I've heard of a 401(k), 403(b) and a Pension Plan. But what's this about a Cash Balance Plan? In this article, we'll dig into defining the Cash Balance Plan basics, the pros and cons of utilizing these plan types, and what situations may call for the use of these plans.
What's A Cash Balance Plan and How Does It Work?
The state of retirement plans seems to be in disarray as rank and file employees don't save enough of their own funds to fully fund a retirement. Key executives and high earners looking for maximum deductions and retirement savings are often unable to do so in Defined Contribution plans as their plan fails a ACP/ADP test and limits the amount a high earner can save. Pension plans (or Defined Benefit Plans) used to be the answer, but years of underfunding and unrealistic earnings expectations have left many of these plans underfunded.
A Cash Balance plan is a hybrid plan that combines the features of both defined contribution and defined benefit plans. As with defined benefit (DB) plans, participants do not make contributions. The Employer determines the benefits level and is on the hook for providing the specified level of benefits at retirement. Also like a DB plan, the assets are pooled and managed as a single fund. However, the plan displays benefits by illustrating hypothetical account balances for each participant much like a 401(k) or 403(b) plan. Why is the account value hypothetical? Its because the balances of each participant account must always be convertible to an underlying annuity payment stream.
A Cash Balance Plan has annual contribution credits that may be considered as constant or increase based on age and/or service. The contributions are credited with a rate of interest that is tied to an outside index such as a short-term US Treasury bill rate. On an annual basis, participants receive a statement that shows the account balance , or the lump sum value of the benefits of the plan. Like a 401(k) or 403(b) plan, cash balance benefits are payable as a lump sum rollover payout upon termination at any age. This gives the cash balance plan the advantage of having portable benefits, a feature that is not available to traditional defined benefit plans.
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In addition to the aforementioned portability of benefits from Employer to Employer, the following are some key benefits of adopting a Cash Balance Plan.
1. PBGC Insured - Since a Cash Balance plan is a type of Defined Benefit plan, plan benefits are insured by the Pension Benefit Guaranty Corporation (PBGC). Protections afforded by ERISA are in place as well.
2. Tax Implications - Contributions are fully tax-deductible to the organization and benefits accrue on a tax-deferred basis.
3. Cost Control Relative to Defined Benefit Plans - Benefit targets for Cash Balance Plans are based upon current salary instead of projected final average salary. Using projected final average salary leads to a higher overall cost to provide the benefit to employees.
The first real negative of these types of plans is the high setup and ongoing costs to maintain Cash Balance Plans. According to Kiplinger.com, "The plans can be more costly to employers than 401(k) plans, in part because an actuary must certify each year that the plan is properly funded. Typical costs include $2,000 to $5,000 in setup fees, $2,000 to $10,000 in annual administration fees, and investment-management fees ranging from 0.25% to 1% of assets." Due to the level of costs, decision makers for their organization must weigh the level of savings for the participants to the costs of the plan.
2. The Employer Bears the Actuarial Risk
Another risk is if the experts of your plan, actuaries, recordkeepers or investment managers, fail to live up to the expectations of the plan. The Employer ultimately bears all the responsibility to provide the promised benefit if a key piece of the plan doesn't work . Like a Defined Benefit Plan, an underfunded plan requires steady and consistent payments by the Employer regardless of economic times or financial health of the Employer. Defined Benefit and Cash Balance required contributions can exacerbate the weakened financial health of the sponsoring organization. This is a key item to consider when establishing a Cash Balance plan and what level of funding can be sustained on a go-forward basis.
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What is the typical situation that exemplifies the advantages of using a cash balance plan?
Business owners or high income earners may look at their retirement nest eggs and find them inadequate to meet their retirement income goals and feel their current level of savings will not adequately allow for them to save for that goal. Enter Cash Balance Plans. From Kiplingers:
Many older business owners are turning to these plans to turbocharge their retirement savings. Cash-balance plans have generous contribution limits that increase with age. People 60 and older can sock away well over $200,000 annually in pretax contributions. In 401(k)s, total employer and employee contributions for those 50 and older are limited to $57,500.
These plans, which held $858 billion in 2012, account for 25% of all defined-benefit plans, up from about 3% in 2001, according to retirement-plan consulting firm Kravitz Inc. The number of cash-balance plans grew 22% in 2012, the latest data available, Kravitz says. Baby boomers who are sole proprietors or partners in medical, legal and other professional groups account for much of the growth, plan consultants say.Dr. Robert Master, a retired cardiologist in Palo Alto, Cal., helped set up a cash-balance plan for his medical group in 2000, after a review of his fellow doctors' 401(k) accounts left him "quite concerned," he says. Given the area's high housing costs, some doctors weren't maxing out their 401(k)s, and others got clobbered in the dot-com stock crash, he says. Even for doctors on the brink of retirement, "the balances to me seemed inadequate," says Master, 63.Today, doctors in the group's cash-balance plan "give me high-fives," Master says. If you take full advantage of both the cash-balance plan and the 401(k), he adds, "you'll have enough money to retire without taking excessive risks."
Whether they are running one-man operations or have a handful of employees, older business owners making more than $250,000 a year may be ideal candidates to establish a cash-balance plan. Plan contributions reduce adjusted gross income, resulting in potentially significant tax savings for people "waking up to this plethora of new taxes" that kicked in last year, says Kravitz president Daniel Kravitz. Those include a new levy on net investment income and higher payroll tax.
We hope this blog post provides you a solid framework you can follow if you're just getting started in evaluating whether a Cash Balance Plan is right for your organization. As a Fiduciary, understanding your duties to your organization's retirement plans is essential. If you have more questions about your fiduciary duties, please feel free to download our free Fiduciary Responsibility Guide eBook below.
Other blogs to consider:
How much does a 401(k) Plan cost?
Strengthen your governance with a 403(b) checklist
IRS 403(b) Audits: Top areas of focus