What Is a Cash Balance Plan and How Does It Work?
Explore cash balance plans: their unique structure, operational mechanics, and strategic benefits for your retirement.
A cash balance plan is a retirement savings vehicle that combines features of traditional defined benefit and defined contribution plans. It functions as a defined benefit plan, with the employer responsible for funding and bearing investment risk, but presents benefits to employees in a way that resembles a defined contribution account.
How Cash Balance Plans Operate
A cash balance plan establishes a “hypothetical individual account” for each participant, which is a record-keeping entry rather than an actual investment account. This account grows through two primary mechanisms: pay credits and interest credits.
Pay credits are a percentage of an employee’s compensation, contributed annually by the employer. These accounts also receive annual interest credits, which can be based on a fixed or variable rate. The employer guarantees this interest rate, ensuring predictable growth and assuming all investment risk.
The final benefit at retirement is based on the accumulated account balance. Participants have options for receiving their benefits upon retirement or separation from service, including a lump-sum distribution or an annuity that provides a series of payments for life.
Comparing Cash Balance Plans to Other Retirement Options
Cash balance plans differ significantly from other common retirement vehicles, such as 401(k)s. Unlike 401(k) plans, where employees contribute a portion of their salary and bear the investment risk, cash balance plans are employer-funded, with the employer assuming all investment risk. A 401(k) benefit depends on contributions and investment performance, making the outcome less predictable, whereas cash balance plans promise a specific account balance through guaranteed pay and interest credits. Cash balance plans are also required to offer benefits as a lifetime annuity, a feature not mandated for 401(k)s.
Compared to traditional defined benefit plans, cash balance plans present the promised benefit as a lump-sum “account balance” rather than a complex formula for a lifetime annuity. This account-based presentation makes cash balance plans easier for participants to understand and track their accrued benefits. Both types are employer-funded and guarantee benefits, but cash balance plans offer greater portability, allowing employees to take their vested account balance with them if they leave the company before retirement.
Who Benefits from a Cash Balance Plan
Cash balance plans are advantageous for specific groups of employers and employees, due to their tax-deferred savings potential. These plans are used by small business owners, highly compensated employees, and professional service firms.
The appeal lies in the ability to make larger tax-deductible contributions than allowed by defined contribution plans. For 2025, the annual benefit limit under a defined benefit plan, which includes cash balance plans, is $280,000, and the maximum compensation that can be considered for benefit calculations is $350,000. This allows owners and highly compensated individuals to accelerate their retirement savings and reduce their taxable income.
A business can establish a cash balance plan with a single employee, provided that employee is the owner. These plans work in conjunction with 401(k)s, allowing employers to maximize contributions for key personnel while still providing benefits to other employees in compliance with non-discrimination rules.
The consistent cash flow required to fund these plans makes them suitable for stable businesses. Individuals closer to retirement age also benefit, as the higher contribution limits enable them to “catch up” on their savings.
Regulatory Oversight and Participant Security
Cash balance plans, as a type of defined benefit plan, operate under a legal framework designed to protect participants’ benefits. The Employee Retirement Income Security Act of 1974 (ERISA) governs these plans, imposing requirements on their operation. These requirements include funding rules, which mandate that employers contribute sufficient amounts to meet future benefit obligations.
ERISA also establishes fiduciary responsibilities for those managing the plan, ensuring they act in the best interests of plan participants. Plan administrators must adhere to reporting and disclosure requirements, providing transparency to both participants and regulatory bodies. Failure to comply with these regulations can result in penalties for plan sponsors.
The Pension Benefit Guaranty Corporation (PBGC) also provides security for participants. The PBGC is a federal agency that insures the benefits of participants in most private-sector defined benefit plans, including cash balance plans, up to certain legal limits.
For 2025, the maximum monthly benefit guaranteed by the PBGC for a single-employer plan participant retiring at age 65 is $12,336.82. Employers pay annual premiums to the PBGC to maintain this coverage, with the flat-rate premium for single-employer plans set at $106 per participant for 2025.
Participant security is further enhanced by vesting schedules, which determine when an employee gains non-forfeitable rights to their accrued benefits. For cash balance plans, the vesting schedule is a three-year “cliff” vesting, meaning employees become 100% vested in their benefits after completing three years of service. If an employee terminates employment before meeting the vesting requirements, the non-vested portion of their account balance may be forfeited.