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Cash Balance 101
What is a Cash Balance Pension Plan?
A Cash Balance plan is a type of defined benefit plan that operates in ways similar to a profit sharing plan. That is, this type of plan clearly shows the amount of contribution being credited to each participant and the value of each participant’s account.
How does a Cash Balance plan work?
Each participant has an individual account which resembles the accounts in a 401(k)/ profit sharing plan. All participant accounts are maintained by the plan actuary who generates an annual “Participant Statement”.
The accounts grows annually in two ways. First, a company contribution that is determined by a formula specified in the plan document. It can be a percentage of pay or a flat dollar amount.
Second, the account grows with an annual interest credit. The rate of return is guaranteed and is not dependent on the plan’s investment performance. The rate of return changes each year and is usually equal to the yield on the 30 year Treasury bond, which in recent years has been around 5%.
When participants terminate employment, they will be eligible to receive the vested portion of their account balance. A Participant’s vested percentage is determined by the plan’s vesting schedule.
What is the history of Cash Balance plans?
Cash Balance plans were first introduced in 1985 by BankAmerica Corporation. It was a new plan created to address changes in the American work force. A 2001 change in tax law improved the funding restrictions on defined benefit plans. The amounts individuals could contribute to these plans increased by as much as 60%. Since then Cash Balance plans have become much more attractive to successful businesses and professional firms. This graph illustrates the 2005 maximum contribution amounts for Cash Balance plans, based on age.
Plan investments and contributions
Individual participants are not able to direct the investment of their account - plan assets are pooled and invested by the trustee or investment manager. The accounts of the participants will be credited with interest at a rate guaranteed by the plan (often 30-Year Treasury rate) regardless of the actual investment return.
If the plan’s investment earnings exceed the 30-Year Treasury rate, the excess will be used to reduce future employer contributions. This will not affect the amount that is credited to the participants’ accounts. That is, the account will increase according to the plan’s schedule and the increase will be funded partly from a reduced employer contribution and partly from the excess investment earnings.
Conversely if the plan’s investment earnings are less than the 30-Year Treasury rate, then future employer contributions will be increased. This make-up is typically spread out over five years.
The assets can be invested utilizing any asset allocation method, although most groups use a conservative allocation model. On a participant level, many view their Cash Balance assets as the conservative, or “bond”, portion of their retirement funds. If they desire more aggressive investment returns they do so with the assets in other retirement plans or other accounts.
Can Cash Balance be offered in addition to 401(k) Profit Sharing plans or other plans?
Yes, the employer can offer qualified retirement plans in combination to produce an additive effect. Just as a 401(k) can be added to a Profit Sharing plan, a Cash Balance plan can be added to them as well.
Distribution options upon retirement or if leaving the employer
In general, the vested accounts in a Cash Balance plan can be paid as a lump-sum distribution or rolled over to an IRA upon the participant’s retirement or termination of service.
Can Cash Balance contributions change? Increase or decrease?
The short answer is yes, but with restrictions. First of all Cash Balance plans are not profit sharing plan under which contributions can vary year to year, depending on profitability. Having said that, Cash Balance plans can be amended periodically to permit different contribution levels, but there are some restrictions on this. Specifically any reductions must made before an employee works 1,000 hours during a plan year. For most participants, 1,000 hours will be reached in June
for a calendar plan year.
Therefore, if an employer’s profit is not expected to be able to support the Cash Balance plan contribution, the plan needs to be amended before participants complete 1,000 hours of service. Many of our clients make budget projections by mid-April to try to make certain they can afford the contribution.
In addition to amending a plan, it can also be frozen or terminated.
Must everyone participate equally in the Cash Balance plan?
No. Employers can designate different contribution amounts for participants. The amount can be a percentage of pay or a flat dollar amount.
Tax deductions and allocation of plan contributions for partnerships
Tax deductions for contributions made on behalf of non-partner employees are taken on the partnership tax return. Tax deductions for contributions made on behalf of partners are taken on their personal or corporate tax returns. However, to be sure that the amount deducted for tax purposes by a partner as shown on Schedule K-1 is the same as the amount contributed on behalf of the partner, the partnership’s agreement must permit this method of allocation. Most partnerships that adopt Cash Balance plans do not want the partners’ contributions allocated like most other firm expenses, in proportion to ownership.
Either the partnership agreement or internal policy should assure that each partner is allocated an appropriate share of the plan’s cost.
Is the plan subject to IRS discrimination testing?
Yes, like any other qualified plan it is subject to discrimination testing. A company or professional firm can anticipate employer contributions in the range of 5% to 7.5% for staff if the owners or partners receive the maximum Cash Balance contribution. The exact percentage required for staff employees depends on the results of discrimination testing.
How does design and administrative costs compare with 401(k) profit sharing plans?
It is more expensive to set-up and administer a Cash Balance plan than a 401(k) profit sharing plan because the plan is maintained annually by an actuary. Expenses will vary by size of plan and annual testing requirements.
Who are good candidates for Cash Balance?
After designing hundreds of Cash Balance plans, we have determined that good candidates have one or all of the following characteristics:
- Owners or partners who desire to contribute more than $49,000/year.
- Companies which have demonstrated consistent profit patterns.
- Companies already contributing 3-4% to employees, or at least willing to do so.
- Owners or partners over 40 years of age who desire to “catch-up” on their pension
savings.
Top 10 advantages of Cash Balance Pension Plans
- Much higher contribution amounts for pre-tax dollars
- Acceleration of retirement savings
- Combine nicely with 401(k) and/or Profit Sharing for even higher contribution amounts
- Easy for participants to understand since they resemble the more common 401(k) and Profit Sharing plans
- Growth of retirement benefit is not dependent on investment earnings
- Portable in the event of job-change or termination
- Assets protected from creditors in the event of bankruptcy
- Provide competitive advantage in recruiting key executives
- More flexible than traditional Defined Benefit plans
- Many options upon retirement: lump sum payout or rollover to IRA
This is published by Louis Kravitz & Associates, Inc. as an information source for our clients and friends. Information is general in nature and is not a substitute for legal advice in a particular case. All rights reserved.
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