How do Cash Balance Plans Differ from Traditional Pension Plans?
There are two general types of pension plans — defined benefit plans and defined contribution plans. A cash balance plan is a defined benefit plan that defines the promised benefit in terms of a stated account balance.
According to the Department of Labor, while both traditional defined benefit plans and cash balance plans are required to offer payment of an employee’s benefit in the form of a series of payments for life, traditional defined benefit plans define an employee’s benefit as a series of monthly payments for life to begin at retirement, but cash balance plans define the benefit in terms of a stated account balance. These accounts are often referred to as “hypothetical accounts” because they do not reflect actual contributions to an account or actual gains and losses allocable to the account.
How do Cash Balance Plans Differ from 401(k) plans?
Cash balance plans are defined benefit plans. In contrast, 401(k) plans are a type of defined contribution plan. According to the Department of Labor, there are four major differences between typical cash balance plans and 401(k) plans.
- Participation – Participation in typical cash balance plans generally does not depend on the workers contributing part of their compensation to the plan; however, participation in a 401(k) plan does depend, in whole or in part, on an employee choosing to make a contribution to the plan.
- Risk of Investment – The investments of cash balance plans are managed by the employer or an investment manager appointed by the employer. The employer bears the risks of the investments. Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. By contrast, 401(k) plans often permit participants to direct their own investments within certain categories. Under 401(k) plans, participants bear the risks and rewards of investment choices.
- Lifetime Annuities – Unlike 401(k) plans, cash balance plans are required to offer employees the ability to receive their benefits in the form of lifetime annuities.
- PBGC – Since they are defined benefit plans, the benefits promised by cash balance plans are usually insured by a federal agency, the Pension Benefit Guaranty Corporation (PBGC). If a defined benefit plan is terminated with insufficient funds to pay all promised benefits, the PBGC has authority to assume trusteeship of the plan and to begin to pay pension benefits up to the limits set by law. Defined contribution plans, including 401(k) plans, are not insured by the PBGC.