Advantages of cash balance plans
The plan offers guaranteed pension benefits for employees
This is the key similarity between cash balance plans and traditional pension plans. Each participant ultimately receives a dollaramount guaranteed under the plan, payable upon retirement (or possibly upon termination of employment) as either a lump sumor an annuity.
As a result, participants enjoy the security of knowing that their retirement benefits are virtually guaranteed — a feature not associated with 401(k)s and other defined contribution plans, where the final payout is based largely on investment performance.
The insurance provided by the Pension Benefit Guaranty Corporation (PBGC) adds further security to these arrangements (seebelow). You, as the employer, pay these PBGC premium insurance costs.
The plan offers unique incentives to attract and retain employees
In addition to the security of guaranteed benefits, a typical cash balance plan offers certain advantages for your participatingemployees. These generally include portability, or the ability of participants to roll over their vested benefits to another retirementplan or to an IRA if they leave your service. Also, the fact that participants accrue benefits evenly throughout their employment(using a fairly simple formula, in most cases) and can see their "accrued benefits" at any time eliminates much of the complexityassociated with traditional pensions, making cash balance plans easier to understand. In addition, many younger employees maylike the idea of being rewarded at the same rate throughout their employment, because it puts them on more of a par with older,higher-paid employees.
Your business has some flexibility with contributions to hypothetical accounts
A cash balance plan is similar to a traditional pension plan in that both "define" future retirement benefits, not employercontributions. As a result, cash balance plans are not subject to the strict annual contribution limits that govern definedcontribution plans. This generally means that you can contribute more to the plan than you would be able to contribute to adefined contribution plan. You also have some flexibility in terms of the formula for determining how much you credit forcontributions to participants' hypothetical accounts. The amount credited is usually either a percentage of the participant's pay, ora flat dollar amount. The credits may also be age- or service-related in some cases. Some employers even credit differentamounts for different components of pay, or base the credits on company performance.
The plan may be less difficult and expensive to maintain than other plans
The administrative costs of a cash balance plan may sometimes be lower than under a traditional pension plan, because it is likelythat many cash balance plan participants will receive a lump-sum payout at termination or retirement. Once the participantreceives a lump-sum payout, you have no additional responsibility, including no responsibility to provide a cost-of-livingadjustment (COLA) for benefits to keep pace with inflation. By contrast, the majority of participants in a traditional defined benefitpension plan will receive a monthly annuity payout at retirement, requiring large numbers of checks to be cut. Also, traditionalpension benefits often include a COLA, resulting in additional costs to you.
In some cases, a cash balance plan may even be less difficult and costly to maintain than a 401(k) or other defined contributionplan. Record keeping will be easier because there is no reconciliation required with trust assets, and because there are noemployee contributions to be taken into account.
Caution:Because records of individual plan accounts must be kept, record-keeping costs associated with a cash balance planmay be higher than under a traditional pension plan. Also, while a traditional pension plan generally allows you to defer paymentof benefits until employees retire, a cash balance plan generally allows terminating employees to take their vested benefits withthem (i.e., cash out or roll over the benefits). When benefits remain in a traditional pension plan until employees retire, you aregenerally able to keep the earnings on that money. For these reasons, a cash balance plan is sometimes not more cost-efficientthan a traditional pension plan. The point is that overall cost efficiency depends on several factors that may vary from one situationto the next, so it is best to consult a retirement plan specialist as to whether a cash balance plan will save you money versus atraditional pension plan or other type of plan.
You receive the benefit if investments perform better than expected
In other words, if you promise to credit each participant's hypothetical account with 3% annual interest, but the plan's underlyinginvestments earn 8% each year, the 5% difference is yours to retain and use. If the earnings on plan assets are higher thanneeded or expected, the employer may take advantage of the surplus by reducing future funding contributions to the plan, or byincreasing the retirement benefits to be paid to participants.
Caution:You, as the employer, also bear the risk of any losses relating to plan investments. If those investments fail to achievethe interest rate needed, you must take steps to make up the difference.
Creditor protection
Funds held in a cash balance plan are fully shielded from your employee's creditors under federal law in the event of theemployee's bankruptcy. If your plan is covered by the Employee Retirement Income Security Act of 1974 (ERISA), plan assets arealso generally fully protected under federal law from the claims of both your employees' and your creditors, even outside ofbankruptcy (some exceptions apply). State law may provide additional protection.
