There are two general categories of retirement plans — defined benefit plans and defined contribution plans. In general, defined benefit plans provide a specific benefit at retirement for each eligible employee, while defined contribution plans specify the amount of contributions to be made by the employer toward an employee’s retirement account. 

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A cash balance plan is a defined benefit plan that defines the promised benefit in terms of a stated account balance or “hypothetical account” instead of a monthly pension payable at a specific retirement age.

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Pros

• Substantial benefits can be provided and accrued within a short time – even with early retirement

• Employers can contribute (and deduct) more than under other retirement plans

• Easier for participants to understand because benefits are expressed in hypothetical account balances

• Vesting can follow a variety of schedules from immediate to spread out over three years

• Benefits do not have to be dependent upon asset returns

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Cons

• Most expensive form of plan

• Most administratively complex plan

• In most all years, a contribution must be made

• Employee benefits cannot be retroactively reduced

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If you establish a cash balance plan, you:

• Can have other retirement plans

• Can be a business of any size

• Need to annually file a Form 5500 with a Schedule SB

• Need an enrolled actuary to determine the funding levels and sign the Schedule SB annually

• Cannot retroactively decrease benefits

• Must create a governing plan document

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Who Contributes

Generally, the employer makes most contributions. Sometimes, employee voluntary contributions may be permitted.

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Contribution and Benefit Limits

Benefits provided under the plan are limited.  Generally, the benefit limits are higher than those allowed in Defined Contribution Plans.   An Enrolled Actuary is needed to determine the Contribution and Benefit Limits

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Filing requirements

Annual filing of Form 5500 is required.  An enrolled actuary must sign the Schedule SB of Form 5500.

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In-service withdrawals

Generally, a defined benefit plan may not make in-service distributions to a participant before age 62.

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How do cash balance plans work?

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In a typical cash balance plan, a participant’s account is credited each year with a “pay credit” (such as 5 percent of compensation from his or her employer) and an “interest credit” (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks are borne solely by the employer.

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When a participant becomes entitled to receive benefits under a cash balance plan, the benefits are defined in terms of an account balance. For example, assume that a participant has an account balance of $100,000 when he or she reaches age 65. If the participant decides to retire at that time, he or she would have the right to an annuity based on that account balance. Such an annuity might be approximately $8500 per year for life. In many cash balance plans, however, the participant could instead choose (with consent from his or her spouse) to take a lump sum benefit equal to the $100,000 account balance.  If a participant receives a lump sum distribution, that distribution generally can be rolled over into an IRA or to another employer’s plan if that plan accepts rollovers.

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The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation.

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How do cash balance plans differ from 401(k) plans?

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Cash balance plans are defined benefit plans. In contrast, 401(k) plans are defined contribution plans. There are four major differences between typical cash balance plans and 401(k) plans:

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1. Participation – Participation in typical cash balance plans generally does not depend on the workers contributing part of their compensation to the plan; however, participation in a 401(k) plan does depend, in whole or in part, on an employee choosing to contribute to the plan.

2. Investment Risks – The investments of cash balance plans are managed by the employer or an investment manager appointed by the employer. The employer bears the risks of the investments. Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. By contrast, 401(k) plans often permit participants to direct their own investments within certain categories. Under 401(k) plans, participants bear the risks and rewards of investment choices.

3. Life Annuities – Unlike 401(k) plans, cash balance plans are required to offer employees the ability to receive their benefits in the form of lifetime annuities.

4. Federal Guarantee – Since cash balance plans are defined benefit plans, the benefits promised by cash balance plans are usually insured by a federal agency, the Pension Benefit Guaranty Corporation (PBGC). If a defined benefit plan is terminated with insufficient funds to pay all promised benefits, the PBGC has authority to assume trusteeship of the plan and to begin to pay pension benefits up to the limits set by law. Defined contribution plans, including 401(k) plans, are not insured by the PBGC.