Cash Balance Plans
A Bright Spot in a Dreary Defined Benefit Landscape
Cash balance retirement plans, an alternative to the traditional defined benefit plan or 401(k), have experienced a surge in popularity over the last five years. In 2008, such plans made up 10% of all defined benefit plans, while today they have increased to almost 20%.
Cash Balance Plan Basics
Cash balance plans work in the following way: they are defined benefit plans with some characteristics of a defined contribution plan. Plan participants have theoretical “accounts” that are credited each year with an amount equal to a percentage of their pay, in addition to an “interest credit” which could either be a pre-set fixed or variable rate that usually follows a market index.
These “accounts” are not the same as found in a defined contribution plan in that the plan’s investment performance doesn’t directly increase or decrease their value. Rather, the employer assumes the risk by setting the interest rates. Therefore, employers are likely to use conservative formulas to derive the interest rates.
When participants retire or leave employment, they have the option of annuitizing their “account” balance, taking a taxable distribution, or rolling it over to an IRA.
Why the Growth
The popularity of these cash balance plans has especially grown with employers with less than 50 employees and less than $5 million in plan assets for the following reasons. Since the annual contribution limits are based on actuarial projections of how much money needs to be contributed to the fund, it allows for greater accumulated retirement savings as compared to a defined contribution plan. For example, business owners can make higher contributions to a cash balance plan than to a 401(k) plan the later in life they begin funding. Furthermore, most dollars in cash balance plans stay with the owner-employees due to compensation differentials and employee turnover frequency. However, the plans must comply with IRS nondiscrimination rules and participants must be 100% vested upon completing three years of service.
Is it Time?
Determining whether cash balance plans are the right retirement vehicle for you and your employees depends on various factors, including the ability to fund the plan annually (required, with few exceptions), employee demographics and an employer’s objectives.
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