If you are a business owner, you need to make important decisions about employee benefits that will help you attract and retain employees. Just as important, those benefits also need to make sense for your company. One type of employee benefit that may be ideal for employers is a cash balance retirement plan.
To determine whether your organization is a good candidate for sponsoring this type of plan, it can be helpful to explore it’s features, pros and cons.
What is a Cash Balance Plan?
Cash balance pension plans are a hybrid of defined benefit and defined contribution plans. In a defined benefit plan, the employer guarantees they will pay the participating employee a certain benefit amount upon retirement based on a predetermined formula – regardless of whether the underlying investments perform positively or not. And funds in this type of plan are pooled together in a single large account, invested and professionally managed and then used to pay benefits to retirees.
Just like traditional defined benefit plans, cash balance plans promise plan participants a benefit when they retire. The employer invests the money on behalf of plan participants; there are no employee contributions into the plan. However, in cash balance plans, the benefit is converted to a dollar amount and credited to a “hypothetical” account balance - similar to defined contribution plans, like a 401(k).
Like in defined benefit plans, participants in a cash balance plan can choose between one lump-sum payment or a traditional annuity (monthly payments for life). But similar to defined contribution plans provide portability - allowing participants to withdraw their funds or roll them into an IRA.
Evaluating the Pros and Cons of Cash Balance Plans
There are many potential benefits to offering cash balance plans; however, there are also some important considerations you should evaluate before sponsoring one.
- Simple to understand. Cash balance plans make it easy for employees to understand their future benefit amounts because they can see their individual balance showing their employer’s contribution and the annual interest credit.
- Reduce costs. You may find that offering a cash balance plan helps reduce pension costs. That’s because your contributions are based on employees’ current salaries rather than their projected final salaries, as is the case with traditional pensions.
- Flexible. Employers also enjoy cash balance plans because they can help the owner-employee with their own retirement plan. Cash balance plans’ contribution limits can increase with age or years of service, making them attractive for older business owners.
- Tax planning. Contributions into employees’ cash balance plan accounts are tax-deductible for the business, and funds grow on a tax-deferred basis.
- Employer risk. As plan sponsor, employers are obligated to provide participants with their promised benefit upon retirement - regardless of investment performance or market fluctuations. In the same way, they must also add a required minimum amount into the fund each year to reach target earnings.
- Reduced benefits. If your business is considering converting from a traditional pension plan to a cash balance plan, there’s a potential that long-term employees will see their benefits decrease. That’s because of the way cash balance plan benefits are calculated – based on earnings in all of the employee’s working years compared to just in their final working years.
- Administrative costs. Compared to 401(k) plans, costs for cash balance plans can run high for employers because of annual administration fees that include required actuarial certifications.
Is a Cash Balance Plan Right for Your Business?
As with any type of business decision, there is not a one-size-fits-all approach. And the same is true when it comes to determining what type of employer-sponsored retirement plan or pension plan solution is best. Review the pros and cons outlined above and determine how they might impact your company.
As you evaluate your options, consider the following factors, which may indicate that your company is a good candidate for a cash balance plan:
- You contribute more than $50,000/year to a retirement account and you are looking to contribute more.
- The company is already contributing 3-4% to employees.
- The business has shown consistent profit patterns.
- You are age 40 or older and want to accelerate your pension savings.
Is a cash balance plan right for your business? Consider the information in this article to help you make a more informed decision.