A cash balance pension plan is a type of pension plan provided by employers to employees of a company. This type of plan credits an employee’s account with a set percentage of his or her yearly compensation plus interest charges. A cash balance plan is often referred to as a ‘hybrid’ pension plan because the plan acts like both a defined benefit and defined contribution scheme.
Defined Benefit Plans
If this technical jargon is a little over your head, that’s okay. Let’s start at the beginning. What is a pension plan? A pension plan is a type of retirement plan that requires employers to set aside money for an employee’s retirement. The money set aside is typically a percentage of the employee’s salary and is invested by the employer to earn returns for the employee. The contributions are put in an general company pool, combined with other contributions from other employee pension plans, and invested as a unit.
Pension plans are most typically defined benefit plans, meaning set dividends or amounts of cash are given to the employee each month during retirement. In traditional pension plans the liability to provide cash for retirement falls on the employer since the employer is required to pay out set amounts of money to employees in retirement.
Defined Contribution Plans
Because of this burden, companies very rarely offer traditional pension plans anymore. Instead, most companies opt for defined contribution plans for retirement like 401(k) plans. 401(k) plans allow employees to have more control, and thus carry the burden of risk, over their own retirement funds. 401(k) plans allow employees to set aside money for retirement and control the investments themselves.
This type of plan offers no guaranteed set amount of dividends or amounts of cash during retirement. Instead dividends are tied to portfolio performance. 401(k) plans are primarily funded by pre-tax contributions from employees, typically capped at a certain percentage like 6%. Employers often offer incentives to match these contributions up to set limits.
Hybrid Defined Benefit and Contribution Plans
A cash balance plan is a hybrid mix of both a defined benefit and defined contribution plan. A cash balance plan, like traditional pension plans, are typically operated by an employer and/or a Board of Trustees. The employer and/or the Board sets the amounts of contributions to the plan for employees. Typically these contribution levels are reflected as a percentage of the employee’s salary. Set dividends for employee beneficiaries during retirement are also predetermined by the employer and/or the Board. Changes in the portfolio do not affect these guaranteed distributions.
However, unlike a traditional pension plan, the contributions are not pooled together. Instead, much more similarly to defined contribution plans, the contributions are invested individually for each employee. The cash balance plan developed primarily as a way for employees to convert traditional pension plans (that are effectively being aged out of the system) into plans that look more like defined contribution plans, the more prevalent type of retirement plan offered today. Because the contributed money is not pooled together if an employee leaves a company, the individual’s total plan assets can be carried over much easier.
Benefits to Business Owners
One of the main attractions for cash balance plans is for business owners who may be behind in their retirement contributions. Cash balance plans offer higher contribution limits than say IRA’s or 401(k) plans, and the contribution limits increase as beneficiaries age. Beneficiaries aged 60 and older can contribute over $200,000 annually in pre-tax contributions under cash balance plans. The exact amounts increase incrementally with age. Compared to the limits of 401(k) plans that set contributions for beneficiaries aged 60 at $57,500 yearly, this is a huge advantage. Plan contributions also reduce adjusted gross income resulting in potentially significant tax savings.