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What You Need to Know About Cash Balance Plans

There's nothing like a little competition to benefit investors. Cash Balance (CB) plans are the fastest growing of the defined benefit plans and could overtake 401(k) plans within the next few years, according to a new study from investment management firm Sage Advisory Services.

So what is the “it investment” that perhaps you haven't heard much about? There are two general types of pension plans – defined benefit (DB) plans and defined contribution (DC) plans. Generally, DB plans provide a specific benefit at retirement for each eligible employee, while DC plans specify the amount of contributions to be made by the employer toward an employee's retirement account. In a DC plan, the actual amount of retirement benefits provided to an employee depends on the amount of the contributions, as well as the gains or losses to the account. A CB plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan – it defines the promised benefit in terms of a stated account balance.

Here's what you need to know.

Around since the 1980s, CB plans have become more popular, particularly in the last decade. According to the United States Department of Labor, there were 7,600 individual CB plans in 2010 with $800 billion in assets, compared to 1,300 plans with $26 million in assets in 2000.

In a typical CB plan, a participant's account is credited each year with a “pay credit” (such as 5% of compensation from his or her employer) and an “interest credit” (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate). Increases and decreases in the value of plan's investments do not directly effect the benefit amounts promised to participants. The employer bears the risk.

When a participant is eligible to receive benefits under a CB plan, the benefits that are received are defined in terms of an account balance. For example, assume you have an account balance of $100,000 when you retire at 65. If you decide to retire then, you would have the right to an annuity based on that account balance. Such an annuity might be approximately $8,500 per year for life. In many CB plans, however, you could instead choose (with consent from your spouse) to take a lump sum benefit equal to the $100,000 account balance.

If you receive a lump sum distribution, that distribution generally can be rolled over into an IRA or to another employer's plan if that plan accepts rollovers. The benefit in most CB plans, as in most traditional DB plans, are protected, within certain limitations by federal insurance provided through the Pension Benefit Guaranty Corporation.

What's to like about a CB plan?

Now, the question you most want answered – what can a CB plan do for me? “Employees have no investment risk or investment decisions like 401(k) plans. Accounts are portable for employees. On average they cost less than traditional DB plans, they are protected by the Pension Benefit Guaranty Corporation and are attractive to younger, mobile employees and attractive to key employees by allowing larger contributions for older employees,” points out Professor Timothy Gagnon, of Northeastern University, Faculty Director MST & MSA On-line.

Furthermore, as with any IRS-qualified retirement plan, CB assets are protected in the event of a lawsuit or bankruptcy, adds Daniel Kravitz, president of Kravitz, which does design, administration and management or retirement plans. CB contributions on behalf of owners/partners are tax-deferred providing significant “above the line” tax savings, reducing both ordinary income and AGI. Contributions on behalf of employees are tax deductible.

“Employees who leave employment before retirement get a better benefit than those would under a traditional DB plan. For plan design, it's an attractive plan for employers in addition to a 401(k) plan so it maximizes savings for the highly compensated employees,” explains attorney Ary Rosenbaum of The Rosenbaum Law Firm.

Understand the rules

Like elsewhere in the investing universe there are limitations. Like all IRS-qualified plans, CB plans are governed by ERISA and must pass a range of IRS fairness tests annually. Contribution amounts are written into the plan document and can only be changed by amendment, so these plans are not suitable for firms without consistent profits, says Kravitz.

Then too, says Gagnon, “Annual contributions are required as are annual actuarial valuations.”

Most workers under a DB plan which converts to a cash plan lose in future benefits, adds Rosenbaum.

Assets must be invested conservatively in order to meet the guaranteed annual interest credit. “A big difference between Cash Balance Plans and a 401(k) profit sharing counterpart is the investment horizon. Defined contribution plan participants have the luxury of riding out market cycles waiting as long as it takes for the markets to recover. Cash Balance Plans cannot. In effect, Cash Balance Plans have a on-year investment horizon,” says Kravitz. Plan investments are typically tied to a conservative benchmark such as the 30-year Treasury.

Overperforming the Interest Credit Rate (ICR) is no a reason to cheer. If the investments have outperformed the ICR, the excess return must be both recognized and realized the following year. This means reduced contribution amounts and smaller tax deductions for owners, which can defeat the purpose of having a CB plan.

By that same token, underperforming the ICR is problematic too. It can lead to benefit restrictions and penalties. If the plan has underperformed the ICR, says Kravitz, plan sponsors must make an additional contribution to maintain the plan's “fully funded” status. If the plan sponsor doesn't make up the shortfall by the company tax filing deadline, the IRS considers it underfunded, and the sponsor faces a series of restrictions. Although losses can be amortized over seven years, says Kravitz, plan assets may be frozen and distributions are restricted.

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Anonymous   |     |   Comment #1
I retired in 2008. I had a cash balance for 10 years. Had no retirement before that except for IRA's that I funded since 1978. What I liked about our cash balance plan was that one of the cash accounts paid about the same as long term CD's. We also could trade every day until 4:00. When I discovered this the last few months before I retired in 2008 I traded a lot near 4:00 o'clock because we would know what the outcome would be. We of course could sell when it was high and put the money in the high interest savings account and buy near 4 o'clock when there was a sell off. In 2008 there was a lot of volatility. I took advantage of that. I did receive a letter that I was not complying with the spirit of the plan. I wrote back that they should change the SPD (summary plan discription) which allowed daily trading. 

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