Cash Balance Pension Plan: Overview, Pros and Cons
What Is a Cash Balance Pension Plan?
A defined-benefit pension plan with the option of a lifetime annuity is known as a cash balance pension plan. For a cash balance plan, the employer credits a participant’s account with a predetermined percentage of their annual salary plus interest. Defined-benefit requirements serve as the foundation for the funding restrictions, specifications, and investment risk. The employer owns all of the portfolio’s gains and losses, and changes to the portfolio have no bearing on the participant’s final benefits upon retirement or termination.
Understanding Cash Balance Pension Plans
There aren’t any single-employer cash balance plans. A cash balance plan (CBP) is kept on an individual account basis, similar to a defined contribution plan. The characteristics of cash balance pension plans are similar to those of 401(k) plans. Professional management of investments and beneficiaries with a guaranteed benefit at retirement exist. The benefits, however, are expressed in terms of a 401(k)-type account balance instead of the terms of an individual monthly income stream.1
For example, a company employee who has a cash balance pension plan can get a 5% salary promise and 5% interest credit. Suppose the employee is paid $100,000 a year. Then he would be given a pay credit of $5,000 with 5% interest credited on the account balance. As the years worked for the company increase, the account balance increases to cover the balance promised by the firm. The worker may have a lump sum or an annuity payment each month at retirement.
Cash Balance Pension Plan vs. Traditional Pension Plan
The most significant difference between a cash balance pension and a traditional pension plan is that the conventional plan generally uses a few years of your highest compensation to determine your monthly benefit. A cash benefit pension plan uses the total years you’ve been with the company.
Cash Balance Pension Plan vs. 401(k)
The most significant difference between a cash balance pension and a 401(k) is that the employer bears the investment risk in a CBP. The employer is responsible for ensuring the employee receives the amount promised, so no matter what happens, it must ensure the employee gets that amount. With a 401(k), the employee bears the investment risk because they choose how the plan invests. The employer has no investment risk. Additionally, the retirement benefit amount depends on the account’s balance; it isn’t guaranteed, as with a cash balance pension.
Pros and Cons of a Cash Balance Pension Plan
While this type of plan has several benefits, there are some disadvantages to consider.
Pros:
- Lump sum payouts
- Rollover options
- Tax-deferred
- Custom contribution limit
Cons:
- Taxable distributions
- High cost to maintain
- No employee contributions
Pros Explained
- Lump Sum Payouts: A cash balance pension payout can be a lump sum. This can benefit someone who wants to place the capital in a traditional preservation instrument like government bonds or money market funds.
- Rollover Options: You can roll a lump sum payout into an IRA or another pension plan.
- Tax-Deferred: Contributions are tax-deferred. This means you don’t pay taxes on the funds until you withdraw or take a lump sum payment. If you’re in a higher tax bracket when you’re contributing than when you make withdrawals, you pay less in income tax.
- Custom Contribution Limit: The annual limit for a cash balance pension depends on how much you make, how old you are, and the target date and balance of the fund to IRAs and 401(k)s have annual limits set by the IRS.
Cons Explained
Taxable Distributions: Although the tax-deferred status is a plus, you have to pay taxes when you take money out.
High Maintenance Costs: It is more expensive to maintain the plans because an actuary must be used to keep it running well enough to satisfy the balance requirements. That means employers will be paying more for it.3
No Contributions by Employees: The employer contributes alone, so you cannot contribute money from your salary.
Special Considerations
When paired with a 401(k) plan, cash balance employer contributions to regular employees typically add up to approximately 6.9% of compensation versus the 4.6% contributions that are standard in 401(k) plans alone.56
Members earn an annual credit of interest. The credit could be fixed at a rate like 5% or variable at a rate like the 30-year treasury rate. Participants may receive an annuity on their account balance at retirement or a lump sum that can be rolled over to an IRA or an employer’s plan.
Is a Cash Balance Pension Plan Better Than a 401(k)?
Both can be excellent retirement plans. Which one is better depends on your preferences, goals, how long you might be with an employer and current income.
What Can I Do With a Cash Balance Plan?
You can choose to make withdrawals or a lump sum payout. If you choose a lump sum, you can roll it into an IRA or other retirement plan.
What Happens to My Cash Balance Pension If I Quit?
Your cash balance pension is portable, so you can take the vested portion with you when you part ways with the company and roll it into another retirement account.
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