Cash balance plans are defined benefit pension plans that express the employee’s benefit in terms of an account balance. Employer pay credits are credited to the account each year along with an earnings credit. Accordingly, to the employee the plan looks like a defined contribution individual account plan even though it is in fact a defined benefit pension plan.
In 2006, Congress laid out the general rules governing the implementation and administration of cash balance plans. Employers were slow to adopt these plans because many questions remained unanswered. However, employers received much of the clarity they were waiting for about the design and structure of cash balance plans when the Internal Revenue Service (IRS) issued proposed and final regulations. In light of these new rules, cash balance plans warrant another look for the following reasons:
- Substantially increased benefits for owners and key employees. One big advantage is the ability to provide for a benefit substantially greater than the $49,000 (or $54,500 after age 50) permitted in a profit sharing or 401(k) plan. Annual retirement benefits may be as high as $195,000.
- Financial Efficiency. In a simple cash balance plan the expected economic cost of the plan can be much less than a comparable benefit provided in a defined contribution plan. The source of this savings is the differential between the rate that a plan will credit on employee accounts (which is often the 10-year or 30-year Treasury rate) and the rate used to determine the actual funding requirements. Under funding and accounting rules, the funding rate is based on corporate investment grade bonds. Given recent market conditions, this differential can result in a 1 to 2 percent spread, potentially saving as much as 2% of payroll each year (or more, if emerging investment performance exceeds the rate earned on corporate bonds).
- Mitigated Financial Risk. A traditional defined benefit plan is exposed to both an investment risk (through its assets) and an interest-rate risk (through its liabilities). These risks are independent on one another. So interest rates may rise while asset values decline exacerbating the plan’s underfunded status. While a cash balance plan is a defined benefit plan, under a typical feature where the annual interest credit is set at a market rate (e.g., 30-year Treasuries), lower funding rates usually reduce a typical cash balance plan’s interest crediting rate, thereby offsetting the increase in the liability due to lower funding rates.
- Balance of Risk. Many employers believe that their assumption of 100% of the financial risks of the retirement program is too far to one extreme. However, a growing number of employers think that having employees assume 100% of the risks goes too far in the other direction. A cash balance plan operating in tandem with a defined contribution plan provides a reasonable middle ground.
- Preservation of Investment Principal. Cash balance plans typically provide a feature that defined contribution plans do not provide under the commonly elected investment options: account values that can only increase from year to year. Essentially, cash balance plans act like stable-value funds providing a dependable floor of protection. Further, although the interest credit in a cash balance plan might seem conservative compared to traditional defined contribution investments, participants could compensate for this conservatism by allocating a larger portion of their DC accumulation to equities.
- Longevity Protection. Surveys have shown that one of the two major fears of employees who are about to retire is outliving their money. (The other is a medical catastrophe that wipes out savings.) Because a cash balance plan is a defined benefit plan, it must offer the option of receiving a lifetime payout rather than a lump sum. To some extent, this also serves as a floor of protection against outliving one’s money.