The Rise in Cash Balance Plans
Cash balance plans—defined benefit plans that define the benefit in terms that are more characteristic of a defined contribution plan—have grown in popularity in recent years. According to the statistics per the most recent IRS Form 5500 filings, these hybrid plans have increased by approximately 17%, whereas traditional 401(k) plans increased by a more modest 3% over the same time period.
Many employers offer cash balance plans to its employees, in addition to defined contribution plans, such as 401(k) plans. Additionally, many of these cash balance plans resulted from conversions of traditional defined benefit pension plans.
Cash balance plans are different from traditional defined benefit plans due to the variability of the ultimate benefit employees receive in cash balance plans. In a typical cash balance plan, participant hypothetical accounts are credited each year with pay credits (usually a percentage of compensation from the participant’s employer) and an interest credit, which is either a fixed rate or a variable rate that is linked to a market index. Recent regulations have given employers more flexibility with respect to the interest crediting rates, with many employers opting to use an actual rate of return formula instead of rates related to long-term Treasury bonds.
Cash Balance Plans benefit both Participants and Employers
When a participant in a cash balance plan retires, the plan must offer them a lifetime annuity in which monthly benefits are determined by the size of the account balance. However, vested participants also have the option of taking a lump sum distribution or IRA rollover of the accumulated account balance, even before retirement. This portability feature is viewed as a significant benefit to participation in a cash balance plan. Furthermore, participants in cash balance plans are able to more easily understand the accrued value of their benefit, compared to a standard defined benefit plan.
Employers have also found benefits in offering cash balance plans. Cash balance plans allow employers a clearer view of the liabilities they are accruing over a standard defined benefit plan. Furthermore, employers who set the interest crediting rate to an index are less vulnerable to market swings. Finally, the size of the monthly lifetime payments at retirement is determined when the participant retires. Therefore, in situations where the cost of an annuity has increased significantly at the time a participant retires, the employer will not be obligated to cover the difference in the monthly benefit that a participant might have received when annuity costs were lower.
Cash balance plans are becoming a more popular retirement vehicle. While there is no expectation that cash balance plans will outnumber traditional 401(k) plans, the growth in cash balances is very noteworthy.
If you have any questions, please contact Ken Kobiernicki or your ORBA advisor at 312.670.7444. Visit ORBA.com for more information about our Employee Benefits Group.