Cash-balance plans are gaining popularity as a hybrid retirement savings option that blends features of traditional pensions with the flexibility of defined contribution plans like 401(k)s. If you’re an employee planning for retirement or an employer seeking a competitive edge, understanding cash-balance plans can help you make informed financial decisions.
What is a Cash-Balance Plan?
A cash-balance plan is a type of defined benefit retirement plan, but it functions more like a defined contribution plan in how it communicates benefits to participants.
Instead of promising a monthly pension based on years of service and final salary, it defines the benefit in terms of a “hypothetical account balance.” This account grows annually through:
- Pay credit (a percentage of salary contributed by the employer)
- Interest credit (a guaranteed rate or variable rate linked to an index)
How Cash-Balance Plans Work
Each year, the employer contributes to the employee’s hypothetical account:
- Pay Credit: For example, 5% of the employee’s salary.
- Interest Credit: A fixed percentage (e.g., 4%) or a variable rate tied to an index like the 30-year Treasury yield.
Even though these amounts are “hypothetical,” the employer is responsible for funding the plan and managing the investment risk.
When an employee retires or leaves the company, they can take the account balance as:
- A lump sum payout (often rolled into an IRA), or
- A lifetime annuity
Advantages of Cash-Balance Plans
1. Predictable Retirement Benefit
Unlike 401(k)s, which depend on investment performance, cash-balance plans offer predictable growth through guaranteed interest credits.
2. Portability
Balances are often easier to understand and transfer, especially when offered as a lump sum at retirement or job change.
3. Higher Contribution Limits
Employers can contribute significantly more to a cash-balance plan than to a 401(k), especially for older, high-income earners—making it ideal for business owners or executives.
4. Employer Control
The employer manages the plan and investment strategy, removing the burden of decision-making from employees.
Drawbacks of Cash-Balance Plans
1. Cost and Complexity
Cash-balance plans are more expensive and administratively complex than 401(k)s. They require actuarial valuations and compliance testing.
2. Investment Risk
Although employees receive a guaranteed return, the employer bears the risk of investment performance falling short of promised credits.
3. Limited Employee Flexibility
Employees don’t direct investments and might not see the same upside potential as with a self-managed 401(k).
Who Should Consider a Cash-Balance Plan?
Cash-balance plans are best suited for:
- Business owners or professionals (doctors, lawyers, etc.) with high income looking to defer taxes.
- Companies wanting to attract and retain top talent with a robust retirement benefit.
- Older employees who want to catch up on retirement savings with higher contributions.
How to Set Up a Cash-Balance Plan
- Consult a retirement plan advisor or actuary
- Design the plan structure (pay credit, interest credit, eligibility)
- File necessary documents with the IRS and Department of Labor
- Fund the plan annually
- Communicate with employees clearly about their benefits
Cash-Balance Plans vs. 401(k)s: Key Differences
| Feature | Cash-Balance Plan | 401(k) Plan |
|---|---|---|
| Type | Defined Benefit | Defined Contribution |
| Employer Contribution | Required | Optional |
| Employee Contribution | Not allowed | Allowed |
| Investment Risk | Employer bears risk | Employee bears risk |
| Contribution Limits | Much higher for older employees | Lower, fixed by IRS |
FAQs About Cash-Balance Plans
Q1: Can I have a 401(k) and a cash-balance plan?
Yes. Many employers offer both. Business owners can maximize tax-deferred savings by combining both plans.
Q2: Are cash-balance plans insured?
Yes. Like other defined benefit plans, they are insured by the Pension Benefit Guaranty Corporation (PBGC).
Q3: What happens if I leave my job?
You can typically roll over your vested account balance into an IRA or another retirement plan, or choose to receive an annuity.
Q4: Can employees contribute to cash-balance plans?
No. Only employers contribute to cash-balance plans. However, they may also offer a 401(k) alongside it for employee contributions.
Q5: Are cash-balance plans tax-deferred?
Yes. Contributions and interest credits grow tax-deferred until distribution.
Cash-balance plans offer a powerful retirement savings solution for both employers and employees, especially in high-income professions. While they involve more complexity than traditional plans, their benefits—predictable retirement income, tax efficiency, and higher contribution limits—can make them a worthwhile investment in long-term financial security.
