Cash Balance Plans: How They Differ from Traditional Pensions

Cash balance plans are a type of defined benefit retirement plan that combines elements of traditional pensions and defined contribution plans like 401(k)s. Unlike traditional pensions, which promise a fixed monthly benefit at retirement, cash balance plans define benefits in terms of a stated account balance. This makes them easier to understand and more flexible for employees who prefer to see their benefits in a more tangible form.

How Cash Balance Plans Work

In a cash balance plan, each participant has a hypothetical account that grows annually in two ways:

• Employer Contributions: A percentage of the participant's salary, as specified by the plan, is credited to their account each year.
• Interest Credits: The plan guarantees a certain rate of return on the account balance, which is not directly tied to investment performance. This ensures predictable growth.

Unlike traditional pensions, the account balance is portable, meaning employees can take it with them if they leave the company, either as a lump sum or rolled into another retirement account.

Key Differences from Traditional Pensions

• Defined Benefit Formula: Traditional pensions provide a fixed monthly income in retirement based on salary and years of service. Cash balance plans, however, define benefits based on contributions and interest credits.
• Portability: Traditional pensions are often not portable, meaning they provide full benefits only to long-term employees. Cash balance plans offer a portable balance that can be rolled over to an IRA or another retirement plan.
• Predictable Growth: While traditional pensions are affected by market conditions and employer contributions, cash balance plans offer predictable growth through guaranteed interest credits.

Advantages of Cash Balance Plans

• Employee Understanding: The account balance format is easier for employees to understand compared to the complex formula of traditional pensions.
• Portability: Employees who change jobs frequently can benefit from the portability of cash balance plans, unlike traditional pensions.
• Employer Flexibility: Employers can make contributions that vary each year, allowing for more flexibility in funding the plan.

Disadvantages of Cash Balance Plans

• Lower Benefit for Long-Term Employees: Employees who stay with a company for many years may receive a lower benefit compared to traditional pensions.
• Complexity in Setup: Cash balance plans can be complex to set up and administer, requiring careful planning and compliance with regulations.

Who Benefits from Cash Balance Plans?

Cash balance plans are ideal for businesses looking to provide attractive retirement benefits while maintaining flexibility. They suit both employers who want predictable costs and employees who value portability and transparency in their retirement benefits.

Conclusion

Cash balance plans offer a unique blend of the security of traditional pensions and the flexibility of defined contribution plans. Understanding the nuances of these plans can help employees make informed decisions about their retirement options and help employers design benefits that align with their workforce's needs.

For more information on cash balance plans, consult with a financial advisor to see how these plans might fit into your retirement strategy.