Cash Balance Plan Example Calculation: The Simple Process

You’ve probably heard by now that cash balance plans are complex. The calculation itself can be very challenging, even for a CPA like me.

In fact, if you want something straightforward, you can stick with a 401(k) or another defined contribution plan. With those plans, you have a maximum annual amount you can contribute, and it doesn’t matter whether or not your assets go up or down.

However, a cash balance plan is a little bit more involved. The complexity is a trade-off for the large plan contributions.

The goal of this post is to provide:

• a straightforward and basic plan calculation;
• an illustration of an initial targeted amount;
• an application of the plan formula to calculate a contribution range; and
• an examination of the impact of investment returns on plan funding.

But please realize that I am not an actuary. My goal is to give you some general guidance as to how contributions are calculated.

I am simplifying the calculation for illustrative purposes. But an actuary can give you a more detailed explanation of the calculation.

So make sure if you have specific questions you reach out to your administrator. Let’s get started.

Some Basics

First, some basics. A cash balance plan is in the defined benefit plan family. As such, the goal is to calculate a contribution that will provide a benefit for a plan participant at retirement.

You may be aware that cash balance plans provide funding ranges. When the actuary provides funding levels for a given year, you will receive the following:

• Target amount
• Minimum amount
• Maximum amount

The target amount is the amount you should contribute to “true-up” or make the accrued benefit at a point in time the exact amount that is actuarily required.

But most people will not contribute the target amount. Fortunately, the IRS allows for a minimum contribution and a maximum contribution. While the targeted amount is the recommended amount, in reality, you can fund anything within the range and still be compliant.

The plan document will also specify the following:

• Pay credit (flat dollar or percent of salary)
• Interest crediting rate

In most situations, the pay credit will be a percentage of salary. The interest credit rate (or “ICR”) is usually a fixed rate of 5% (or something close).

So, now that you have some basic information, how is the annual funding range calculated? That’s what I will walk through in a very basic example and show you how this contribution would work.

Plan Assumption Example: Target Funding

So, let’s look at the first step: calculating the target. First, assume that a business owner has an S-Corp and is the only employee. The table below summarizes the plan requirements and amounts:

You can use a beginning of year or end of year valuation. We typically use an end of year valuation and that will be used in this example. As such, for valuation purposes, the pay credit occurs on December 31st, so no interest credit occurs in year one (except when using prior service with an initial opening balance).

We will assume that the company opens up the plan on January 1st of the first year and contributes the amount of $100,000 on December 31st of that year. This is the target calculation based on the plan formula as illustrated above.

At the end of the year (December 31st), the owner/employee would have a hypothetical account balance of $100,000. As such, the year end account balance will equal the year one pay credit. See the table below:

You can have a fixed contribution amount in year one. In fact, you could even have a fixed contribution amount throughout the life of the plan (subject to testing). But for simplicity, we have used the above amounts.

Hybrid plan

It is important to note that a cash balance plan is a “hybrid” plan. The hypothetical account balance is the amount the owner is entitled to if he or she left the company (vesting aside).

But remember, there is a disconnect between the investment account and the hypothetical account balance. That’s because it is virtually impossible for an investment return to exactly match 5%.

Let’s assume that the owner invested the entire account balance in stocks. This 100% equity allocation is not recommended and is not something any client should do. The goal is generally to mimic the interest crediting rate of 5%.

But as the client is the plan’s trustee, they can certainly use this asset allocation if they want. However, it can result in significant plan volatility.

Investment volatility

Remember that the year one contribution of $100,000 is assumed to be made on December 31st. Let’s now assume the entire account balance went down by 30% during year two. So, if the owner puts all $100,000 into stocks, the balance at the end of the year is $70,000. Take a look at the table below for year two:

This excludes the year two contribution because that is assumed to be made on December 31st, with no investment return. There is a shortage in the account of $30,000. What happens to this, and how does this affect future contributions? I’ll explain.

With an underfunded amount, we’re going to roll the calculation into the year two contribution. Do you have to make up that entire shortfall in year two, or do you have additional time?

Year Two Calculation Example

Now let’s calculate year two’s target, minimum, and maximum amount.

Let’s assume the same information in year two as in year one. The owner has the same W-2 of $100,000, which results in a 100% pay credit of $100,000.

The only difference is that the actuary now has to consider the ending year two investment balance of $70,000 and the $30,000 shortfall.

Calculating the target

In year two, the target contribution will be the amount needed to essentially “true-up” the plan. The goal is to make the target contribution the amount to get the plan asset balance to match the employee’s hypothetical amount.

Here is the year two target contribution:

The target for year two would be the $100,000, plus the shortfall of $30,000, plus the year two interest credit of $5,000. So, the target is $135,000.

Calculating the minimum

Now we need to calculate the minimum. When it comes to the minimum, the IRS allows that $30,000 shortfall to be amortized over 15 years. When you amortize this over 15 years, you get $2,000.

The minimum calculation becomes the $100,000 pay credit noted above, plus the year two interest credit of $5,000 (remember there is no interest credit in year one), plus the $2,000. So the minimum is $107,000. See the table below:

Calculating the maximum

Now it’s time to calculate the maximum contribution. This is a little bit more challenging.

When calculating a maximum, you get more flexibility to the upside. The IRS allows you to contribute up to 150% of the accrued benefit plus the current year accrual.

This is calculated by taking the ending year two balance. The employee is guaranteed a hypothetical balance of $205,000. This would be $100,000 for each of the two years, plus an interest credit of $5,000 in year two.

Then we take that amount and add an add’l 50%. This upside cushion is another $102,500. So the most you can fund would be $307,500.

We then compare this to the balance in the account from the end of the year of $70,000, and you have a maximum contribution that is the difference between those two numbers. This is calculated at $237,500. See the table below:

Final Thoughts

So the final min, max and target calculations are as follows:

As you can see, there is a pretty wide funding range. Assuming you fund towards the target each year this range should get wider as the plan matures.