Table of Contents
- What Is a Cash Balance Pension Plan?
- Key Takeaways
- Understanding Cash Balance Pension Plans
- Important Note
- Cash Balance Pension Plan vs. Traditional Pension Plan
- Cash Balance Pension Plan vs. 401(k)
- Pros and Cons of a Cash Balance Pension Plan
- Special Considerations
- Is a Cash Balance Pension Plan Better Than a 401(k)?
- What Can I Do With a Cash Balance Plan?
- What Happens to My Cash Balance Pension If I Quit?
- The Bottom Line
What Is a Cash Balance Pension Plan?
Let me explain what a cash balance pension plan really is. It's a defined-benefit pension plan that gives you the option of a lifetime annuity. As your employer, I credit your account with a set percentage of your yearly compensation plus interest charges. The funding limits, requirements, and investment risk all follow defined-benefit rules. Any changes in the portfolio won't affect the final benefits you get upon retirement or termination, and the company handles all profits and losses in the portfolio.
Key Takeaways
You receive a set percentage of your yearly compensation plus interest charges in a cash balance pension plan. I maintain this on an individual account basis, similar to a defined-contribution plan. There are no contribution limits because I fund it to reach a specific account balance at your planned retirement date.
Understanding Cash Balance Pension Plans
A cash balance plan, or CBP, is kept on an individual account basis, just like a defined-contribution plan. Its features are a lot like those of 401(k) plans. Investments are managed professionally, and you're promised a specific benefit at retirement. But the benefits are expressed as a 401(k)-style account balance, not a monthly income stream.
For example, if you're on a cash balance pension plan, you might get a promise of 5% of your salary with a 5% interest credit. Earning $100,000 annually means a pay credit of $5,000 plus 5% interest on the balance. As your years with the employer increase, the account grows to meet the promised balance. At retirement, you can pick a lump-sum payment or a monthly annuity.
Important Note
The benefits of private-sector pension plans are protected by federal laws, such as the Employee Retirement Income Security Act (ERISA).
Cash Balance Pension Plan vs. Traditional Pension Plan
The biggest difference is that a traditional pension plan usually uses a few years of your highest compensation to figure out your monthly benefit. A cash balance pension plan, however, uses the total number of years you've been with the company.
Cash Balance Pension Plan vs. 401(k)
The key difference here is that in a CBP, the employer bears the investment risk. I'm responsible for making sure you get the promised amount, no matter what. With a 401(k), you bear the investment risk because you choose the investments. The employer has no risk. Also, the retirement benefit in a 401(k) depends on the account balance and isn't guaranteed like in a CBP.
Another difference is the contribution limit. If you're 60 or older, you can put away much more annually in pretax contributions.
Pros and Cons of a Cash Balance Pension Plan
This type of plan has benefits, but there are disadvantages too.
Pros
- Lump Sum Payouts: You can get a cash balance pension payout as a lump sum, which is useful if you want to put the money into something like government bonds or money market funds.
- Rollover Options: You can roll a lump sum into an IRA or another pension plan.
- Tax-Deferred: Contributions are tax-deferred, so you pay taxes only on withdrawals or lump sums. If your tax bracket is higher now than at withdrawal, you save on taxes.
- Custom Contribution Limit: The annual limit depends on your earnings, age, and the fund's target date and balance. This differs from fixed IRS limits on IRAs and 401(k)s.
Cons
- Taxable Distributions: You pay taxes when you withdraw the money.
- High Costs to Maintain: These plans need an actuary to ensure they meet balance requirements, leading to higher costs for employers.
- No Employee Contributions: Only the employer contributes; you can't add from your wages.
Special Considerations
When you combine a cash balance plan with a 401(k), employer contributions for regular employees often end up as a slightly higher percentage of pay than with just a 401(k). You get an annual interest credit, which could be fixed at 5% or variable like the 30-year Treasury rate. At retirement, you can take an annuity based on your balance or a lump sum to roll into an IRA or another plan.
These plans are often more expensive to administer than 401(k)s because they require certification for adequate funding. Fees vary, but cash plans have higher startup costs, annual charges, and management fees.
Is a Cash Balance Pension Plan Better Than a 401(k)?
Both are solid retirement plans. Which is better depends on your preferences, goals, how long you'll stay with an employer, and your income.
What Can I Do With a Cash Balance Plan?
You can make withdrawals or take a lump sum payout. If it's a lump sum, you can roll it into an IRA or another allowed retirement plan.
What Happens to My Cash Balance Pension If I Quit?
Your cash balance pension is portable, so you take the vested portion with you and roll it into another retirement account.
The Bottom Line
A cash balance pension plan is like other retirement accounts. Contributions are tax-deferred for you, and the principal grows with compounding interest and capital gains. The employer takes all the investment risk. You can use your wages to invest in another fund of your choice.
While it's a good option, choose it carefully. Compare the expected tax treatment at retirement to see if it or another plan fits your situation better.
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