Is a Cash Balance Plan a Defined Benefit Plan?

Understanding Cash Balance Plans

A cash balance plan is a type of retirement plan that provides a defined benefit, though it presents itself with individual account balances. Each participant has a hypothetical individual account where contributions and interest credits are allocated. These are bookkeeping entries, not actual investments in separate employee accounts. The employer maintains a single pooled trust fund for all plan assets.

The benefit grows through two main types of credits: pay credits and interest credits. Pay credits are typically a percentage of an employee’s annual compensation or a flat dollar amount for each year of service. These credits are added to the hypothetical account annually, similar to employer contributions to a 401(k) plan.

Interest credits are applied to the hypothetical account balance, allowing it to grow. The rate can be a fixed percentage, tied to a market index, or based on the plan’s actual investment returns, often with a minimum guarantee. This combination allows participants to observe their retirement benefit accumulating, contributing to the misconception that these plans are similar to defined contribution plans.

Why Cash Balance Plans are Defined Benefit Plans

Despite their appearance of individual accounts, cash balance plans are legally classified as defined benefit plans due to several fundamental characteristics and regulatory requirements. The employer, not the employee, bears all investment risk. The employer guarantees specified interest credits; if investments perform poorly, the employer must contribute additional funds. If investments outperform, the surplus typically benefits the employer, reducing future contributions.

Cash balance plans are subject to complex actuarial funding requirements, necessitating regular valuations by enrolled actuaries. These valuations determine the minimum funding contributions an employer must make to ensure the plan meets its future benefit obligations. Employers must contribute enough to the plan’s trust to cover projected future benefits, unlike a fixed contribution in a defined contribution plan. This ensures the plan’s long-term solvency and benefit security.

Cash balance plans are insured by the Pension Benefit Guaranty Corporation (PBGC), a federal agency protecting retirement incomes in defined benefit plans. PBGC coverage provides protection for participants’ benefits, up to statutory limits, in the event of plan termination. This insurance is not available for defined contribution plans, solidifying the cash balance plan’s classification. The comprehensive regulatory framework under the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code treats these plans as defined benefit plans, imposing specific rules for funding, vesting, and benefit accrual.

Distinguishing from Traditional Defined Benefit Plans

Both cash balance plans and traditional defined benefit plans are legally classified similarly, but differ in how benefits are expressed and paid out. Traditional defined benefit plans, often called pension plans, usually express benefits as a formula-based annuity payable at retirement. This formula might promise a percentage of a final average salary or a flat dollar amount per month, creating a predictable income stream. Participants typically do not see an accumulating account balance during their working years.

In contrast, cash balance plans express a participant’s benefit as a hypothetical account balance, resembling an individual savings account. This allows participants to see their accumulated retirement benefit as a single, growing sum, providing a clearer understanding of their accrued benefit. This transparency makes the benefit feel more tangible and understandable.

Benefit distribution also differs. Traditional defined benefit plans typically default to annuity payments upon retirement. Cash balance plans commonly offer participants a lump sum payment at termination or retirement, in addition to an annuity option. This lump sum feature contributes to their perceived similarity to defined contribution plans, as participants can take control of their retirement savings. The clear account balance also offers greater portability compared to traditional defined benefit plans, where benefit value might not be as readily apparent or transferable.

Distinguishing from Defined Contribution Plans

Confusion often arises when comparing cash balance plans to defined contribution plans, like 401(k)s, due to their account-like appearance. A fundamental difference is who bears the investment risk. In a defined contribution plan, the employee bears this risk; their account value fluctuates with investment performance. Poor investment performance decreases employee savings.

Conversely, in a cash balance plan, the employer bears the investment risk, guaranteeing interest credits. The employer ensures the plan has sufficient assets to pay all promised benefits, regardless of market fluctuations. An employee’s benefit is not directly affected by the plan’s investment performance. Another key difference is the certainty of the benefit versus the certainty of the contribution.

In defined contribution plans, the employer’s contribution is defined, but the final benefit amount is not guaranteed and depends on investment returns and employee contributions. For cash balance plans, the benefit formula (pay credits plus interest credits) is defined and guaranteed by the employer. The employer’s annual contribution amount may vary based on actuarial calculations to fund promised benefits. Funding and regulatory requirements also diverge significantly. Defined contribution plans involve straightforward tracking of individual contributions and investments.

Cash balance plans are subject to extensive regulatory oversight, including annual IRS filings detailing their funded status. While both plan types involve “individual accounts,” their nature differs. Defined contribution plans feature actual individual investment accounts owned by the employee, with segregated assets. Cash balance plans use hypothetical accounts for tracking; plan assets are held in a single trust by the employer, not allocated to individual employee accounts.