Cash Balance Defined Benefit Pension Plans
Cash Balance Plan - What Is It?
For retirement savings, there are several types of plans. The two main ones are defined benefit and defined contribution plans. Basically, defined benefit plans tell you an amount you are guaranteed to receive at retirement. In defined contribution plans, the employer will state the percentage of compensation or amount it will contribute. That money is invested, and the resulting benefit at retirement is based on the contributions made, along with gains and losses.
A type of defined benefit plan is the cash balance plan. This type of defined benefit plan promises a benefit in terms more similar to a defined contribution plan, but guaranteeing a total balance at retirement.
Ins and Outs of Cash Balance Plans?
Predominantly, payments to a participant's account are made in what’s called a plan credit. This plan credit represents a stated percentage of compensation given by the employer to the participant. The participant also receives an "interest credit” which is like a guaranteed rate of return.
Each year the employer deposits a contribution based on the promised plan credit and promised interest credit. The amount that the employer has to deposit is calculated by an actuary and based on the promised benefit and the total actual balance in the investment account at year end. The money is invested, and unlike a defined contribution plan, the employer bears the investment risk. In the end, there must be enough money in the account to pay out the promised benefits.
In most defined benefit plans, including cash balance plans, assets are protected and insured to a certain extent the Pension Benefit Guaranty Corporation.
Traditional Defined Benefits Plans vs. Cash Balance
The biggest difference between a traditional defined benefit plan and a cash balance defined benefit plan is the way in which the benefit at retirement is defined. For instance, the traditional defined benefit plan tells the participant what their annual benefit will be for life beginning at retirement. The cash balance plan defines their benefit as a contribution each year based on their compensation plus a guaranteed interest credit.
Cash Balance Plans vs. 401(k) Plans
As mentioned above, cash balance plans are a type of defined benefit plan. 401(k) plans are a type of defined contribution plan. Note the use of benefit vs. contribution. It’s the difference between the end result and amounts going in over the time of the employee’s participation. Below are some distinct differences between typical cash balance plans and 401(k) plans:
- Employee Participation: Cash balance plans typically do not require the participant to put in his/her own money to get a benefit. The employer contribution amount in a 401(k) plan can be dependent upon the amount being contributed by the employee if the employer contribution is an employer match.
- Investment Direction: As mentioned above, the employer bears the investment risk in a cash balance plan. However, 401(k) plans typically put the investment direction in the hands of the participant, thereby placing the investment risk with the participant as well. The balance available at retirement will be based on the amount contributed over the years plus investment gains or losses. There is not a guaranteed account balance at retirement.
- Installment Payments – Cash balance plans are required to offer installment payments, or annuities, as forms of payout of benefits. Annuities are not required by, or typically offered by, 401(k) plans. However both cash balance plans and 401(k) plans allow for lump sum payments to be rolled over into an IRA or other retirement investment vehicle where installment payments could be set up.
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