Understanding Cash Balance Plans for Retirement Savings

Cash balance plans are a type of retirement savings plan that can be a game-changer for those who want to supplement their traditional 401(k) or IRA.

A key benefit of cash balance plans is that they offer a guaranteed minimum benefit, which is a fixed amount that the plan promises to pay out in retirement. This can provide a sense of security for participants.

These plans are often offered by employers as an alternative to traditional pension plans. In fact, many companies have switched to cash balance plans in recent years due to their flexibility and cost-effectiveness.

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A cash balance plan is a type of retirement plan that earns a fixed rate of return, which can change over time.

In the US, over 20% of workers with defined benefit plans were in cash balance plans as of 2003, according to the Bureau of Labor Statistics.

These plans are often the result of conversions from traditional defined-benefit plans, which can be a complex process.

Legislation has recently been passed to clear the way for plan sponsors to adopt cash balance plans, making it easier to set up and maintain these plans.

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A cash balance plan is a type of defined benefit plan that offers high contribution limits, allowing many high earners to double or triple their annual tax-deferred retirement savings.

Cash balance plans are often referred to as "hybrid plans" because they combine the high contribution limits of defined benefit plans with the ease of understanding a defined contribution plan.

The contributions from the company for owners and executives are typically very large, with a smaller contribution provided to staff to meet Internal Revenue Service (IRS) requirements.

Here are some key features of cash balance plans:

A cash balance plan's design is based on providing each worker a "hypothetical account" with pay credits and interest credits. The plan typically credits a 5% pay credit on current salary and a 6% interest credit on the prior year's balance.

The interest rate used for discounting back to the current age is often lower than the rate used for interest credits on the hypothetical account balances, resulting in higher lump sum values. This is known as the "whipsaw" process.

The employer contribution to the plan may differ from the amounts added to the participant accounts, due to differences in interest rates, return on investments, vesting, or changes in IRS required assumptions.

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A cash balance plan is designed to provide each worker with a "hypothetical account" that accumulates over time. This account balance is determined by pay credits and interest credits.

A typical design for a cash balance plan provides a 5% pay credit of the worker's current salary each year. The interest credit is 6% of the prior year's balance.

The worker's account balance is calculated by adding the prior year's balance to the current year's pay credit and interest credit. This process is repeated each year until termination.

For example, a worker starting at age 25 with a $2000 a month starting salary would begin with a zero account balance. The first year's pay credit would be $1200, leaving an end of first year balance of $1200 in their "hypothetical" account.

The worker's account balance grows as they receive pay credits and interest credits each year. By age 26, with a 3.5% salary increase, their monthly salary would be $2070, resulting in a 5% pay credit of $1242 and an interest credit of $72.

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The interest credit is calculated as 6% of the prior year's balance, which in this case is $1200. The ending balance in the "hypothetical" account for the second year would be $2514 ($2514 = $1200 + $1242 + $72).

This process is repeated each year until the worker reaches normal retirement age, at which point the account balance can be used to calculate the legally required benefit.

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In the early 2000s, several court cases clarified the rules for calculating lump sums in cash balance plans.

The Third Circuit in Goldman v. First National Bank of Boston (1993) initially decided that a terminated worker did not demonstrate a violation of age discrimination rules.

In 2000, the Eleventh Circuit in Lyons v. Georgia Pacific and the Second Circuit in Esden v. Bank of Boston found that employers violated rules for calculating lump sums.

The lump sum calculation process, also known as the "whipsaw", involves taking the account balance forward from the terminated worker's current age up to their normal retirement age before discounting back to the current age.

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If the interest rate used for discounting back is lower than the rate used for interest credits on the hypothetical account balances, then the legally required lump sum values would be higher than the worker's account balance in their hypothetical account.

A district court in Illinois, Cooper vs. IBM Personal Pension Plan (2003), decided that the very design of the cash balance plan had indeed violated the age discrimination rules because the rate of benefit accruals decreased on account of the attainment of any age.

The Seventh Circuit in Berger v. Xerox Corp. Retirement Plan (2003) held that the lump sum calculation for workers terminating service prior to retirement cannot violate the rules for defined-benefit plans.

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The interest credited to a cash balance plan's hypothetical accounts is guaranteed by the plan document, but if actual trust earnings exceed this rate, the excess is used to reduce future employer contributions.

The amount credited to a participant's account will increase according to the plan's schedule, funded partially by employer contributions and partially by excess earnings.

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Typically, employer contributions will be different from the amounts added to participant accounts, mainly due to differences between credited interest and plan investment returns.

This difference can also be caused by vesting or changes in IRS required assumptions, which can impact the amount credited to a participant's account.

The interest credited to hypothetical accounts is used to calculate the legally required benefit, an annuity payable for the life of the participant or beneficiary who elects to commence payment at normal retirement age.

A cash balance plan can be an ideal solution for business owners looking to reduce tax liabilities and accelerate retirement savings. It's a type of IRS-qualified retirement plan that combines the best of both worlds.

Here are some key benefits of a cash balance plan:

The employer takes on all of the investment risk, which can be beneficial for business owners.

Cash balance plans can be more expensive to administer than traditional retirement plans, with higher startup costs, annual administration charges, and management fees. This is because they require certification to ensure they're adequately funded.

Employers must make contributions every year, and the plan must meet minimum participation rules and nondiscrimination testing. This can be a challenge, but it's not insurmountable.

If you quit your job, your cash balance pension is portable, and you can take the vested portion with you, rolling it into another retirement account.

