How do cash balance pension plans work?
Similar to DB plans, participants in cash balance plans receive a specified benefit at retirement. The 2022 IRS maximum annual benefit is the lesser of $245,000 or 100% of a participant’s average compensation for the three highest consecutive calendar years. To help fund this benefit, plan sponsors typically contribute a percentage of participants’ salaries to hypothetical accounts each year based on the benefit formula in the plan document. (There are many ways to design a benefit formula, which are beyond the scope of this article. An actuary or third-party administrator can help you determine the best approach for your business.)
Participant accounts are also credited with a guaranteed rate of interest every year regardless of the plan’s actual investment return. For example, you can use a fixed rate, such as 4%, or a variable rate based on the yield of the 30-year U.S. Treasury or another index.1
All plan assets are invested collectively in one pooled account, and sponsors bear the investment risk—just like with DB plans. If your plan’s investment earnings exceed the guaranteed interest rate, you can use the excess to reduce future employer contributions. If your plan’s investment earnings are less than the guaranteed rate, you’ll most likely have to contribute more over time to make up the shortfall.
Eligibility and nondiscrimination testing
Similar to 401(k) plans, all full-time employees who are at least age 21 and have completed a year of service are generally eligible to participate; you can, however, select less restrictive eligibility requirements. Additionally, you have to perform annual nondiscrimination tests to ensure your cash balance pension plan doesn’t unfairly favor highly compensated employees (HCEs) over non-highly compensated employees (NHCEs). Your test results may influence how much you can contribute to certain participants each year.
Participants are entitled to the vested portion of their accounts when they retire or leave your business. They can receive their benefit either as a lump sum or as an annuity, depending on the terms of your plan document. Similar to 401(k) plans, participants who receive a lump sum can roll the money into an IRA or another qualified plan, if permitted by their new employer.2
Now that we've covered the basic features, let’s look at why you might pair a cash balance plan with your 401(k) plan.
Why consider using a cash balance plan?
1 Accelerated retirement savings
While 401(k) plans are the cornerstone of retirement planning, HCEs may not be able to save as much as they want because of the annual contribution limits. For 2022, the most HCEs can save between salary deferrals and employer contributions is $61,000 ($67,500 if age 50 or older).
Cash balance plans have higher contribution limits and are one way to help these individuals supplement their savings. The closer participants are to retirement, the more they can receive because there’s less time to fund the promised benefit. For example, a 40-year-old participant could potentially receive a maximum contribution of $105,000 in 2022, while a 55-year-old participant could potentially receive a maximum contribution of $222,000. Of course, the actual amount will vary based on the participant’s compensation, the actuarial formula, and the terms of your plan document.
To illustrate how a cash balance plan can help accelerate retirement savings, let’s look at a hypothetical professional corporation with three HCEs and four NHCEs.3 The HCEs are able to save $42,250 under the 401(k) and profit-sharing plan. This figure jumps to $194,750 when paired with a cash balance pension plan—more than 4.5 times higher.
2 Increased tax savings
Employer contributions are generally tax deductible, so the larger annual contributions may lead to larger tax deductions, which can help to further reduce your business taxes.
3 Ease of understanding
A cash balance plan may be easier for participants to understand because the benefit is expressed as a hypothetical account balance. The more participants understand about a cash balance plan, the more likely they’ll view it as a valuable benefit, which can help with your recruitment and retention efforts.
4 More predictable cost than traditional DB plans
The way interest is credited to cash balance accounts can help make it easier to match your annual contributions with projected benefits. The rate typically only changes once a year, if at all, and doesn’t vary based on a participant’s age. The opposite is true for traditional DB plans, which can make plan funding more challenging.
What are the potential drawbacks?
While cash balance pension plans can offer some potential benefits, you also need to consider the potential drawbacks.
- Inflexible funding—Regardless of how your business performs, you’re required to contribute to the cash balance plan every year, so this option may not be right for you if your cash flow fluctuates significantly.
- Complex administration—Cash balance plans involve actuarial assumptions and multifaceted benefit formulas, making them more challenging to administer. If you decide to move forward, you’ll want to work with an actuary and third-party administrator who specialize in these plans.
- Higher plan costs—Because of the increased complexity, administrative expenses are generally higher for cash balance plans compared with 401(k) and profit-sharing plans. You’ll want to factor in this added cost when making your decision.
Take a fresh look at your retirement benefits
In a tight labor market, you may need to consider creative ways to stand out from the competition, such as offering retirement benefits that go beyond the traditional 401(k) plan. Adding a cash balance plan may help demonstrate your commitment to helping your employees maximize their retirement savings. This commitment could be one of the things that helps sway executives and other professionals to join your organization.
1 The performance of an index is not an exact representation of any particular investment. It is not possible to invest directly in an index. 2 There are advantages and disadvantages to all rollover options. Participants are encouraged to review their options to determine if staying in a retirement plan, rolling over to an IRA, or another option is best for them. 3 This is a hypothetical mathematical example, for illustrative purposes only, and may not be reflective of your situation. It does not take into consideration a number of variables that may need to be included in a specific plan’s contribution calculation. All numbers are based on maximum salary deferrals ($20,500) and a catch-up ($6,500) for HCEs, 6% salary deferrals for NHCEs, 3% safe harbor contributions for both HCEs and NHCEs, 2% profit-sharing contributions for HCEs and 4% for NHCEs, and 50% cash balance contributions for HCEs and 2.5% for NHCEs. Compensation is capped at $305,000, the 2022 IRS compensation limit. Your plan consultant can assist you with generating an actual allocation formula and performing nondiscrimination testing.
The content of this document is for general information only and is believed to be accurate and reliable as of the posting date, but may be subject to change. It is not intended to provide investment, tax, plan design, or legal advice (unless otherwise indicated). Please consult your own independent advisor as to any investment, tax, or legal statements made.
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