What Is a Cash Balance Plan, and How Does It Work?

If you’ve never used a cash balance pension plan before, you’re probably wondering what it is, how it works and how it differs from other pension plans. Saving for retirement is an important part of life, so it behooves you to understand your pension options. More importantly, if you’re a business owner, you need to be familiar with the options you present to your employees.

Here’s an overview of cash balance plans. If you need further information on whether this is the right choice for your business, consult the experts at Fiduciary Advisors, Ltd.

What is a cash balance plan?

When it comes to pensions, there are two broad categories: defined benefit plans and defined contribution plans. Defined benefit plans give an employee a specific benefit when they reach retirement. Defined contribution plans stipulate the amount an employer will contribute to the employee’s retirement account. In other words, you know what you’ll get at retirement if you have a defined benefit plan, but defined contribution plans depend on gains, losses and contributions over time.

A cash balance plan is a defined benefit plan, but that defined benefit often sounds more like a defined contribution plan—the defined benefit is a stated account balance.

How do cash balance plans work?

Generally, cash balance plans will have a pay credit and an interest credit. The pay credit could be a set percentage of the employee’s yearly compensation, while the interest credit is either a fixed or variable rate linked to an index. While the employer is free to invest the plan however they’d like, the promised amount doesn’t change, even if there are gains and losses.

At retirement age, the employee can either withdraw a lump sum or take an annuity, based on the cash balance in their account. If they choose to take the lump sum, that can be rolled over into an IRA or another plan (assuming the new employer plan takes rollovers).

How are cash balance plans different from other pension plans?

The main difference between cash balance plans and other pension plans is that cash balance plans define the retirement benefit as a stated account balance, rather than a series of payments that begins at retirement.

For example, 401(k) accounts are defined contribution accounts, while a cash balance plan is a defined benefit account. 401(k) plans allow the employee to make their own investments—but they also bear the risk of any gains or losses. 401(k)s do not necessarily guarantee the option to take a lifetime annuity.

Another major difference between cash balance plans and 401(k) plans is that because cash balance plans are defined benefit plans, they’re insured by a federal agency. That means that even if the plan is terminated with insufficient funds, the insurance guarantees the pension benefits will be paid according to the law. 401(k)s do not offer the same protection.

For more information about cash balance plans versus other pension plans, get in touch with Fiduciary Advisors, Ltd. today to arrange a consultation.