Pros and Cons of Cash Balance Plans

Cash benefit plans have seen a surge of popularity in recent years and now account for almost half of all defined benefit plans.¹ The plans are particularly attractive to high earning sole business owners or professional groups such as attorneys, physicians, and accountants.

A cash balance plan can help business owners reduce their tax burdens and build a more comfortable retirement. Establishing and contributing to a cash balance plan can result in sizable retirement savings and big tax deductions. In addition, employers may contribute hundreds of thousands of dollars to a cash balance plan each year.

Here’s why small businesses owners, especially those approaching retirement, should consider a cash balance plan.

How it works

A cash balance plan is a form of defined benefit plan that also includes features of a defined contribution plan like a 401(k).

In a typical cash balance plan, the employer makes contributions to a pension trust fund account. Each participant is allocated a portion of the account or “cash balance” for record-keeping purposes. Contribution amounts (pay credits) are usually a percentage of the participant’s salary but may also be a flat dollar amount in some cases. A participant’s balance adjusts every year by an “interest credit” tied to a target return or index stated in the plan documents.

• Interest credit rates are often tied to a target return between 4% to 6%.
• When the account investment returns are less than the target return for interest credits, the employer may increase contributions, thereby increasing related tax deductions.
• When investment returns exceed the target return, the surplus may offset future contributions, but also decrease the related tax deductions.

The range of amounts that an employer contributes each year is determined by an actuary. In addition to prior contributions, the crediting rate, and investment returns, actuaries also consider:

• Retirement benefits promised by the plan
• Life expectancy, salary, and retirement age of the participants
• Projected future salary increases of the participants
• Projected turnover, disability, and mortality of the participants

The participant’s balance at the time benefit payments begin can never be less than the sum of all the contribution credits to the participant’s cash balance. This is referred to as the preservation of capital requirement.

Distributions

At retirement, cash balance plans may allow plan participants to take the money out as a lump sum in addition to the annuity payment option offered in other pension plans.

Vested plan benefits are generally portable. Funds can be rolled over to an IRA or another employer retirement plan, preserving tax deferral benefits.

Why use a cash balance plan

Cash balance plans can be compelling for business owners for several other reasons:

Maximized Savings and Tax Deductions: Business owners, especially those who are also employees of their own business, can maximize their retirement savings while receiving substantial tax deductions.

Flexibility: Employers can structure the plan to help meet specific goals, such as retaining key employees and managing compensation costs; contribution levels can be set based on the different classes of employees.

Attraction and Retention: Cash balance plans offer a unique and attractive incentive to attract and retain valuable employees.

Creditor Protection: Funds in the cash balance plan may be protected bankruptcy and other creditor claims.

Employees can benefit from cash balance plans because:

Employer-driven contributions: The employer, not the employee, funds the plan.

Predictability: Employees do not bear the investment risks. Unlike a 401(k) and other defined contribution plans, the cash balance plan has a defined benefit at retirement, determined by the pay credits and interest credits defined in the plan document.

Portability: At retirement, participants can roll the lump sum into an IRA or another employer’s plan, which makes it portable and continues tax deferral benefits.

Combining a cash balance plan and a 401(k)

Business owners can sometimes maximize their retirement savings and tax benefits by combining a cash balance plan and a 401(k) plan. The two plans aren’t merged into one. Rather, the business maintains both plans simultaneously and independently, each with its own rules, contribution limits, and investment options. While there can be additional costs associated with having both a cash balance plan and a 401(k), there can also be several advantages worth considering:

Higher contribution limits: The maximum contribution to a 401(k) for 2024 is $22,500 plus an additional $7,500 catch-up for those over 50. For those who have already maxed out these limits, a cash balance plan may allow business owners to contribute hundreds of thousands of dollars more, tax deferred.

Diversified savings options: While cash balance plans target moderate returns (usually 4% to 6%), investment options inside a 401(k) can include more growth-oriented investments like stock mutual funds.

Employee retention and recruitment: Offering two types of retirement plan options can help attract and retain top talent.

In short, by combining a cash balance plan and a 401(k), a business can take advantage of the unique features offered by each and provide employees with more than one retirement savings option. Flexibility and customization can benefit both the owner and the employees.

Bottom line

A cash balance plan provides a hybrid approach to retirement savings, offering high contribution limits and defined benefits of a pension plan along with the individual account features like a 401(k). This makes it a particularly attractive option for high-income earners and business owners looking to help maximize their retirement savings while benefiting from tax advantages. At the same time, business owners want to carefully weigh the costs versus the benefits to ensure a cash balance plan aligns with their financial and business goals. Reach out to your financial advisor to see what type of retirement plan is optimal for your business.

¹National Cash Balance Research Report, 12^th Annual Edition. FuturePlan. March 2023. https://assets.futureplan.com/futureplan-assets/FuturePlan-National-Cash-Balance-Research-Report-12th-Edition.pdf