There are two general types of pension plans — defined benefit plans and defined contribution plans. Defined benefit plans provide a specific benefit at retirement for each qualified employee, while defined contribution plans specify the amount of contributions to be made by the employer toward an employee’s retirement account
A cash-balance plan is a type defined benefit plan, but with a few elements that bear a resemblance to a defined contribution plan. Much like traditional defined benefit plans, cash balance plans don’t invest any of the individual’s own money in the plan and they do not have any responsibility for the investment decisions. However, the difference between the two plans is that instead of the benefit in retirement being based on a formula that takes into consideration how long the individual worked for the company and their average salary during their last few years of employment, the cash-balance plan credits their account with a set percentage of their salary each year, typically 5%, plus a set interest rate that is applied to their balance.
The individual should receive an annual statement that shows the hypothetical value of their account, as well as what sort of monthly income payout (or lump sum) that will generate when they are of age to retire.
Differences between typical cash balance plans and 401(k) plans
There are four big differences between typical cash balance plans and 401(k) plans:
- Participation– Participation in typical cash balance plans generally does not rely on the participants contributing a portion of their pay to the plan. Conversely, participation in a 401(k) plan does depend on an employee choosing to make a contribution to the plan, whether that is partial or entirely, it depends on the employee.
- Investment Risks– The investments of cash balance plans are managed by the employer or an investment manager chosen by the employer. The employer then carries the risk of those investments. The benefit amount that is promised to individuals is not directly affected by increases and decreases in the value of the plan’s investments. Therefore, the investment risks are carried solely by the employer, not the individual. In a 401(k) plan, the actual amount of benefits provided to an employee depends on the amount of the contributions as well as the gains or losses of the account.
- Life Annuities– Cash balance plans are required to offer employees a choice as to whether they will receive their benefits in the form of lifetime annuities. 401(k) plans are not required to offer any type of annuity option for a distribution.
- Federal Guarantee– Benefits in nearly all cash balance plans, just as most customary defined benefit plans, are protected by federal insurance provided through the Pension Benefit Guaranty Corporation, within certain limitations. Defined contribution plans, including 401(k) plans, are not insured by the PBGC.
Regarding plan design and administration, cash balance plans are generally preferred over a traditional defined benefit solution. Of course, each situation needs to consider the details and circumstances as well as the objectives and desires of the client. We believe that larger firms with multiple owners/partners need a plan design that can meet the individual needs of each shareholder/partner without exposing them to cross subsidization issues or greater liabilities associated with traditional DB plans. Your TRCO Consultant will work hard to ensure you can contribute as much as possible from year to year while managing your plan closely to avoid potential pitfalls such as over-funding and diminishing benefits.