Benefit calculation may mean less benefit funding than typical traditional pension plan
Cash balance plan retirement benefits are largely based on a straight percentage of each participant's compensation. By contrast,a traditional defined benefit pension plan's formula for calculating benefits may weigh more heavily a participant's highest-earningyears prior to retirement, and total years of service. Consequently, some employers can save significantly on benefits paid under acash balance plan.
Disadvantages of cash balance plans
Your business must make periodic payments to the plan
In general, if you establish or convert to a cash balance plan, you, as the employer, are committing to making all of the plancontributions — whether or not you have profits or the cash to do so. Contrast that with a 401(k) plan where the employeesgenerally make the bulk or all of the contributions.
With a cash balance plan, you must fund the plan on an annual or more frequent basis. Consequently, a cash balance plan maynot be the appropriate type of retirement plan for your business if you suspect that your business might not have the money tofund the plan in future years. You may be subject to substantial penalties by the IRS if you underfund the plan. Consult a taxadvisor for details.
Your business may have to pay for pension insurance
A covered cash balance plan is subject to mandatory insurance coverage through the Pension Benefit Guaranty Corporation(PBGC). The PBGC is the federal agency that "insures" benefits accrued under certain defined benefit plans (including cashbalance plans). If you default on or terminate the plan, the PBGC will pay benefits to the plan participants according to theprovisions of the plan (up to certain ceilings). The PBGC is funded through mandatory premiums paid by employer sponsors ofcovered plans. If you wish to terminate your plan, the PBGC must be notified in advance and must approve any distribution of planassets to participants.
Caution: Professional employer plans covering less than 26 employees are not covered by the PBGC.
Your business must invest plan assets and bear all the investment risk
Under a cash balance plan (as under a traditional pension plan), the responsibility of investing the plan assets for the participantsrests with the employer. This is in contrast to many defined contribution plans [such as 401(k) plans], which are self-directed inthat participants generally choose their own investments and have flexibility to move money around. As the employer, you maychoose to not actually select the investments or manage the assets yourself. You may instead hire an administrator to handlethese duties for you. However, you still bear all risks associated with plan investments. If investment returns do not keep pace withfunding requirements, additional unanticipated funding contributions will have to be made.
This type of plan may not be beneficial for certain workers
Cash balance plans are often perceived as less advantageous than traditional defined benefit pension plans for older, highlycompensated employees who have been with your company for many years. This is because cash balance plans generallyreward each participant evenly throughout the duration of his or her employment.
By contrast, traditional defined benefit pension plans often weigh later, higher-earning years more heavily in calculating retirementbenefits. Particularly in the case of a conversion from a traditional defined benefit pension to a cash balance plan, many older,longer-service employees may sometimes lose significant benefits (unless the cash balance plan has grandfather provisions orother protections, or gives older employees the choice of opting out of the conversion).
The plan is subject to various requirements
As a qualified retirement plan, a cash balance plan is not allowed to discriminate in favor of certain employees.
Basically, thismeans that highly compensated employees may not benefit substantially more under the plan than your non-highly-compensatedemployees. To ensure that this is the case, your plan is generally required to undergo annual nondiscrimination testing. Thesetesting requirements are beyond the scope of this discussion. You should consult additional resources for further guidance.
A qualified defined benefit plan (including a cash balance plan) is also subject to "top-heavy" requirements of IRC Section 416.These requirements generally prohibit high-level employees from accruing more benefits under the plan than lower-levelemployees. A retirement plan is considered top heavy if the present value of the accrued benefits of the key employees (generally,the company owners and officers) is more than 60% of the present value of the accrued benefits of all participating employees. Ifa plan is top heavy, a minimum retirement benefit of the lesser of 20% of pay or 2% per year of service must be provided for allnon-key employees. In addition, top-heavy plans must provide for a more rapid vesting schedule than would otherwise apply.
Finally, cash balance plans must comply with the vesting, funding, disclosure, reporting, fiduciary, and other requirements thatapply to qualified plans under ERISA and the IRC. Consult a tax advisor or retirement plan specialist for more information.
Tip: ERISA doesn't apply to governmental and most church retirement plans, plans maintained solely for the benefit ofnon-employees (for example, company directors), plans that cover only partners (and their spouses), and plans that cover only asole proprietor (and his or her spouse).
The information in this newsletter is not intended as tax, legal, investment, or retirement advice or recommendations, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented, nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Broadridge Advisor Solutions. © 2019 Broadridge Investor Communication Solutions, Inc. CRN202110-255702