A cash balance plan is often described as a defined benefit plan that “looks like” a 401(k). The reason is the hypothetical account balance, which is the number shown on your annual statement.
It feels like an account you own, with a balance that grows each year. But it is not a separate investment account with your name on it.
This explains why two owners in similar businesses can see very different “balances” in the same year. In this article, we’ll break down what the hypothetical account balance is and how it works in plain English.
Background
The hypothetical account balance is a bookkeeping calculation built into the plan document. It typically grows through two credits:
- Pay credit; and
- Interest credit.
The pay credit is the amount the employer allocates for the year. The interest credit is a stated rate or formula that increases the balance over time.
An important concept to understand about cash balance plans is that, as stated earlier, the hypothetical accounts are just that; there is no actual account for any participant.
The plan defines the participant’s benefit in terms of an account, and that is how it is communicated to participants. But the “account” is simply the plan formula working to determine the participant’s benefit, stated as a present value.
Understanding this balance matters because it is the foundation for your benefit and the plan’s funding decisions. It impacts how contributions are projected, how benefits are communicated, and what you can take if you retire or terminate employment.
Cash Balance Plan Hypothetical Account Balance
The hypothetical account is credited with hypothetical employer contributions, usually referred to as pay credits, and the hypothetical earnings on the prior balance, usually referred to as interest credits. The use of the word “credit” can help distinguish cash balance plans from defined contribution plans.
In defined contribution plans, the employer makes actual contributions to the plan and allocates them to a participant’s account, which then grows or declines based on investment gains or losses.
None of that happens in a cash balance plan. In a cash balance plan, the formula defines a pay credit that is added to a hypothetical account, which then accumulates interest credits at a rate specified in the plan document.
An actual contribution to the cash balance plan equal to the amount of the pay credit is not required, and even if a contribution equal to that amount is contributed, it is not allocated to a separate account for the participant.
Interest Crediting Rates
In addition, the interest credits do not equal the actual investment returns on the pay credit amount. Rather, they are calculated using a formula specified in the plan.
The plan’s investment policy may take the plan’s interest crediting rate into account (e.g., a more conservative interest crediting rate may result in a more conservative investment policy), but the plan assets need not be invested in the assets used to determine the plan’s interest crediting rate.
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For example, a cash balance plan with an interest crediting rate based on the yield of 30-year Treasury bonds does not have to be invested in 30-year Treasury bonds.
Typical Scenario
For our assumed participant, if the employer sponsors a cash balance plan with a hypothetical pay credit of 5% of pay, the participant’s hypothetical account balance will be credited with a $5,000 pay credit ($100,000 salary x 5%), and grow based on the plan’s specified interest crediting rate.
If the interest credit is 5%, that is what will be credited to the account regardless of the plan assets’ actual investment return. For this purpose, it does not matter how plan assets actually perform, and the employer may have to make additional contributions if the plan’s investment return is less than the plan’s interest crediting rate.
IRS guidance indicates that future interest credits are “earned” when the pay credit is earned. In other words, when a pay credit is earned with service in Year 1, and the plan document indicates that the plan’s interest crediting rate is the yield on one-year Treasury bills, the participant is entitled to receive credits to the hypothetical account based on the one-year Treasury bill until the account is ultimately distributed. This means that the interest crediting rate cannot be changed for hypothetical account balances that have already been earned, unless the IRS anti-cutback rules are satisfied.
Another important concept is that, because a cash balance plan is a type of defined benefit plan, the normal form of payment under the plan must be an annuity (a single-life annuity for an unmarried participant or a qualified joint and survivor annuity for a married participant).
The key difference between a cash balance plan and a traditional defined benefit plan is how the lump-sum value is determined. In a cash balance plan, the lump-sum value is the hypothetical account balance.
This account balance is converted to an annuity if the participant does not elect a lump-sum payment. In a traditional defined benefit plan, the normal retirement benefit is expressed as an annuity. The benefit must be converted to a lump-sum value, and the conversion rate cannot exceed the IRC §417(e) rate.
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Sample Cash Balance Plan Participant Hypothetical Account Balance
| Age | Pay credit | Annual Accrual (Each Year’s Pay Credit plus Interest to Age 65) | Hypothetical Account Balance |
|---|---|---|---|
| 35 | $10,000 | $57,435 | $10,000 |
| 36 | $10,000 | $54,184 | $20,600 |
| 37 | $10,000 | $51,117 | $31,836 |
| 38 | $10,000 | $48,223 | $43,746 |
| 39 | $10,000 | $45,494 | $56,371 |
| 40 | $10,000 | $42,919 | $69,753 |
| 41 | $10,000 | $40,489 | $83,938 |
| 42 | $10,000 | $38,197 | $98,975 |
| 43 | $10,000 | $36,035 | $114,913 |
| 44 | $10,000 | $33,996 | $131,808 |
| 45 | $10,000 | $32,071 | $149,716 |
| 46 | $10,000 | $30,256 | $168,699 |
| 47 | $10,000 | $28,543 | $188,821 |
| 48 | $10,000 | $26,928 | $210,151 |
| 49 | $10,000 | $25,404 | $232,760 |
| 50 | $10,000 | $23,966 | $256,725 |
| 51 | $10,000 | $22,609 | $282,129 |
| 52 | $10,000 | $21,329 | $309,057 |
| 53 | $10,000 | $20,122 | $337,600 |
| 54 | $10,000 | $18,983 | $367,856 |
| 55 | $10,000 | $17,908 | $399,927 |
| 56 | $10,000 | $16,895 | $433,923 |
| 57 | $10,000 | $15,938 | $469,958 |
| 58 | $10,000 | $15,036 | $508,156 |
| 59 | $10,000 | $14,185 | $548,645 |
| 60 | $10,000 | $13,382 | $591,564 |
| 61 | $10,000 | $12,625 | $637,058 |
| 62 | $10,000 | $11,910 | $685,281 |
| 63 | $10,000 | $11,236 | $736,398 |
| 64 | $10,000 | $10,600 | $790,582 |
| 65 | $10,000 | $10,000 | $848,017 |
Bottom Line
A cash balance plan’s hypothetical account balance is the core number that drives everything else in the plan. It tracks the pay credits you receive each year plus the plan’s interest credits. It is called “hypothetical” because it is a bookkeeping balance, not a separate investment account. Your actual plan assets are pooled and invested for the plan as a whole.
This balance matters because it determines what you have earned, what must be disclosed on statements, and what you can take when you leave or retire. If the plan uses a variable interest crediting rate, your hypothetical balance can rise faster in strong markets and slow in weak ones.
If the plan uses a fixed rate, the balance grows more predictably, but the employer may need to contribute more when investment results lag. Either way, the plan’s funding and your benefit are tied to how that hypothetical balance is calculated.
The best step is to review the plan document and your annual statement together so you understand what is being credited and why. Confirm the pay credit formula, the interest crediting method, and how forfeitures or expenses are handled.
If you are planning a big contribution year, ask for an updated illustration before funding. When you understand the hypothetical account balance, you can make smarter decisions about contributions, cash flow, and long-term retirement planning.
