Why companies like cash balance plans

In 1985, there were 114,000 defined benefit plans in America. By 2011, that number had shrunk to 38,000. Since 1985, some businesses have elected to replace a traditional pension plan with an alternative: a cash balance plan.1

But what are they? And how might they work for your business? We here at Lighthouse Financial are happy to help you answer those questions, so contact us to schedule an appointment. In the meantime, here are some basics to help you answer some of the most commonly asked questions. 

Cash balance plans offer partners and owners of highly profitable businesses an option to ramp up their retirement savings through large pre-tax contributions. Contributions to these plans are age-dependent, so the older you are, the more you can potentially sock away for retirement. They are not for every business, as they demand annual contributions from the plan sponsor. Yet they may prove less expensive to a company than a traditional defined benefit plan, and offer significantly greater funding flexibility and employee benefits in comparison to a defined contribution plan.2

How does a cash balance plan differ from a traditional defined benefit plan? In a cash balance plan, a business or professional practice maintains a hypothetical account balance for each employee. Employees get periodic statements showing their “balances”.

Each plan participant collects pay credits and interest credits. (The interest rate for a cash balance plan is commonly linked to the 30-year Treasury.) When a plan participant retires, the plan pays out either a lump sum or a pension-style income. Cash balance plans are portable: the vested portion of the account balance can also be paid out if an employee leaves before a retirement date.3

As an example of how credits are accrued, let’s say an employee named Joe Green earns $75,000 annually at the XYZ Company. He participates in a cash balance plan that provides a 5% annual salary credit and a 5% annual interest credit once there is a balance. Joe’s first-year pay credit would be $3,750 with no interest credit as there was no balance in his hypothetical account at the start of his first year of participation. For year two (assuming no raises), Joe would get another $3,750 pay credit and an interest credit of $3,750 x 5% = $187.50. So at the end of two years of participation, his hypothetical account would have a balance of $7,687.50.

Per Internal Revenue Code Section 412, an employer must make annual contributions to a cash balance plan. Each year, an actuary must make valuations to determine the current value of a participant’s accrued benefit and the minimum yearly contribution.

Designing the plans. While a cash balance plan resembles a defined contribution plan to an employee, it is considered a defined benefit plan and must follow the rules set up for those plans. As a result, a cash balance plan has to meet some basic tests:

  • It must be non-discriminatory (it can’t be structured to favor executives).
  • Allocations to plan participants must meet IRC Section 415 standards.
  • Allocation formulas must be in line with the IRC’s top-heavy required minimum contribution (if relevant).
  • Plan contributions must be in amounts deductible by the business per IRC Section 415.4

Assuming those tests are met, there are some compelling reasons to adopt a cash balance plan in place of a traditional defined benefit plan.

 Two major advantages. A cash balance plan offers business owners the potential to keep any excess profits earned above the annual interest credit owed to employees. Additionally, the company has a consistent payment stream to direct to its retired employees, plus designated hypothetical accounts set up for that purpose.3

An alternative to the safe harbor formula. A safe harbor formula may help a traditional defined benefit plan avoid charges of age discrimination, yet it has a downside: it predisposes the plan to tilt greater amounts of money to a company’s longest-tenured workers, leaving less for owners. In cash balance plans, the oldest and youngest employees simply collect credits that represent either a percentage of pay or a flat dollar amount.5,6

Benefit allocations based on career average pay, not just “the best years”. In a traditional defined benefit plan, the eventual benefit is based on a 3- to 5-year average of peak employee compensation multiplied by years of service. In a cash balance plan, the benefit is determined using a career average pay formula – an average of all years of compensation.6

Less sensitivity to interest rates. As rates rise and fall, liabilities in a traditional pension plan fluctuate. This opens a door to either overfunding or underfunding (and underfunding is a major risk right now with such low interest rates). By contrast, a cash balance plan has relatively minor variations in liability valuation.6

Are there any demerits to these plans? Yes. For one, they often have greater administration costs than traditional defined benefit plans – and the business must make annual contributions. It isn’t like a SEP IRA where an employer can opt out of plan contributions in a lean year. The employer bears 100% of the plan cost.7

Plan participants lack the power to invest plan assets as they choose, as there are no individual accounts – all plan assets are in one commingled account. If plan assets perform worse than anticipated, the business will need to ramp up contributions.7

Cash balance plans cannot be administered with any degree of absentmindedness. They have to pass yearly non-discrimination tests; they need to be submitted for IRS approval every five years instead of every six; a plan document must be drawn up and periodically amended; and as usual, there are annual reporting requirements.6,7

Still, these plans have grown increasingly popular. Some businesses have even adopted dual profit-sharing and cash balance plans. Maybe it is time your business looked into this intriguing alternative to the traditional pension plan.

 

This material was prepared by MarketingLibrary.Net Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. All information is believed to be from reliable sources; however we make no representation as to its completeness or accuracy. Please note – investing involves risk, and past performance is no guarantee of future results. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. All indices are unmanaged and are not illustrative of any particular investment.

 Citations:

1 – www.irs.gov/retirement/article/0,,id=108950,00.html [4/15/11]

2 – www.cashbalancedesign.com/cashbalance101/contributionlimits.html [10/20/11]

3 – www.mwlawgroup.com/erisa/Articles-Cash-Balance-Plans.pdf [2006]

4 – www.cbginc.com/Cash%20Balance%20Plan.htm [2006]

5 – montoyaregistry.com/Financial-Market.aspx?financial-market=5-savings-secrets&category=29 [10/20/11]

6 – www.cashbalanceactuaries.com/cb_vs_dbp.htm [2010]

7 – www.journalofaccountancy.com/Issues/2009/Jan/PlanDesignInTheBalance.htm [1/09]

 

Tags:

Subscribe

Subscribe to our e-mail newsletter to receive updates.

Comments are closed.