Cash Balance Plans

A “Cash Balance” Defined Benefit Plan ("DB Plan") is a type of Defined Benefit Plan that appears to participants in many respects to be similar to a Defined Contribution Plan ("DC Plan", such as a Profit Sharing Plan).  However, it is fundamentally still a DB Plan in that it requires an annual actuarial valuation, allows substantially higher contributions, and retains other important underlying features.

How is a Cash Balance Plan like a DC Plan?

One of the principle differences between a traditional DB Plan and a Cash Balance Plan is that the Cash Balance Plan appears to participants to be very similar to a DC Plan (such as a Profit Sharing Plan).  For a Cash Balance Plan, annual contributions are credited to a “hypothetical account” for each participant, and a specific interest rate is credited to that account.

Participant statements are structured like statements for a DC Plan, and include the following items:

  • Beginning balance
  • Contribution credits
  • Interest credits
  • Ending balance

“Contribution credits” are usually defined as either a percentage of that year’s compensation, or a flat dollar amount.

“Interest credits” are based on an index or an amount defined in the plan (but must conform to IRS regulations).

Distributions generally agree with the participant’s hypothetical account balance at the time of distribution.  This allows participants to have a better understanding of the value of their retirement account than with a traditional DB Plan.

How is a Cash Balance Plan like a Traditional DB Plan?

Even though participant statements may appear similar to those of a DC Plan, a Cash Balance Plan is still a type of Defined Benefit Plan.  The participants do not have an actual account under the plan: it is merely a “hypothetical” account.  For this reason, participant-directed investment accounts cannot be allowed.

The investment risk is still borne by the plan sponsor.  The “interest credit” is applied to each hypothetical account without regard to the actual performance of the plan investments.  For this reason, investment performance greater than the interest crediting rate would tend to lower annual contributions; likewise, investment performance less than that rate would tend to require higher annual contributions.

Most traditional DB Plan rules still apply to Cash Balance Plans.  These affect such things as limits on maximum distributions, minimum accrual requirements, Top Heavy contribution requirements, and other factors.

Vesting Schedule
Recent tax law changes have clarified many aspects of Cash Balance Plans.  However, they also introduced a more restrictive vesting schedule for Cash Balance Plans than required for other types of qualified retirement plans.

All Cash Balance Plan participants must be 100% vested after 3 years of plan participation.  For this reason, most Cash Balance Plans are setup with a 3-year “cliff” vesting schedule: 0% vested until the third year of service is accrued, at which time the participant is 100% vested.


Combining a Tiered Profit Sharing Plan & a Tiered Cash Balance Plan

A stand-alone DB Plan (whether traditional or Cash Balance) works best when the owner (and other targeted employees, if any) is substantially older than the rest of the plan participants.

However, for companies with a few older, non-targeted employees, it’s often possible to design a combined Tiered program that minimizes the impact of those older employees. This plan design may result in a high percentage of the annual contributions funding the retirement benefits of the targeted employees.

Cash Balance Plans are usually combined with a Defined Contribution Plan (such as a Profit Sharing Plan or 401(k) Plan).  This is done because contributions to the DC plan result in more favorable testing than if they were made to a stand-alone Cash Balance Plan.  Because of this, the “two plan” approach is much more favorable to the plan sponsor.

This program combines a Tiered Profit Sharing Plan and a Tiered Cash Balance Plan.  The basic contributions under the program begin with the following:

  • The Tiered Profit Sharing Plan allocates a minimum of 7.5% of compensation to the non-targeted employees, and up to the $49,000 maximum to the owners.
  • Non-targeted participants under the Tiered Cash Balance Plan Plan accrue a 0.5% minimum retirement benefit, and up to the DB maximum benefit accrual for the owners.

The plan contributions are subject to special discrimination testing, so the actual formulas will depend on company demographics: in some cases the allocation to the non-targeted employees may be higher.

Plans covered by the PBGC can make a full DC and full DB contribution.  However, for plans not covered by the PBGC (e.g., small professional companies, like medical or dental practices, and law firms), the total company contribution to this program is subject to the DC Plan’s deduction limit of 25% of covered compensation, plus the 6% of covered compensation allowed by PPA (for a total of 31%).  So, this design is not optimal for most small professional companies.

Combining a 401(k) Plan & a DB Plan
The Pension Protection Act of 2006 included provisions that make it even easier for a successful small company to combine a 401(k) with a Defined Benefit Plan (traditional or Cash Balance).

A couple of key items to keep in mind when combining a 401(k) Plan and a DB Plan are:

  • An owner’s salary deferrals under a 401(k) Plan do not affect the DB Plan’s deduction limit.  This could effectively increase the amount the owner could contribute by $16,500 (or $22,000 if age 50 or older) in a properly designed plan.
  • Company contributions of up to 6% of covered compensation may be made to a DC Plan without affecting the DB Plan’s deduction limit.  This PPA ’06 change makes it possible to add a Safe Harbor 401(k) Plan to a traditional DB Plan, even for the micro employer.

There are a number of different configurations of this type of program.  Below are a couple of options.

DB Plan combined with a Safe Harbor 401(k) Plan
On this program, a basic Safe Harbor 401(k) is added to a DB Plan, increasing the owners ability to save for retirement by at least 16,500 (or $22,000 if age 50 or older).

Since the employer contribution to the 401(k) Plan is less than 6% of covered compensation, the 401(k) contributions do not impact the contributions to the DB Plan.

Tiered Cash Balance Plan combined with Tiered Safe Harbor 401(k) Plan
Any employer who is a candidate for the Tiered Profit Sharing Plan combined with the Tiered Cash Balance Plan should consider this option.

Company contributions to this program are the same as the non-401(k) options, but the Safe Harbor 401(k) provisions increase the owners ability to save for retirement by 16,500 (or $22,000 if age 50 or older) in most cases.