Why Your Employees May be Better off with a Cash Balance Plan than a Traditional Defined Benefit Pension Plan
Behind every successful business you will find key people that help drive its success. Every smart business owner knows that without the team, there would be no business. This is probably the primary reason why the cash balance retirement plan has become the most popular type of defined benefit plans for small businesses.
What is a Cash Balance Plan?
A cash balance plan is a type of defined benefit pension plan. A cash balance plan guarantees an employee an employer contribution equal to a percent of each year’s earnings and a rate of return on that contribution. The benefit is always expressed as a total account balance.
Cash balance plans build value steadily and often at the same speed for all employees—whether they’ve worked for the employer for one or 25 years. The emphasis of these plans is on wealth building and “portability.” Whereas, traditional defined benefit plans are designed to encourage career employment with one employer. Rather than focusing on wealth accumulation, it generally focuses on providing retirement security. In other words, the way a defined benefit plan is designed it does not reward employees who choose to change jobs.
How Do They Work?
Cash balance plans are funded on an actuarial basis, in the same way that traditional defined benefit plans are funded. In a cash balance plan, the amount the employer contributes to the plan each year on behalf of all employees is based on actuarial assumptions. Employees’ retirement accounts grow by earning annual credits that typically are based on a flat percentage of pay. In addition, accounts earn an interest credit each year that is tied to some external index, such as the Consumer Price Index or the rate on U.S. Treasury bills.
Although the calculation details are complex, in general, the benefit accrual rules under a cash balance plan allows employee benefits to grow more evenly over an employee’s career than would result under a traditional defined benefit plan, which is based on final average pay—in which the majority of benefit accrual takes place in the final few years prior to retirement. In other words, employee retirement benefits for cash balance plans are determined by an employee’s pay averaged over his or her total years of service. Hence, because a cash balance plan’s benefit accrual formulas is based on an employee’s career average earnings, the results tend to be more beneficial to employees just beginning their careers than to employees who are close to retirement and have worked most of their career under a more traditional defined benefit plan.
What is a Traditional Defined Benefit Plan?
A traditional defined benefit pension plan usually bases the accrued benefit on a multiple of an employee’s salary level and years of service. Traditional defined benefit plans are characteristically back-loaded—meaning much of the value of the benefit is earned in the final years just prior to the employee’s retirement. Thus, traditional defined benefit plans are ideal for employees who spend their entire career with a single employer.
The foundation of the traditional defined benefit plan is based on the notion that employees experience their highest earnings toward the end of their career which implies that the pension benefit due to them would accrue much faster at a later stage of their employment. If employees leave the business before qualifying for retirement, typically age 65 under most plan documents, they suffer a pension “capital loss” by giving up the opportunity for a substantial graduated increase in pension benefits.
Therefore, an employee that remains with the same employer for many years will benefit the greatest in a traditional defined benefit plan. Whereas, for more mobile employees that tend to switch jobs multiple times in their career, a cash balance plan would be more beneficial since the accrual benefits calculation does not take into account years of service, but only salary and age.
Why Choose a Cash Balance Plan?
The American workforce is far more mobile today than it was twenty or so years ago. For mobile workers, cash balance plans can provide more significant retirement benefits sooner and more evenly over their working career. One of the great benefits of a cash balance plan compared to a traditional defined benefit plan is that it is better suited for a more mobile workforce who want to transfer accumulated pension benefits when changing jobs. This cash balance portability characteristic presents employees who switch jobs the opportunity to leave their assets in the plan (where they will continue to receive interest credits), elect an annuity, or roll over their account balance to their next employer’s retirement plan or into an IRA. These type of portability options are rarely offered in traditional defined benefit pension plans.
Most business owners understand that it is just not realistic to keep all your team members forever. Therefore, those business owners that want to provide their employees with the best opportunity to maximize their retirement benefits under a defined benefit plan, will tend to go with the cash balance plan versus the traditional defined benefit plan.
To learn more about the benefits of the cash balance defined benefit plan, please contact one of our pension experts at 800-401-1336.
