Capital Ideas^™ 
Investment insights from Capital Group

Defined contribution plans continue to eclipse defined benefit plans by an ever-widening margin in terms of the number of plans and assets. However, there’s at least one growth area in the defined benefit world: the cash balance plan.

A cash balance plan is a defined benefit plan in which an employer credits a participant’s account with a “pay credit” (a percentage of pay or a flat dollar amount) and an “interest credit” (either a fixed or a variable rate).

In fact, this plan type can offer the best of both defined contribution and defined benefit worlds, which may be especially attractive for business owners and their key employees who are playing catch-up with their retirement savings.

More specifically, a cash balance plan may best fit organizations with a predictable cash flow and consistent profits. These could include, but aren’t limited to:

• Professional groups, including lawyers, doctors, dentists, engineers, architects and accountants
  
• Family and closely held businesses
• Sole proprietors
• Organizations that already contribute the maximum to their current defined contribution plans

Here are three reasons employers should consider adding a cash balance plan:

1. Employers and Key Employees Can Accumulate More for Retirement and Reduce Current Taxes

The main attraction of a cash balance plan is that employers and their key employees can typically contribute more — often much more — to the plan.

For example, as the accompanying table illustrates, a 60-year-old owner or key employee could contribute up to $24,000 to a 401(k) plan or up to $60,000 if the 401(k) plan is coupled with a profit-sharing plan. Adding the cash balance plan to the 401(k) and profit sharing plans, however, would permit total employee and employer contributions of up to $305,000.

Moreover, employer contributions are deductible for the business. This means that an employer could have saved more than $126,000 in taxes on that same 60-year-old.

And while a cash balance plan may have higher administrative costs than a 401(k) plan, largely because its funding must be certified by an actuary each year, the tax benefits of investing six-figure annual contributions into cash balance plans can offset this additional administrative cost.

2. It’s Easier for Employees to Understand Than a Traditional Defined Benefit Plan

Determining the payout of a traditional defined benefit plan typically involves actuarial tables and complex calculations. Worse, interim projections are hypothetical. The actual payout for a traditional defined benefit plan is not certain until all service and earnings variables are known at the actual retirement date.

Contrast this with a cash balance plan, which in most cases guarantees a specific rate of interest on contributions. For this reason, projecting an account balance at a specific date in the future is far simpler and more reliable, and unlike other defined benefit plans, the actual investment returns do not affect the benefit amounts promised to participants.

The bottom line? Because participants have a better understanding of their cash balance plan account, they will appreciate the plan more.

3. It’s More Portable Than a Defined Benefit Plan

Upon separation from service, cash balance account values can, as a lump sum, be distributed or rolled over to an IRA or another employer-sponsored plan.

This makes cash balance plans more portable, and therefore more appealing to participants.

Deciding Whether a Cash Balance Plan Is Right for a Particular Business

A cash balance plan, however, may not be right for all companies. Since a cash balance plan must be funded on an annual or more frequent basis, employers should be confident the firm’s cash flow and profitability will permit it to meet its funding requirements.

The responsibility for investing plan assets for participants rests with the employer. If investment returns do not keep up with funding requirements, additional, and often unanticipated, contributions will have to be made. Generally, a local third-party administrator can help with the plan design.

Also, business owners should expect to make cash balance contributions amounting to roughly 5% to 8% of employees’ pay, compared with the 3% contribution that’s more typical in a 401(k) plan.

Learn more about how to incorporate a cash balance plan for your business in our latest white paper, “Add a Cash Balance Plan to Increase Tax Savings and Improve Participant Outcomes.”