What is a cash balance plan?

There are two general types of pension plans — defined benefit plans and defined contribution plans. In general, defined benefit plans provide a specific benefit at retirement for each eligible employee, while defined contribution plans specify the amount of contributions to be made by the employer toward an employee's retirement account. In a defined contribution plan, the actual amount of retirement benefits provided to an employee depends on the amount of the contributions as well as the gains or losses of the account.

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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.

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How do cash balance plans work?

In a typical cash balance plan, a participant's account is credited each year with a "pay credit" (such as 5 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.

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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.  The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation.

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How do Cash Balance Plans differ from traditional pension plans?

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.

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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. There are four major differences between typical cash balance plans and 401(k) plans:

1. 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.

2. Investment Risks - 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.

3. Life 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.

4. Federal Guarantee - 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.

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Is there a federal pension law that governs these plans?

Yes. Federal law, including the Employee Retirement Income Security Act (ERISA), the Age Discrimination in Employment Act (ADEA), and the Internal Revenue Code (IRC), provides certain protections for the employee benefits of participants in private sector pension plans.

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If your employer offers a pension plan, the law sets standards for fiduciary responsibility, participation, vesting (the minimum time a participant must generally be employed by the employer to earn a legal right to benefits), benefit accrual and funding. The law also requires plans to give basic information to workers and retirees. The IRC establishes additional tax qualification requirements, including rules aimed at ensuring that proportionate benefits are provided to a sufficiently broad-based employee population.

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The Department of Labor, the Equal Employment Opportunity Commission (EEOC), and the IRS/Department of the Treasury have responsibilities in overseeing and enforcing the provisions of the law. Generally, the Department of Labor focuses on the fiduciary responsibilities, employee rights, and reporting and disclosure requirements under the law, while the EEOC concentrates on the portions of the law relating to age discriminatory employment practices. The IRS/Department of the Treasury generally focuses on the standards set by the law for plans to qualify for tax preferences.

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Disadvantages to a Cash Balance Plan...

Disadvantages to a business owner include the cost and complexity of plan administration. A certified actuarial must value the plan each year and Form 5500 is required to filed with the IRS on a yearly basis to show that the plan is fully funded.  These costs can be several thousand dollars each year, in addition to the actual contribution cost of the plan. For an employee, the disadvantage lies in the lack of control of investment choices or contributions. The employee may not contribute to the plan; that responsibility lies with the employer.

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Allow us to help determine if a cash balance plan is a viable solution for your business by downloading, and completing the employee census, and returning it to 401k@SamraWealthManagement.com

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What are the Risks Associated with a Cash Balance Plan...

While the benefits of a Cash Balance Plan can seem attractive to business owners, there are also significant risks that should be considered: If investment returns do not keep up with funding requirements, additional, and often unanticipated, contributions will have to be made.  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.

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What is a 401(k) Profit Sharing Plan...

A profit-sharing plan accepts discretionary employer contributions. There is no set amount that the law requires you to contribute. If you can afford to make some amount of contributions to the plan for a particular year, you can do so. Other years, you do not need to make contributions. Also, your business does not need profits to make contributions to a profit-sharing plan.

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If you do make contributions, you will need to have a set formula for determining how the contributions are divided. This money goes into a separate account for each employee.

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One common method for determining each participant's allocation in a profit-sharing plan is the "comp-to-comp" method. Under this method, the employer calculates the sum of all of its employees' compensation (the total "comp"). 

To determine each employee's allocation of the employer's contribution, you divide the employee's compensation (employee "comp") by the total comp. You then multiply each employee's fraction by the amount of the employer contribution. Using this method will get you each employee's share of the employer contribution.

If you establish a profit-sharing plan, you:

• Can have other retirement plans

• Can be a business of any size

• Need to annually file a Form 5500

 

As with 401(k) plans, you can make a profit-sharing plan as simple or as complex as you want.

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Pros and cons

• Flexibile contributions – contributions are strictly discretionary

• Good plan if cash flow is an issue

• Administrative costs may be higher than under more basic arrangements (SEP or SIMPLE IRA plans)

• Need to test that benefits do not discriminate in favor of the highly compensated employees.

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