CASH BALANCE PLANS
Cash Balance Plans resemble Defined Benefit Plans because the employer bears all the cost. However, instead of funding for a future defined benefit, they maintain individual accounts like a Defined Contribution Plans. These plans were designed to reduce the annual cost to the employer for providing a retirement plan.
How They Operate
An employee has an accumulation much like a Defined Contribution Plan. The plan will define what is known as a “Pay Credit”. (For example: 5% of compensation per year) Also defined in the plan is an interest credit that is applied to the participants. (For example: 4% per year of the account balance) If the investment vehicles in which the funds are invested lose money, the participant still earns the interest and the employer eats the loss.
As time goes on and a participant reaches their Normal retirement Age and decides to retire, the employer will communicate to the participant the amount of a monthly annuity that can be purchased by the account balance.
Let me explain this a little further. In a Defined Benefit Plan, when a participant retires, say at age 65, there is an annuity rate that, when multiplied by the monthly benefit equals the lump sum amount it would take to purchase that annuity. Whether that is paid to an outside company or to an insurance company, that company agrees to guarantee that monthly benefit for the remainder of the participant’s life.
For example: If Jack Hammer has a Normal retirement Benefit of $600 per month and the annuity rate is 100 for age 65 (which means the cost is $100 per $1.00 of benefit) the $600 is multiplied by 100, which is $60,000. So, $60,000 is paid to an insurance company (most often it is an insurance company) and the insurance company pays out $600 to Jack and guarantees it for life.
Like a Defined Benefit Plan, Jack’s wife would have to sign an agreement if Jack elects to take the full $600 per month as a Straight Life Annuity as opposed to taking it as a 50% or 100% Joint Life Annuity.
In the case of a Cash Balance Plan, the value of the participant’s account is used to purchase a monthly benefit by dividing the fund by the annuity rate. Using the same example, Jack has accumulated $60,000 in his account as of the time he decides to retire. The employer divides the annuity rate of 100 into the account balance and determines that Jack can purchase a $600 monthly annuity.
Of course, jack also has the option of taking the $60,000 and rolling it over to an IRA to defer paying taxes or take the money and report it as ordinary income on his Federal Tax Return for the he takes the lump sum. He can also roll over some of the money and take the rest.
An employer can combine a 401(k) Plan with a Cash Balance Plan, allowing plan participants to generate a larger amount of retirement savings. Cash Balance are not going to provide what you might need at retirement to feel financially ready to retire. Therefore, it is always to your advantage to enroll in a 401(k) plan if the employee offers it in combination with the Cash Balance Plan.
Defined Benefit Plans have a few different definitions of a participant’s Average Monthly Compensation. For Example:
- Highest five consecutive years divided by 60 months.
- Highest five out of the final ten years of employment divided by 60 months.
- Highest ten consecutive years of employment divided by 60 months.
So, while a your monthly benefit under a Defined Benefit Plan is based on your highest pay levels, a Cash Balance Plan uses every year of your compensation while employed. As a result, the monthly benefit determined by a Cash Balance Plan is going to be less than the one determined by a Defined Benefit Plan.
The employer funds the entire amount of your account including a defined fixed interest on the account. If there is a market crash or a recession and the portfolio of funds into which the employer has invested the retirement plan funds takes a major hit, your account is not affected at all.
Termination of Employment
If you resign from your job prior to your earliest retirement age, and your next employer also offers a Cash Balance Plan, you can roll your account over to the new plan in order to defer paying taxes on it. Or you can roll it over to an IRA for the same reason. Rollovers have to be completed within 60 days after the termination of your employment, regardless of the type of plan in which you were enrolled.