What Is a Cash Balance Plan and How Does It Work?
Understand the mechanics of cash balance plans, a unique retirement solution offering guaranteed growth and a clear account balance for employees.
A cash balance plan blends aspects of traditional pension plans with features of individual retirement accounts. Employers sponsor these plans to provide a structured retirement benefit for employees.
Understanding a Cash Balance Plan
A cash balance plan is a defined benefit plan that presents benefits like a defined contribution plan, such as a 401(k). This “hybrid” nature means the plan promises a specific retirement benefit defined as a stated account balance. Participants see a hypothetical account that grows over time, appearing as an individual savings account.
The funds within a cash balance plan are bookkeeping entries, not segregated accounts for each employee. The employer, not the employee, bears the investment risk. If investments perform poorly, the employer must cover any shortfall to meet promised benefits. This differs from defined contribution plans where employees bear investment risk.
How a Cash Balance Plan Operates
A cash balance plan grows through two primary mechanisms: contribution credits and interest credits. Each year, an employer credits a participant’s hypothetical account with a “pay credit,” calculated as a percentage of compensation or a flat dollar amount. This credit represents the employer’s contribution towards the employee’s future benefit.
Hypothetical accounts also receive “interest credits.” These are guaranteed returns applied to the account balance, regardless of the plan’s actual investment performance. The interest rate is pre-defined in the plan document, either fixed or variable. This guaranteed interest protects employees from market volatility, ensuring predictable growth.
The employer or a designated investment manager manages the plan’s actual investments. The employer must ensure sufficient funds cover all promised benefits. Regular contribution credits and guaranteed interest credits lead to steady growth of the hypothetical account balance.
Comparing Cash Balance Plans to Other Retirement Options
Cash balance plans differ from traditional defined benefit plans and defined contribution plans like 401(k)s. Traditional defined benefit plans, or pensions, promise a monthly annuity payment at retirement based on salary and years of service. Cash balance plans express benefits as a lump-sum hypothetical account balance, making the benefit more tangible. Both are defined benefit plans and can offer an annuity option, but cash balance plans more readily provide a lump-sum distribution choice.
In a 401(k), employees contribute their own pre-tax or after-tax dollars and direct their individual account investments, bearing the investment risk. A 401(k) retirement benefit depends on contributions, investment gains or losses, and fees. For a cash balance plan, the employer funds the plan and bears the investment risk, guaranteeing interest credits regardless of market performance.
401(k) plans have annual contribution limits set by the IRS, with employees making elective deferrals. Cash balance plans, as defined benefit plans, allow for higher employer contributions. 401(k) plans provide investment control to the employee, while cash balance plans centralize investment management with the employer.
Receiving Cash Balance Plan Benefits
When a participant becomes eligible for benefits, usually upon retirement or termination, options are available. Eligibility depends on meeting the plan’s vesting schedule, which is often a three-year “cliff” vesting. This means employees are 100% vested after three years of service. If an employee terminates employment before full vesting, their unvested balance may be forfeited.
A distribution option is a lump-sum payment, where the participant receives the entire vested hypothetical account balance. This lump sum can be rolled over into another qualified retirement account, such as an Individual Retirement Arrangement (IRA) or another employer’s 401(k), to defer taxation. Direct rollovers avoid mandatory 20% federal income tax withholding if the payment is made directly to the participant.
Participants may elect to convert their account balance into periodic payments, known as an annuity. This provides a steady income stream over a specified period, similar to a traditional pension payout. Distributions from cash balance plans, whether lump sum or annuity, are taxable as ordinary income in the year received, unless rolled over into a tax-deferred account.