Cash Balance plans are Defined Benefit plans, but are not much like Pensions as you may know them, or other types of retirement plans, for that matter.
On one side of the retirement isle you have defined contribution plans, such as 401(k)s and SEPs and so on, where the contributions are certain, or at least ascertainable, while the ending balance or benefit of each employee’s account is unknown, or at least does not have to be (and in most cases isn’t).
Defined Benefit plans, on the other side of things, are more structured because they are built around a promise and guarantee that a certain benefit will be payable to the employee when retirement comes. This is usually done with the help of actuaries who estimate the life expectancy of employees and help to figure our how much income can be paid to each employee for the rest of his or her life.
They base this income amount on the length of time worked for the employer, the employee’s salary, and other factors. Defined Benefit Plans like that are known as Pensions. Cash Balance plans are a different type of Defined Benefit plan.
Unlike Pensions, Cash-Balance Plans are mobile – if you leave your job, you can roll the money into an IRA, just like you can with a 401(k). That is partially because the defined benefit in a Cash Balance plan is a lump sum that waits for the employee, rather than an income stream, as in a pension.
Cash Balance plans are funded with contributions that may be adjusted every few years, but which are credited with a fixed interest rate, making the benefit amount down the road certain, depending on what contributions were put into the plan.
Also, in Pension Plans, the assets are all pooled and no particular amounts are separated into accounts for each employee. In Cash Balance plans, the assets are also pooled, but employees do have “hypothetical” accounts with their personal balances.
Money purchase plans are also called pensions, but cash balance plans are defined benefit, while money purchase plans are defined contribution. Money purchase plans required that all employees receive a fixed percentage of their salary as a contribution from the employer, and the percentage is the same for all employees.
A cash balance plan allows for some discrimination as to the amount that is contributed for each employee, but this may require that an employer also sets up a safe harbor 401(k) to satisfy nondiscrimination requirements of ERISA. Contributions to Cash Balance Plans do have to be monitored by their administrator to make sure they’re not top-heavy.
How Does a 401(k) Compare With Other Retirement Plans?
Will My Cash-Balance Payments Affect My Social Security payments?