What Is a Cash Balance Plan and How Does It Work?

A cash balance plan offers a distinct approach to retirement savings for businesses and their employees. This type of plan has seen increased adoption across the United States, particularly among small to mid-sized businesses and professional service firms. With over $1 trillion in assets nationwide, cash balance plans represent a growing segment of the retirement plan market. Their numbers have increased substantially over the past two decades.

Defining a Cash Balance Plan

A cash balance plan functions as a type of defined benefit pension plan, yet it incorporates features commonly associated with defined contribution plans like a 401(k). This blend earns it the designation of a “hybrid” retirement plan. Unlike traditional defined benefit plans that promise a specific monthly income at retirement, a cash balance plan defines the benefit in terms of a stated account balance.

Each participant in a cash balance plan has a hypothetical individual account, maintained by the plan administrator. This account is a record-keeping mechanism that tracks the employee’s accrued benefit. Its hypothetical nature differentiates it from defined contribution plans, where actual investment accounts are held for each participant. The employer retains all investment risk and responsibility for managing the plan’s assets.

The employer guarantees the hypothetical account balance will grow according to a predetermined formula, regardless of the plan’s actual investment performance. This distinguishes it from defined contribution plans, where employees bear the investment risk. The plan is designed to meet a target retirement benefit.

How Benefits Accumulate

An employee’s benefit in a cash balance plan grows through two primary components: pay credits and interest credits. Pay credits are annual hypothetical contributions made by the employer to each participant’s account, often expressed as a percentage of their compensation. For instance, a plan might credit an employee’s account with 5% of their annual salary.

Interest credits are then applied to the hypothetical account balance, allowing it to grow over time. This interest rate is a fixed percentage, such as 4% or 5%, or it can be tied to an external market index like the one-year Treasury bill rate. The plan document specifies the guaranteed interest crediting rate. This guaranteed growth ensures the employee’s retirement benefit is not affected by market fluctuations.

To illustrate, consider an employee with an initial hypothetical balance of $10,000. If the plan offers a 5% pay credit and a 4% interest credit, and the employee earns $50,000 annually, they would receive a $2,500 pay credit ($50,000 0.05). The existing balance would also earn $400 in interest ($10,000 0.04), bringing the new hypothetical balance to $12,900.

Employer Responsibilities and Funding

Employers sponsoring a cash balance plan carry the sole responsibility for its funding. This means the employer must ensure there are sufficient assets within the plan to cover all promised future benefits to employees. The contributions made by the employer are generally tax-deductible business expenses.

Actuaries play a role in managing these plans, performing complex calculations to determine the required contributions. They assess factors such as employee demographics, projected salaries, and expected interest credits to ensure the plan remains adequately funded. An enrolled actuary, approved by the IRS, must annually certify the plan’s funding status. This certification helps prevent underfunding, which the IRS closely monitors.

The employer, not the employee, bears the investment risk associated with the plan’s assets. If the plan’s investments underperform the guaranteed interest rate, the employer must contribute more to make up the difference. Conversely, if investments perform better than the guaranteed rate, the excess earnings can sometimes reduce future employer contributions, but they do not directly increase the participants’ hypothetical account balances beyond the stated interest credit.

Employee Rights and Protections

Employees participating in a cash balance plan acquire rights to their accumulated benefits through a process called vesting. While specific vesting schedules can vary, many cash balance plans utilize a “cliff” vesting schedule, meaning employees become 100% vested in their benefits after three years of service. If an employee leaves before completing the vesting period, any non-vested amounts are forfeited and may be used to offset future employer contributions.

Upon termination of employment, or at retirement, employees have options for how to receive their vested benefits. Common choices include taking a lump-sum distribution, which can be rolled over into an Individual Retirement Account (IRA) or another qualified retirement plan, or electing to receive an annuity, which provides a series of payments over time. The option for a lifetime annuity is a requirement for cash balance plans, distinguishing them from 401(k)s.

A protection for employees in many cash balance plans is the insurance provided by the Pension Benefit Guaranty Corporation (PBGC). The PBGC is a federal agency that insures certain defined benefit pension plans, including most cash balance plans, up to a legally defined limit. This insurance safeguards a portion of an employee’s promised benefit if a plan terminates with insufficient funds. Employees also receive an annual statement detailing their hypothetical account balance and the benefits they have accrued.