Cash balance plans: Frequently Asked Questions

Q: What is a cash balance plan?

A cash balance plan is a hybrid retirement plan, blending the features of a traditional pension plan with the look and feel of a 401(k)/profit-sharing plan. It is a qualified plan and all contributions to the plan are made on a tax-deferred basis by the employer. A cash balance plan is a defined benefit plan subject to all the requirements of such plans. As a defined benefit plan, the benefit under a cash balance plan is determined based on formulas in the plan document. The benefits are supported by a pooled fund; however, the amount of money in the fund is not used in determining the amount of the benefit. Cash balance plans are insured by the Pension Benefit Guaranty Corporation (PBGC) unless the employer meets one of the coverage exceptions.

Q: What are some advantages of a cash balance plan?

• Allows for tax-deferred contributions in excess of statutory 401(k)/profit-sharing plan annual limits.
• Cash balance plans may allow for tiered benefit levels, meaning that each participant can have a unique pay credit under the plan (subject to applicable nondiscrimination testing).
• Unlike a 401(k)/profit-sharing plan, participants can be shielded from investment risk by setting the plan’s interest crediting rate as a fixed return. The plan’s assets can be invested to generally exceed this level of return (although ultimately the plan sponsor would retain investment risk).
• Cash balance plans can be designed to minimize the plan sponsor’s investment risk by setting the plan’s interest crediting rate equal to trust’s rate of return.
• Participants don’t bear investment risk, as the interest crediting rate is stated in the plan document.
• Benefits under a cash balance plan are protected from creditors, which includes legal expenses.
• Generally easier for participants to understand the benefit offering (when compared to a traditional defined benefit plan), which enhances employee satisfaction.

Q: What are some disadvantages of a cash balance plan?

• Subject to minimum funding requirements under the Internal Revenue Code, which may require cash funding in years the plan sponsor would rather not contribute at all or as much as necessary.
• With an exception for small benefits, because a cash balance plan is a defined benefit plan, it must offer forms of payment other than lump sums (e.g., Qualified Joint and Survivor).
• In most cases, plans are subject to PBGC coverage and are required to pay an annual premium.
• Accelerated vesting requirements (when compared to a traditional defined benefit plan).
• Because cash balance plans are subject to many of the requirements of defined benefit plans, they can be more difficult to understand for participants compared to a 401(k)/profit-sharing plan.

Q: Can an employer sponsor a cash balance plan if it has an existing 401(k) plan?

A cash balance plan can be adopted as a standalone plan, but it also can be adopted by an employer that already sponsors a 401(k)/profit-sharing plan. If an employer currently does not have any retirement plans in its benefits package, it can adopt the two plans simultaneously. In many cases, the pairing of a cash balance plan with a 401(k)/profit-sharing plan can create the opportunity for significant tax-deferred savings.

Q: How does a cash balance plan work?

Each participant has a benefit that resembles a 401(k)/profit-sharing plan account balance. The benefit is portable and is typically paid out in a lump sum at termination of employment. The benefit takes the form of a hypothetical account balance that grows through pay credits and interest credits. Both components (pay and interest credits) must be decided in advance and written into the plan document.

• The pay credit can be defined as either a fixed dollar amount, as a percentage of salary, or as some combination of the two.
• The interest credit can be a fixed rate (e.g., 5%) or a rate that is based on some market-related index (e.g., the 10-year Treasury yield). The interest credit is independent from the actual return on the plan’s assets (although plans can be designed to take the plan’s asset return into account). If the plan’s interest credits follow actual returns (and allow for negative returns), cash balance plans have a “preservation of capital” requirement such that the hypothetical account balance can never be less than the sum of earned pay credits.

Q: What pay credits can be offered in a cash balance plan?

Pay credits can be a flat dollar amount or a percentage of salary. In addition, the plan can be designed such that the pay credits vary by age. Older participants can receive larger pay credits in a cash balance plan than younger participants due to the time value of money. Larger pay credits are permitted for older participants as they have less time to accumulate funds prior to retirement.

Q: Can the pay credits change from year to year?

Cash balance plans are meant to be permanent. The formula determining pay credits should not fluctuate from year to year to avoid the perception the employer is treating the plan as a discretionary profit-sharing plan. However, the plan could update the pay credits every three to five years, if determined based on an objective business criterion (e.g., compensation review, etc.). Because of the annual contribution requirement, it is important to note that a cash balance plan is a good fit for an organization that has shown a consistent pattern of profits.

Q: What are the tax advantages of a cash balance plan?

A cash balance plan has the potential to offer significantly expanded tax benefits for business owners beyond those available in a 401(k)/profit-sharing plan. Please see our schedule of maximum contributions to a cash balance plan. Contributions to a cash balance plan are deductible dollar for dollar for the business, and taxes for the participant are deferred. For employees who receive W-2 wages, benefits earned under the plan are exempted from FICA taxes, providing permanent tax savings. When distributed, cash balance benefits are taxed as ordinary income.

Q: Who is required to receive a benefit in a cash balance plan?

Participation in the employer’s cash balance plan does not need to be universal. A cash balance plan must provide a “meaningful” benefit to the lesser of (a) 40% of non-excludable employees, or (b) 50 participants. If the cash balance plan does not cover the employer’s entire population, then it is typically paired with a 401(k)/profit-sharing plan with a nonelective employer contribution designed to satisfy nondiscrimination testing requirements.

Q: What are the vesting requirements in a cash balance plan?

Unlike traditional defined benefit plans, cash balance plans have accelerated vesting requirements. Plan participants must be 100% vested in their benefits no later than after completing three years of vesting service. Unlike defined contribution and traditional defined benefit plans, no graded vesting schedule is allowed.

Q: How are investments in a cash balance plan managed?

Assets in the plan are not allocated to individual participants. The pooled fund is invested by the Trustee(s) and their investment advisors. Gains (or losses) from investments reduce (or increase) the plan sponsor’s required annual contributions.

Q: What is the time commitment if our company adds a cash balance plan?

Because this is a defined benefit plan, the plan would need to follow the Internal Revenue Service (IRS) rules regarding permanency. The company would need to commit to funding the plan for more than a few years (i.e., generally no fewer than five years), unless there is a legitimate business reason for freezing or terminating the plan (such as sale of the business or bankruptcy).

Q: What are Pension Benefit Guaranty Corporation (PBGC) premiums?

The PBGC is a government agency that insures defined benefit plans. Almost all defined benefit plans are covered by the PBGC and plan sponsors must pay premiums for this coverage; however, certain plans for small professional services firms and plans covering only substantial owners are exempt. PBGC premiums consist of a flat rate premium and a variable rate premium. The flat rate premium is a per participant annual fee of $88 in 2022. The variable rate premium fee is $48 per $1,000 of unfunded vested benefits in 2022. All plans are subject to the flat rate premium, but only plans with unfunded vested benefits are subject to the variable rate premium.