What is a Cash Balance Plan?
A cash balance plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance.
In general, defined benefit plans guarantee a specific benefit at retirement to each eligible employee. A cash balance plan is a defined benefit plan that in some ways resembles a 401(k) plan. Like 401(k) plans, typically cash balance plans credit a participant’s hypothetical account annually with a “pay credit” (such as five percent of compensation) and an “interest credit” (either a fixed or a variable rate linked to an index such as the one-year treasury bill rate).
Unlike 401(k) plans, those hypothetical accounts are then used to determine the monthly benefit the eligible employee will receive at retirement. Also, unlike 401(k) plans, increases and decreases in the actual value of the plan’s investments are the responsibility of the employer and do not directly impact the benefit amounts promised to participants.
In a cash balance plan, the rules do not limit the annual contribution amount but instead limit the ultimate benefit payable from the plan. The current maximum benefit is a life annuity of $230,000 per year payable beginning at age 62, subject to adjustments based on age, years of service, and participation. The lump sum equivalent of that benefit at retirement age is over $2.5 million. So you can see, cash balance plans offer the potential to generate enormous retirement savings that can be several times that of 401(k) profit sharing plans alone.
For 2020, an employee with 10 years of participation in a cash balance plan can receive a maximum annual benefit payout of $230,000 per year beginning at the age of 62. As previously discussed, the IRS places a limit on compensation used in the calculation of benefits. For 2020, the maximum (which is indexed to the CPI) was $285,000 and for 2019 it was $5,000 lower. Alternatively, they could receive an equivalent lump sum of approximately $2.9 million. The benefit limit applies to single-life annuities that will begin between the ages of 62 and 65, with an adjustment made to reflect the starting age and form of payment.
How Does a Cash Balance Plan Work?
According to the DOL, in a typical cash balance plan, a participant’s account is credited each year with a “pay credit” (such as five percent of compensation from his or her employer) and an “interest credit” (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks are borne solely by the employer.
When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance. For example, assume that a participant has an account balance of $100,000 when he or she reaches age 65. If the participant decides to retire at that time, he or she would have the right to an annuity based on that account balance. Such an annuity might be approximately $8500 per year for life. In many cash balance plans, however, the participant could instead choose (with consent from his or her spouse) to take a lump sum benefit equal to the $100,000 account balance.
If a participant receives a lump sum distribution, that distribution generally can be rolled over into an IRA or to another employer’s plan if that plan accepts rollovers.