Many employers offer their workers a retirement plan to help them save for their later years. These retirement plans can come in many different forms, including 401(k) plans and pension plans. One of the plans available to companies is the cash balance pension plans, which is an employer-sponsored plan that guarantees workers a certain account balance at retirement, based on their years of service with the company and their salary during employment.
Cash balance pension plans have some unique features that make them stand out from other pension plans and from more common employer-sponsored plans like 401(k) plans. In this article, you’ll learn how cash balance pension plans work, how they differ from other plans, and their key benefits to employees.
How Do Cash Balance Pension Plans Work?
Before we talk about exactly how a cash balance pension plan works, we should briefly talk about the different types of pension plans. There are generally two types: a defined benefit plan and a defined contribution plan.
In a defined benefit plan, the employer guarantees the employee a certain monthly income during retirement based on their years of service and their salary during employment. A defined contribution plan, on the other hand, is when an employer guarantees the employee a certain percentage-based contribution to their pension plan. The actual amount they’ll have during retirement is based on investment returns, and there are no guarantees.
A cash balance pension plan is a type of defined benefit plan, but also incorporates some features of a defined contribution plan.
When an employer offers a cash balance pension plan, they contribute to an account on behalf of each employee. An employee is guaranteed those contributions — known as the pay credit — plus a certain interest credit at either a fixed or variable rate. The actual investment returns for the account are irrelevant since this is a type of defined benefit plan.
For example, suppose a company had a cash balance pension plan where an employee was promised a pay credit of 5% of their salary. For an employee earning $100,000 per year, their pay credit would be $5,000 per year. Let’s say an employee also earns an interest credit at a fixed rate of 5%. Each year, their account grows based on the following calculation:
Annual Benefit = (Wage x Pay Credit) + (Balance X Interest Credit)
The employee will be guaranteed a certain account balance by the time they reach retirement. The account balance they’re promised will be based on their years of service with the company, their salary during their working years, and possibly the market interest rates (if they have a variable-rate interest credit). Then, they’ll either receive a lump sum distribution for their entire account balance or can be paid a monthly annuity based on their balance.
Cash Balance vs. Traditional Pension Plans
A traditional defined benefit pension plan guarantees an employee a certain monthly income during retirement based on their years of service and their salary during employment. During an employee’s working years, the company makes contributions to their pension account.
Companies invest the money in their employees’ pension accounts, but benefits aren’t dependent on those investments. Even if the investments provide lower-than-expected returns, the company must still provide employees with their promised benefit.
In many ways, cash balance pension plans and traditional defined-benefit plans are similar. Both guarantee the employee a certain retirement benefit, and in neither case is the employee’s benefit impacted by investment performance.
The key difference between the two types of plans is what exactly the employer promises. In the case of a traditional defined benefit plan, the employer promises a certain monthly benefit. But in the case of a cash balance plan, the employer promises a total account balance that can be paid out either in a lump sum or in monthly payments.
Cash Balance vs. 401(k) Plans
A 401(k) plan is another popular type of employer-sponsored retirement account. A 401(k) is a type of defined contribution plan, which means that an employer promises each employee a certain contribution during their working years.
In most cases, an employer’s contributions to an employee’s 401(k) plan are usually set as a percentage of their salary and are dependent on the employee to contribute as well. For example, a company might promise to match an employee’s contributions up to 3% of their salary. But if the employee doesn’t contribute anything, the company often doesn’t either. This feature is different from a pension plan, where the company contributes regardless of the employee’s contributions.
Once money is contributed to a 401(k) plan, the employee is responsible for choosing how it’s invested — this is different from a pension plan where the company usually chooses the investments. The amount that an employee has set aside for retirement is based on their market returns. There are no guarantees.
Perhaps the largest difference between a cash balance pension plan and a 401(k) plan is who bears the investment risk. In a cash balance pension plan, it’s the company that bears the risk. In the case of a 401(k) plan, it’s the employee.
How Are Cash Balance Pension Plans Regulated?
Like other employer-sponsored retirement plans, cash balance pension plans are regulated by the Employee Retirement Income Security Act (ERISA). They are also regulated by the Age Discrimination in Employment Act (IDEA) and the Internal Revenue Code (IRC).
The laws that govern cash balance pension plans set standards for participation, vesting, benefit accrual, funding, and fiduciary responsibility. Each pension plan is legally and ethically obligated to act in the best interests of its participants. Additionally, plans are required to provide both workers and retirees with basic information about the plan.
Benefits of a Cash Balance Pension Plan
There are many different types of retirement plans, each of which comes with its own advantages. Let’s talk about some of the key benefits of a cash balance pension plan.
Guaranteed Benefits
A cash balance pension plan is a type of defined benefit plan, which means benefits during retirement are guaranteed. The amount of benefits an employee will receive have nothing to do with the fund’s investment returns, since the company bears all of the risk.
Tax Advantages
Cash balance pension plans are a type of tax-advantaged retirement plan, which means that contributions are tax-deductible. The company can claim tax deductions for any contributions they make, and the accounts are tax-deferred for the employee until they begin taking distributions during retirement.
Contribution Limits
The contribution limits of cash balance pension plans are considerably larger than those of other types of retirement plans. Contribution limits are based on age and can exceed $200,000 for many older employees.
Flexible Distributions
One of the key benefits of cash balance pension plans for participants is the flexible distribution options. An employee has the ability to choose between a lump sum distribution or a monthly annuity. In the case of the lump sum, the employee can roll the balance over into an individual retirement account (IRA) or another retirement plan to continue investing in. If they choose the monthly annuity, they’ll receive monthly payments from the plan.
Federal Guarantee
The funds in pension plans — including cash balance pension plans — are guaranteed by the Pension Benefit Guaranty Corporation (PBGC). The purpose of this plan is to ensure that even if the plan is terminated or the company goes out of business, plan participants will continue to receive their promised benefits. This guarantee only applies to defined benefit plans like cash balance plans and doesn’t apply to defined contribution plans like 401(k) plans.
The Bottom Line
No matter what type of plan you have available to you, it’s important to prioritize retirement savings. If your company offers a cash balance pension plan, then you’d probably be well-served to take advantage of it. If no such plan is available, then a 401(k) or even an IRA (or both) can still help you prepare for a financially comfortable retirement.
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Personal Capital compensates Erin Gobler (“Author”) for providing the content contained in this blog post. Compensation not to exceed $500. Author is not a client of Personal Capital Advisors Corporation. The content contained in this blog post is intended for general informational purposes only and is not meant to constitute legal, tax, accounting or investment advice. You should consult a qualified legal or tax professional regarding your specific situation. Keep in mind that investing involves risk. The value of your investment will fluctuate over time and you may gain or lose money.