Cash Balance Plans

Navigating retirement plan
options can be confusing.

This guide is designed to answer your questions about the pros and cons of a Cash Balance Plan to help you decide if it’s right for you business.

What is a Cash Balance Plan?

According to the U.S. Department of Labor, there are two types of retirement plans: defined benefit plans and defined contribution plans. A defined benefit plan provides a specific benefit at retirement for each eligible employee. A defined contribution plan specifies the amount of contributions to be made in an employee’s retirement account. A Cash Balance Plan is sometimes called a “hybrid” of the two because it guarantees a specific benefit at retirement for each participant, but the benefit is based on ongoing, and fixed, annual contributions.

The advantage? The hybrid format of a Cash Balance Plan allows for the larger tax deductions and accelerated retirement savings of a defined benefit plan, while maintaining some of the flexibility and portability of a defined contribution plan.

How does a Cash Balance Plan work?

With a Cash Balance Plan, each participant’s benefit grows annually in two ways: a contribution credit, and an interest crediting rate. Participant benefits are guaranteed by the employer, who solely bears the investment risk.

The contribution credit is the amount that the employer contributes annually on behalf of owners and participants. The contribution is deposited in the following year prior to business taxes being filed. This amount can either be a flat dollar value or a percentage of income; for example, $1,000 annually per participant or 2% of a participant’s annual compensation.

This contribution can be different for employees and owners so long as the plan passes compliance testing. The annual funding formula is specific for each company and is dependent on employee demographics and employer goals. A Cash Balance illustration can model funding formula options for your specific business to help you evaluate whether this is a good strategy. The interest crediting rate (ICR) is the rate at which the plan guarantees interest on accumulated contributions. This rate is typically tied to an index, such as the 30-year Treasury yield.

An actuary calculates the required employer contribution each year based on market growth of plan assets, plan census data, and the interest crediting rate. The actuary also makes sure that the plan passes annual compliance testing. These tests assess whether contributions made to highly-compensated employees bear a reasonable relationship to contributions made to non-highly-compensated employees.

Assets within a Cash Balance Plan are pooled and come only from the employer. Investments are directed by the plan trustee, not individual participants. Typically investments within the plan seek returns that are consistent with the interest crediting rate to minimize risk for the employer.

Cash Balance Plans are generally used in conjunction with a 401(k) Profit Sharing Plan in order to maximize benefits to the owner and pass compliance testing. Contributing to a 401(k) Profit Sharing Plan provides some funding flexibility to the employer. This can also help mitigate the employer’s investment risk because assets in the 401(k) Profit Sharing Plan are not subject to the employer-guaranteed interest crediting rate.

Are There Risks Associated with a
Cash Balance Plan?

Yes. At Fisher\SMB, we are committed to providing unbiased and balanced information on every aspect of a Cash Balance Plan. While the benefits of a Cash Balance Plan can seem attractive to business owners, there are also significant risks that should be considered.

Value Fluctuation. Investment risk is borne solely by the employer. The employer guarantees that the assets within the plan will grow by the stated interest crediting rate (ICR), regardless of actual market performance.

For example, if the beginning of year (BOY) balance is $100,000 and the interest crediting rate is 4%, the end of the year (EOY) balance should be $104,000. If, due to market performance, the EOY balance is only $50,000, the employer is responsible to fully fund the $54,000 shortfall in addition to the planned contribution credit. If the contribution credit is $100,000, the employer’s contribution requirement is $154,000. The shortfall funding requirement can be amortized over seven years to help smooth out market volatility.

Conversely, if, due to market performance, the EOY balance is $124,000, the employer’s contribution requirement would decrease by $20,000. Instead of contributing $100,000, the employer must contribute $20,000 less, or $80,000, which decreases the employer’s tax deduction for that year. Because market volatility affects the predictability of annual ongoing contributions, assets within a Cash Balance Plan typically seek returns consistent with ICR.

Risks of Over/Under Performing the ICR

The following simplified case studies illustrate the concept of value fluctuation risk.

Where does the money for a Cash Balance Plan come from?

All assets within a Cash Balance Plan come from company coffers. Generally, a minimal amount is contributed on behalf of employees, while the majority of the assets are contributed for the principals. Typically, principals will use the Cash Balance contribution to reduce their taxable income.

For example, a 50-year-old doctor who earns $500,000/year might choose to reduce his salary to $350,000 and take $150,000 as an annual Cash Balance Plan contribution. Because money in the Cash Balance Plan is tax-deferred, this directly reduces the doctor’s tax burden.

This can get tricky when there are multiple principals involved. Each principal will need to decide how much they want to put toward the Cash Balance Plan and will need to adjust their compensation accordingly.

Some businesses have a practice manager who can facilitate individual meetings with each principal to determine how much each would like to contribute.

How to Establish a Cash Balance Plan

Fisher\SMB will walk you through the following process in order to establish a
Cash Balance Plan for your business.

Inflexible Funding. Contribution credits are required annually and cannot be modified from year to year. Before adopting a Cash Balance Plan, the employer should be sure that it can commit to the ongoing annual funding requirements. If a business is unable to sustain cash flow sufficient to fund the plan over the long term, a Cash Balance Plan is not a good option.

Administrative Expense. Because a Cash Balance Plan requires ongoing actuarial work, it is typically more costly to administer than a 401(k) Profit Sharing Plan.

Administrative Complexity. Generally speaking, a Cash Balance Plan is more complex than a 401(k) Profit Sharing Plan. Because it is a more sophisticated benefit, it requires ongoing administrative effort, additional decision-making, and associated costs.

Roles and Responsibilities

What are the roles and responsibilities associated with a Cash Balance Plan?

Fisher\SMB partners with an independent actuary to help your business evaluate your financial needs, goals, and circumstances. Each role in your Cash Balance Plan is described in the chart below.

Glossary

Cash Balance Plan: A type of defined benefit plan that acts similarly to a defined contribution plan because the benefit amount is based on annual ongoing employer contributions.

Contribution Credit: The annual amount that an employer must contribute to a Cash Balance Plan on behalf of the participants. This can be a dollar value or a percentage of the participant’s income.

Defined Benefit Plan: This type of plan, also known as a traditional pension plan, promises the participant a specified monthly benefit at retirement. The employer is responsible for determining how the plan’s assets are invested and bears all risk if the plan’s assets are insufficient to cover the promised benefit. Often, the benefit is based on factors such as salary, age, and the number of years of employment.

Defined Contribution Plan: In a defined contribution plan, the employee and/or the employer contribute to the employee’s individual account under the plan. The employee often decides how their account is invested and bears all investment risk. The amount in the account at distribution includes the contributions and investment gains or losses, minus any investment and administrative fees. The 401(k) plan is a popular type of a defined contribution plan.

Interest Crediting Rate (ICR): The annual rate at which the sponsor of a Cash Balance Plan guarantees interest on the accumulated contributions credits. This rate is typically tied to an index such as the 30-year Treasury rate.