Here's a brief rundown of the key takeaways:

Keep in mind that there are some downsides to consider, such as taxable distributions and high costs to maintain the plan.

If a participant in a cash balance pension plan is terminated, they'll be eligible to receive the vested portion of the hypothetical account balance. This is determined by the plan document and can be 0 percent for up to three years of service.

A participant's vested percentage can be 0 percent for up to three years of service, but it must be 100 percent upon completion of three years of service. This is a standard rule that applies to all cash balance plans.

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If you're a participant in a cash balance plan and you're considering leaving your employer, you should review your plan document to understand your vested percentage. This will give you an idea of how much of your hypothetical account balance you can take with you when you go.

Here are some key facts to keep in mind:

In Onan Corp., a District Court Judge agreed with proponents of cash balance plans, ruling that they don't violate age discrimination statutes because the terms "rate of benefit accrual" and "accrued benefit" are ambiguous.

Pension actuaries, however, have long considered these terms to be very familiar and unambiguous, which is why they were able to construct initial balances in each worker's hypothetical account for these new cash balance pension plans.

The Code defines "accrued benefit" and "normal retirement benefit" in specific terms, but supporters of cash balance plans argue that these definitions are not applicable to cash balance plans.

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In Kathi Cooper v. IBM Personal Pension Plan, a District Court Judge came to the opposite conclusion, ruling that the plan design of the cash balance plan violated the age discrimination statutes because benefits accrued at a decreasing rate solely based on increases in age.

The ruling was later reversed on appeal in 2006, but the case highlights the potential for age discrimination in cash balance plans with flat rate pay credit design.

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The Pension Protection Act of 2006 was signed into law in August 2006, prospectively making flat salary credit type cash balance plans immune from age discrimination.

This law also eliminated the "whipsaw" and allowed the use of a higher interest rate for calculation of lump sums.

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Congress has taken steps to address age discrimination in pension plans.

The Pension Protection Act of 2006 was signed into law in August 2006.

Senator Charles Grassley (R) of Iowa proposed a law to statutorily fix the problem of age discrimination suits.

This law prospectively made flat salary credit type plans immune from age discrimination.

The law also eliminated the "whipsaw" by allowing the use of a higher interest rate for calculation of lump sums.

The law fixes age discrimination only prospectively, meaning it does not apply to past cases.

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Cash balance plans are generally insured by the Pension Benefit Guaranty Corporation (PBGC). This means that most plans have a safety net in place to protect benefits in case the plan sponsor can't pay them out.

Plans that are covered by PBGC insurance must pay a premium to the PBGC each year. The premium is based on the plan's size and the amount of benefits it offers.

If plan investments don't perform well or the plan sponsor chooses to contribute less than recommended, the plan could have unfunded benefit liabilities. This increases the amount of premium that must be paid.

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Employers appreciate the flexibility and cost savings of cash balance plans, which allow them to make contributions in the form of a percentage of pay rather than a fixed amount.

Cash balance plans can be more expensive for employees, especially those with lower salaries, as they often require higher contributions to achieve the same benefits as traditional pension plans.

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Employers can also use cash balance plans to attract and retain top talent, as they can offer more competitive retirement benefits.

However, employees may be concerned about the complexity and potential risks associated with cash balance plans, which can be difficult to understand and navigate.

Employers can help alleviate these concerns by providing clear and transparent information about the plan, including its terms and conditions.

A cash balance plan can be a valuable tool for employers looking to offer competitive retirement benefits while also managing costs.

When deciding between a cash balance pension and a traditional pension plan, consider how your benefit is calculated. A traditional pension plan generally uses a few years of your highest compensation to determine your monthly benefit, whereas a cash balance pension plan uses the total number of years you've been with the company.

If you're considering a cash balance pension versus a 401(k), note that the employer bears the investment risk in a cash balance pension. This means the employer is responsible for ensuring you receive the promised amount, regardless of market performance.

The contribution limit for a 401(k) is higher for people 60 years or older, allowing them to save significantly more annually in pretax contributions.

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In a traditional pension plan, your monthly benefit is usually based on a few years of your highest compensation. This can be a great benefit if you've had a few high-earning years, but it may not accurately reflect your overall compensation history.

The key difference between a traditional pension plan and a cash balance pension plan is how your benefit is calculated. A cash balance pension plan uses the total number of years you've been with the company, making it a more straightforward and predictable benefit.

In a traditional pension plan, your benefit is often based on a few years of high earnings, which can be a gamble if you've had a few low-earning years. This can make it harder to plan for your retirement.

On the other hand, a cash balance pension plan provides a more stable and predictable benefit, based on your total years of service. This can give you more confidence in your retirement plans.

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A cash balance pension plan bears the investment risk, whereas with a 401(k), the employee is responsible for choosing the investment strategy and bears the risk.

The employer's investment risk in a cash balance pension means they must ensure the employee receives the promised amount, regardless of market fluctuations.

The contribution limit for a 401(k) is higher for people 60 years or older, allowing them to save significantly more in pretax contributions.

Unlike a 401(k), the retirement benefit amount in a cash balance pension is guaranteed, not dependent on the account balance.

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Cash balance plans are becoming increasingly popular among small business owners, and for good reason. The government is looking to privately funded pension plans to help fund the retirement of America's workers, especially those who are getting closer to retirement age.

One of the main reasons cash balance plans are gaining traction is that they reduce taxable income, which can be a huge benefit for small business owners. By reducing taxable income, cash balance plans can help businesses fall below the qualified business income (QBI) income threshold.

This can be a game-changer for small business owners, as it can help them save money on taxes and allocate more funds towards their retirement plan.

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