In the 1980s, two types of qualified retirement plans were born that allowed employees to avoid being taxed on deferred compensation. You’re likely familiar with the well-known 401(k) Plan and perhaps have heard of the lesser known cash balance plan.
While 401(k) plans grew quick in popularity, reaching $1 trillion in assets by the mid-’90s and becoming a household word, cash balance plans grew slower. However, through positive legislative and regulatory changes, cash balance plans have really picked up steam. The number of plans more than quadrupled in the last decade and plan assets finally reached over $1 trillion.
Cash balance plans are now promoted by savvy tax, finance and pension professionals who know the unique advantages cash balance plans provide and how they can meet or exceed their clients’ goals for their retirement plan program.
What is a Cash Balance Plan and How Does it Differ From a 401(k) Plan?
Due to their prevalence, 401(k) plans are well-known and for the most part, understood. In their simplest form, participants may contribute a portion of their salary on a tax-deferred basis and the plan sponsor may make additional tax deductible employer contributions. These contributions are discretionary and they can often be flexible in their application. As of 2019, participants are subject to annual contribution limits of $62,000 for a person over age 50 and their retirement benefits are equal to their account balances which are subject to investment earnings and fees.
On the surface, cash balance plans look a lot like 401(k) plans. Participant benefits are tracked as account balances that are credited annually with contributions and interest. The accumulation of these annual contribution and interest credits determine participant benefits at retirement.
However, unlike 401(k) pans, contribution credits in cash balance plans are not discretionary and must be defined in the governing plan document. Interest credits are also defined in the plan document and do not necessarily reflect the investment experience of the plan assets. Participant account balances represent a plan liability and the plan sponsor funds these liabilities through annual contributions to the plan.
A cash balance plan has flexibility in terms of how it defines the contribution formula. For example, it can be defined as a percentage of pay or a flat dollar amount. In addition, the plan is permitted to apply different formulas to participants or job classification groups. There is also flexibility in terms of how the interest credit is defined. It can be based on a fixed rate, the actual rate of return experienced by the plan assets and other approved rates. However, an amendment to the plan document is required to change the formula for future contribution accruals and options to amend the interest crediting rate range from very limited to not permitted. Simply put, cash balance plans are not as flexible as 401(k) plans once the plan provisions have been set.
Why Would an Employer Choose to Sponsor a Cash Balance Plan if It Isn't as Flexible as a 401(k) Plan?
While cash balance plans are not as flexible, they offer significantly higher retirement savings and deduction opportunities than 401(k) plans.
As mentioned previously, participants in 401(k) plans are limited to an annual contribution of approximately $62,000 for a person over 50. On the other hand, cash balance plans limit participants to a maximum benefit at retirement age. This benefit limit is based on a single life annuity and currently cannot exceed an annual payout of $225,000. This limit increases with the cost of living and requires at least ten years of participation in the plan to fully accrue.
A cash balance plan participant would need an account balance of nearly $3 million in order to purchase the current maximum permitted annuity at retirement age. Assuming a participant began accruing a maximum benefit in a cash balance plan at age 55, the plan would only have ten years to fund nearly $3 million for that participant. This would result in contributions ranging from over $200,000 to nearly $300,000 per year for a single participant.
Even younger participants with a longer investment horizon can benefit from higher contributions in cash balance plans. For example, a participant in his or her early 40s could still potentially accrue over $100,000 per year in a cash balance plan and this amount would increase each year as the participant comes closer to retirement age.
Qualified retirement plans are also subject to annual deduction limits. For example, 401(k) plans cannot deduct employer contributions that exceed 25% of their total plan compensation earned by benefiting participants. However, cash balance plans are permitted to deduct contributions required to fully fund accrued benefits regardless of the amount and, in some cases, can deduct contributions that fund up to 150% of accrued benefits. This results in higher overall plan contribution deductions than would otherwise be permitted in a 401(k) plan.
Better still, plan sponsors are not required to choose one plan over the other. They can choose to have both a 401(k) plan and a cash balance plan. With some exceptions, by combining a 401(k) plan with a cash balance plan, plan sponsors can take advantage of both the 401(k) plan and cash balance plan deduction limits.
Are There Any Other Benefits to Sponsoring a Cash Balance Plan?
Yes! They can be helpful for annual non-discrimination testing requirements and for attracting and retaining valuable talent.
Qualified retirement plans must not discriminate in favor of owners or highly compensated employees. Employer contributions in 401(k) plans and cash balance plans can be allocated at different rates to employees as long as the plans can prove the contributions are not discriminatory. This is often accomplished by converting the actual contribution dollar amount to an estimated benefit at retirement age. By doing so, it is possible to prove smaller contributions to younger non-highly compensated employees are as valuable as larger contributions to older owners or highly compensated employees. This is because younger participants have a longer period of time to accrue interest on contributions before reaching retirement age.
When performing non-discrimination testing, employer contributions in a 401(k) plan are assumed to accrue interest at a rate of 7.5% to 8.5% per year. However, cash balance plans assume an interest rate based on what is being accrued as an interest credit to plan participants for that particular year. This typically ranges from 0% to 5% per year. By allocating the bulk of employer contribution to owners and highly compensated employees to a cash balance plan and the bulk of the non-highly compensated employees’ contributions to a 401(k) plan, it is possible to take advantage of this interest rate disparity to further improve non-discrimination testing results.
Proving non-discrimination also requires coverage testing. Cash balance plans can be combined with 401(k) plans to prove coverage is not discriminatory. Even though cash balance plans do have unique minimum coverage requirements, it is possible to adopt a cash balance plan and limit participation to specific groups of employees (e.g. partners of a law firm or doctors in a medical practice). In some circumstances, this can be accomplished without impacting the contributions currently being provided to other employees if they are already receiving employer contributions in a 401(k) plan. As a result, cash balance plans can be adopted as an additional benefit for select employees in order to attract and retain their talent. This can be a significant advantage for employers sponsoring cash balance plans during times of low unemployment and in competitive job markets.
Who is a Good Candidate to Sponsor a Cash Balance Plan?
Considering the unique advantages cash balance plans provide, they are a powerful tool to help meet or exceed employer goals for their retirement plan program. However, due to their limited flexibility in comparison to 401(k) plans, potential cash balance plan sponsors should meet some or all of the following criteria:
- Needs to increase or accelerate retirement savings
- Needs larger tax deductions than what is permitted with a 401(k) plan
- Already sponsors a 401(k) plan and is looking to provide additional benefits to attract and retain talent
- Has consistent cash flow that will be sufficient to fund cash balance plan benefits each year
Learn More About Cash Balance Plans
To learn more about how cash balance plans may be advantageous to your or your client’s retirement plan program, the Aldrich Retirement Solutions team is ready to help.