How is a Cash Balance Pension Plan Different from a 401(k) Plan?
Types of Retirement Plans
There are two general types of retirement plans at your workplace. These are defined benefit pension plans and defined contribution plans.
Defined Benefit Pension Plan
Defined benefit pension plans provide a specific benefit at retirement. For example, if you work for so many years, you could get the number of years times your salary to calculate some percentage of monthly income in retirement.
Defined benefit pension plans are becoming increasingly rare in the private sector but are more common in government. Public service workers such as educators and federal, state, and local government workers commonly have pension plans. With a defined benefit pension plan, you will typically know your monthly benefit before you retire since a formula calculates the benefit.
Defined Contribution Plan
While defined contribution plans such as 401(k) and 403(b) are based on contributions towards an employee's retirement account, there may be an employer match to your contributions.
In a defined contribution plan, the actual amount of retirement benefits provided to an employee depends on the contributions and the gains or losses of the account at retirement. The employee bears all of the investment risks. But can get a better return than what would get received in the defined benefit plan.
Cash Balance Plan
A cash balance plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan in terms of what’s in the account. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance.
A participant’s account is credited each year in a typical cash balance plan. This interest credit increases and decreases the value of the plan's investments but do not directly affect the benefit amounts promised to participants. Thus, the employer’s investment risks are borne solely by them, which makes the cash balance plan similar to the defined benefit pension plan in terms of investment risk on the employer.
When a participant becomes entitled to receive benefits under a cash balance plan, the benefits are defined in terms of an account balance.
For example, assume that a participant has an account balance of $100,000 when they reach age 65. Then, if the participant decides to retire, they would have the right to an annuity (or monthly income) based on that account balance. Such an annuity might be approximately $8,500 per year for life. When you are able to take the pension you are typically given a range of choices of monthly income.
In many cash balance plans, however, the participant could instead choose (with consent from their spouse) to take a lump sum benefit equal to the $100,000 account balance. Typically you would roll this money over into an Individual Retirement Account (IRA) and invest the money in retirement. If you decide to take the lump money out as cash, you will typically pay much more in income taxes as it could push you into a higher tax bracket.
Options for Retirement
If a participant receives 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 rollover is the most common option if you don't take the annuity.
As in most traditional defined benefit plans, the benefits in most cash balance plans are protected by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC). But the drawbacks are you are limited in the returns you get because you don’t manage the money. So the returns might be less than what you would get invested the money yourself in a 401(k) plan.
How do Cash Balance Plans differ from 401(k) plans?1
As mentioned, cash balance plans are defined benefit plans. In contrast, 401(k) plans are defined contribution plans, what you save is what you get in retirement. There are four significant differences between typical cash balance plans and 401(k) plans that you should be aware of:
Participation - Participation in standard cash balance plans generally does not depend on the workers contributing part of their compensation. While participation in a 401(k) plan depends on an employee choosing to contribute to the plan. There may be an employer match for the 401(k) plan, but contributions to the plan are essential for it to grow.
Investment Risks - The investments of cash balance plans are managed by the employer or an investment manager appointed by the employer. The employer bears the risks of the assets. Increases and decreases in the value of the plan's investments do not directly affect the benefit amounts promised to participants. By contrast, 401(k) plans often permit participants to direct their investments within certain limits. You would typically get a selection of mutual funds to choose from. As an employee, you have to be careful and match the investments with your level of risk and goals. Participants bear the risks and rewards of investment choices under 401(k) or 403(b) plans.
Life Annuities - Unlike 401(k) plans, cash balance plans are required to offer employees the ability to receive their benefits in lifetime annuities. An annuity is a lifetime monthly income and the possibility of survivor benefits for a spouse, typically half of the monthly annuity. This can be a benefit as your monthly income is not exposed to market risk. But most cash balance plans do not have protections against inflation, which can decrease the purchasing power of your monthly income over time.
Federal Guarantee - Since they are defined benefit plans, the benefits promised by cash balance plans are usually insured by a federal agency, the Pension Benefit Guaranty Corporation (PBGC). Suppose a defined benefit plan is terminated with insufficient funds to pay all promised benefits. In that case, the PBGC has the authority to assume the plan’s trusteeship and begin to pay pension benefits up to the limits set by law. Defined contribution plans, including 401(k) plans, are not insured by the PBGC. As a result, you bear all of the risks of loss of principal or poor investment performance.
Cash balance plans are becoming more common in government. Governments are in fact converting defined benefit pension plans to cash balance plans to reduce the liability of funding the pension. A cash balance plan provides lifetime income for government workers and limits the government's exposure to financing the traditional pension plan. A wise decision on what to do with a cash balance plan is important for a comfortable retirement. Reach out to me if you want to learn more about how your cash balance plan fits into your retirement goals.
*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on to avoid federal tax penalties. Individuals are encouraged to seek advice from their tax or legal counsel. In addition, individuals involved in the estate planning process should work with an estate planning team, including personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.