A Cash Balance Plan is a defined benefit plan, similar to a pension. Each participant in a Cash Balance Plan has an account, and those account balances can increase in two unique ways.
First, each plan participant receives a "pay credit." These credits are typically calculated as a percentage of employee income. Second, each plan participant receives an "interest credit," a percentage increase on their entire account. This "interest credit" percentage is typically tied to Treasury yields.
These are striking differences when comparing Cash Balance Plans to 401(k) plans.
With 401(k) plans, the employee is allowed to define their contribution. And 401(k) plans allow plan participants to choose their own investment choices.
Not so with Cash Balance Plans. The "pay credit" and the "interest credit" are out of the participants' control. Participants take zero investing risks inside of Cash Balance Plans.
All of the investment risks are taken by the plan administrator (e.g., the employer). And that's important to consider as we ask: could a Cash Balance Plan fit your business?
Cash Balance Plan - A Good Fit?
Good candidates for Cash Balance Plans typically meet a few of the following criteria.
1) An older owner or partner who needs to catch up on years of missed retirement savings.
Young workers typically have a hard time saving for retirement, and that's doubly true for owners who are re-investing money back into their businesses. For these types of owners/partners/workers, Cash Balance Plans can be a perfect way to catch up.
Cash Balance Plans cap the "pay credit" based on employees' ages. For example, a 50-year old in 2021 could earn as much as $158,000 from a Cash Balance Plan, tax-deferred. A few years of that type of benefit will quickly make up for years of missed retirement contributions.
2) Looking to attract and retain talent
Cash balance plans are a valuable tool for catching the eye of would be employees. Additional dollars towards retirement can be attractive across the employee spectrum, in particular if you are targeting those individuals who may feel they are behind or who might benefit from the age weighted cash balance formula.
3) Business owners looking for large tax deferral above the 401(k) plan.
For the lower end of the earning spectrum, 401(k) maximums can represent a savings percentage plenty high enough to fund a comfortable retirement. For individuals earning a more significant amount of income, the flat dollars of a 401(k) plan may represent only single digit savings percentage.
These high earners are hit with a double whammy when considering that they also often face the highest income tax rates. Cash balance plans often provide the opportunity to put away more dollars in years of high income and corresponding high tax rates.
4) Companies that are already contributing to employees' retirements or that are willing to do so.
All Cash Balance Plans need to provide contributions to their employees. For many companies already providing 401(k) matching, this is a non-issue. But if you're not already providing contributions to employees' retirement plans, make sure your company can handle it financially!
Typical contribution rates fall in the range of 5% - 7% of total salary.
5) Companies with consistent profit.
Remember - Cash Balance Plans provide both the "pay credit" and the "investment credit" regardless of the investment markets’ performance, regardless of any 'employee contributions' (there are none), and regardless of the company's financials.
A company that is losing money should not add a Cash Balance Plan onto its books. Only a profitable company can reliably afford to take on the expense of a Cash Balance Plan.
Granted, most Cash Balance Plans grow at higher rates than what they payout. The investment credit, for example, is typically set at the risk-free rate (tied to Treasury bonds). The plan portfolio will likely grow faster due to the presence of riskier assets.
Nevertheless, Cash Balance Plans cannot afford to risk both 1) poor internal performance at the company and 2) poor external performance in asset markets. Considering the second risk is not entirely within the plan's circle of control, the plan must ensure that the first risk is, essentially, zero.
Summary
Cash Balance Plans fit a particular retirement planning niche, and they do so exceptionally well. If you’re a profitable business with employees looking to catch up on retirement savings, perhaps a Cash Balance Plan is the right plan for you.
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