Today’s business owners are tasked with a significant challenge: Attracting (and retaining) the best talent while simultaneously supporting their own bottom line. One strategy for achieving both of these goals? Choosing the best retirement plan. If you’re in the process of deciding whether a cash balance or 401(k) plan is more suitable for your employees and your business, here’s what you need to know.
Understanding Your Retirement Plan Options
A cash balance plan is a plan in which an employer credits an employee’s hypothetical retirement account with set percentages of their yearly compensation (plus interest charges). Similar to traditional pension plans, this defined-benefit plan relies on a formula which takes multiple factors into account, including salary history and length of employment. Participants in cash balance plans are assured a precise income stream upon retirement.
Conversely, a 401(k) retirement plan is an employer-sponsored, defined-contribution retirement plan through which eligible employees can make salary-deferred contributions to an account that is completely portable once vested. Additionally, the employer sponsoring the 401(k) may or may not make matching contributions. The funds that participants will have in retirement are not “defined” but instead dependent on market performance.
Differences Between Retirement Plans
We’ve established that a key difference between cash balance retirement plans and 401(k) retirement plans is that the former are defined-benefit while the latter are defined-contribution. However, there are other notable differences, as well.
For starters, the cost to administer these plans varies. Compared to 401(k) plans, cash balance plans can be more expensive for employers due to annual administration fees, including required actuarial certifications ensuring that plans are properly funded.
Meanwhile, the upfront expenses may also be higher with cash balance plans - business owners can expect to contribute as much as 8% of an employee's pay annually compared with the 3% contribution that’s more typical in a 401(k) plan.
Another key difference between cash balance plans and 401(k) plans pertains to risk. With the former, the employer is responsible for making up any shortfall to the promised amount in the event of a market downfall and therefore is at increased risk. With the latter, however, employees assume the risk because the amount that accumulates relies on their self-determined contributions and market performance.
Funding options also differ between the two types of retirement plans. While cash balance plans are inherently limited, 401(k) plan sponsors have a breadth and depth of investment options from which to choose. This can be particularly appealing for retirement-minded younger employers, as well as for business owners themselves who are eager to improve their retirement savings prospects.
Lastly, comes the issue of contribution limits. Cash balance plans may be appealing to older employers - not only because contribution limits are more generous, but also because they increase with age. However, longtime employers converting from traditional pension plans to a cash balance plan may also suffer as cash balance benefits are based on salaries for all of a participant’s working years. And while contribution limits to 401(k) plans are more limited (but increasing), they do offer benefits to savers who maximize their contributions.
Certainly, there are pros and cons to both cash balance and 401(k) retirement plans. Utilizing expert retirement plan services can help business owners identify the type of plan that best suits their employees’ retirement goals, as well as their own retirement and business goals.