk and the nature of the promised benefit. In a cash balance plan, the employer guarantees a specific future benefit, defined by the hypothetical account balance and its guaranteed interest credits. The employer manages the investments and is responsible for ensuring the plan has sufficient assets to pay the promised benefits, absorbing any investment gains or losses. Conversely, in a defined contribution plan, the employer (and often the employee) contributes a specified amount to an individual account, but the ultimate retirement benefit depends entirely on the investment performance of that account. The employee chooses investments within the plan's offerings and bears all the investment risk and rewards, including potential capital gains or losses. Furthermore, cash balance plans are typically required to offer lifetime annuity options, whereas defined contribution plans are not.⁴

FAQs

Q1: Is a cash balance plan a "real" account like a 401(k)?

No, while a cash balance plan provides participants with statements showing an "account balance," this is a hypothetical account. No actual contributions are made to an individual investment account for the employee. Instead, the employer pools the plan's assets and manages them collectively, guaranteeing the stated pay credit and interest credit.

Q2: Are my benefits in a cash balance plan insured?

Yes, benefits promised by a cash balance plan are generally insured by the Pension Benefit Guaranty Corporation (PBGC), a federal agency. This provides a layer of protection, up to certain limits, in case the employer's plan terminates without enough funds to pay all promised benefits.², ³

Q3: Can I take a lump sum from a cash balance plan when I leave my job?

In many cash balance plans, participants have the option to receive their accrued benefit as a lump sum distribution when they leave their employer. Alternatively, they may choose to convert their hypothetical account balance into a lifetime annuity payment.¹ This flexibility is a key feature that appeals to a mobile workforce.