CASH BALANCE PENSION PLAN
A cash balance plan is a defined benefit plan that
defines the benefit in terms that are more characteristic of a defined
contribution plan. In other words, a cash balance plan defines the promised
benefit in terms of a stated account balance.
How do cash balance plans work?
In a typical cash balance plan, a participant’s account is
credited each year with a pay credit (such as 5 percent of compensation from his
or her employer) and an interest credit (either a fixed rate or a variable rate
that is linked to an index such as the one-year Treasury bill rate). Increases
and decreases in the value of the plan’s investments do not directly affect the
benefit amounts promised to participants. Thus, the investment risks and rewards
on plan assets are borne solely by the employer.
When a participant becomes entitled to receive benefits under a cash balance
plan, the
benefits that are received are defined in terms of an account balance. For
example, assume
that a participant has an account balance of $100,000 when he or she reaches age
65. If the
participant decides to retire at that time, he or she would have the right to an
annuity. Such
an annuity might be approximately $10,000 per year for life. In many cash
balance plans,
however, the participant could instead choose (with consent from his or her
spouse) to take
a lump sum benefit equal to the $100,000 account balance.
In addition to generally permitting participants to take their benefits as lump
sum
benefits at retirement, cash balance plans often permit vested participants to
choose (with
consent from their spouses) to receive their accrued benefits in lump sums if
they terminate
employment prior to retirement age. Traditional defined benefit pension plans do
not offer
this feature as frequently.
If a participant receives a lump sum distribution, that distribution generally
can be rolled
over into an Individual Retirement Account (IRA) or to another employer’s plan
if that plan
accepts rollovers.
The benefits in most cash balance plans, as in most traditional defined benefit
plans, are
protected, within certain limitations, by federal insurance provided through the
Pension
Benefit Guaranty Corporation.
How do cash balance plans differ from traditional pension plans?
While both traditional defined benefit plans and cash balance plans are required
to offer
payment of an employee’s benefit in the form of a series of payments for life,
traditional
defined benefit plans define an employee’s benefit as a series of monthly
payments for life tobegin at retirement, but cash balance plans define the benefit in terms of a
stated account
balance. These accounts are often referred to as hypothetical accounts because
they do not
reflect actual contributions to an account or actual gains and losses allocable
to the account.
How do cash balance plans differ from 401(k) plans?
Cash balance plans are defined benefit plans. In contrast, 401(k) plans are a
type of defined
contribution plan. There are four major differences between typical cash balance
plans and
401(k) plans.
• Participation. Participation in typical cash balance plans generally does not
depend on the workers contributing part of their compensation to the plan; however,
participation in a 401(k) plan does depend, in whole or in part, on an employee choosing to
make a contribution to the plan.
• Investment Risks. The investments of cash balance plans are managed by the
employer or an investment manager appointed by the employer. The employer bears the risks
and rewards of the investments. Increases and decreases in the value of the plan’sinvestments do not directly affect the benefit amounts promised to participants.
By contrast, 401(k) plans often permit participants to direct their own investments
within certain categories. Under 401(k) plans, participants bear the risks and rewards
ofinvestment choices.
• Life Annuities. Unlike many 401(k) plans, cash balance plans are required to
offer employees the ability to receive their benefits in the form of lifetime
annuities.
• Federal Guarantee. Since they are defined benefit plans, the benefits promised
by cashbalance plans are usually insured by a federal agency, the Pension Benefit
Guaranty Corporation (PBGC). If a defined benefit plan is terminated with insufficient
funds to pay all promised benefits, the PBGC has authority to assume trusteeship of the
plan and to begin to pay pension benefits up to the limits set by law. Defined
contribution plans, including 401(k) plans, are not insured by the PBGC.
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