Suppose you are thinking about switching from a traditional pension plan to a cash balance plan for your company and employees. How much will this cost your company? What is a cash balance plan? How does it work? If you have never heard of a cash balance plan these may be questions that you have in this situation. Let's look at what a cash balance plan is so that if a situation like this ever comes up you know what to expect.
What is a Cash Balance Plan?
A cash balance plan is like a traditional pension with a twist. Both have an option for workers to have a lifetime annuity. Unlike a traditional pension, a cash balance plan creates an individual account for each employee. A cash balance plan sets a certain amount of money that will be available to employees once they retire. The plan is funded by the employer and compound interest. Once the employee retires, they can choose to take the money in one lump sum or have payments spread out over time. With a cash benefit plan, all investment risk is put on the employer, not the employees. A cash balance plan is considered a Defined Benefit plan.
How Benefits are Typically Calculated?
A typical simple formula to calculate the annual benefits an employee receives each year with a cash balance plan may be annual benefit = (wage x pay credit rate) + (account balance x interest credit rate). A quick overview of this formula is that the pay credit rate is the percentage of the employee’s wages that the employer provides in contributions. The account balance is how much the employee has already accrued. Finally, the interest credit rate is the percentage the employer has set for the expected growth of contributions.
Pros of Cash Balance Plans
The contribution limits are substantially higher than a traditional 401(k) plan
You can combine a cash balance plan with other plans like a 401(k) plan
Contributions are tax-deductible
Age-weighted contributions increase amounts for older employees and minimize amounts to younger employees
All the investment risk falls on the employer, not the employee
Employees do not have to make contributions toward their retirement
Cons of Cash Balance Plans
Cost more to maintain and operate than a traditional 401(k) plan
Interest rates are typically lower and less risky, but high return investments, are advised against
Plans are meant for the long term and are less beneficial for short term employment and investments
Employer contributions are mandatory
The plan is more complex than other pension or 401(k) plans
A cash balance plan is just one of many types of retirement plans available. Like most retirement plans, a cash balance plan has both advantages and disadvantages. Whether you are an employee or an employer, you must look at all advantages and disadvantages and decide if they are right for you and your company. For more information on cash balance plans check out our blog post: Cash Balance Plans: What are They and How do I Know if They are Right for Me?
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