Cash Balance Plan Formula: Easy 5 Step Process [Video]

I’m going to be honest with you. Cash balance plans can be intimidating. For example, how much do you know about the cash balance plan formula? Also, how are cash balance plan contributions calculated?

You probably don’t know much about it. But the calculation is not as bad as you might think. You just have to understand a few key inputs.

Many business owners just want to maximize contributions so that they can get big tax deductions. But there are certain rules in how pay credits and interest credits impact the contribution.

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Simple Calculation$ Amount
Beginning of year (BOY)$50,000
Established interest crediting rate4%
W2 compensation$100,000
Pay credit20% of comp
End of year (EOY)$72,000

In this post, we will take a look at the cash balance plan pay credit formula. Let’s dive in.

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What is the pay formula used in a cash balance plan?

A cash balance plan is a type of defined benefit plan. Each participating employee receives a hypothetical cash balance account.

Typically, the account balance begins at zero in year one. Interest credits and pay credits are added to the beginning of year hypothetical account balance.

Pay credits are generally expressed as a specified flat percentage of pay or a flat dollar amount. This “credit” is then added to the account each year. But it’s careful to note that the sum of these credits will typically not be the same as the contribution made by the employer to fund the plan.

Cash balance plan formula example

For every year that company employees participate in the plan, they will accrue a benefit based on the formula below:

(Compensation x Pay Credit Rate) + (Interest Credit Rate x Account Balance) = Accrued Benefit

Interest credits are also added to the cash balance account. The rate of interest credited can vary on an annual basis, but the method for determining and allocating it must be specified upfront in the plan document. It is not allowed to be made at the sole discretion of the company.

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The interest rate allocated can be either a fixed rate or tied to an index, such as a Treasury note rate or the consumer price index. The interest rate is allowed to be tied to the actual plan investment return in some cases. Although that can create very volatile results when it comes to testing the plan and lead to volatile annual contribution requirements.

How do the pay credits work?

A wide range of pay credit rates are available. Most plans use a percentage of pay, but a flat dollar amount is allowable. The company decides before plan adoption. It should be analyzed for cost, ease of administration and to ensure that it fulfills the company objectives.

For the benefits to be definitely determinable, the plan document must specify the pay credits. If the plan sponsor ever wants to change the pay credit, it is allowed provided that the anti-cutback rules with regard to the accrued benefit are satisfied.

Examples of pay credits (pay formula) include:

  • $5,000 for each participant
  • 5% of compensation for each participant
  • $1,000 per year of service
  • 4% of compensation for each participant with fewer than 65 points, and 5% of compensation for each participant with at least 65 points. Total points are equal to the sum of age and years of service.

Note that in the last bullet above, a newly hired 45-year-old participant has 45 points. The same person after 10 years of service will be age 55 with 10 years of service resulting in 65 points. Care must be taken, however, so that pay credits that increase with service do not violate the accrual rules against back loading under IRC 411(b).

How are cash balance plan contributions calculated?

Generally, the pay credit is applied to the current year compensation at the end of the year. Eligible current year compensation will be defined in the plan, and could either include or exclude bonus and overtime, just as in a final average compensation defined benefit plan.

cash balance plan formula
cash balance plan formula

Integration with social security is an allowable option when selecting a pay credit structure, whereby benefits are skewed to the higher paid, similar to a traditional defined benefit plan. An example of this is a 6% pay formula credit for compensation above the Social Security Taxable Wage Base, plus a 4% pay credit for compensation below the wage base. There is no safe harbor permitted disparity formula available for cash balance plans, therefore general testing is commonplace.

How is a cash balance plan calculated?

So let’s take a look at an example of how the pay credit formula would work. It’s sounds very complicated but it is not. You don’t have to be a CPA to perform the calculation (although it helps). Here is the 5 step process:

  • Beginning of year account balance is $20,000
  • Interest crediting rate is 5%
  • Compensation (typically the W2) is $100,000
  • Pay credit is set at 4% of pay
  • End of year account balance is ($20,000 × 1.05) + ($100,000 × 4%) = $25,000

The hypothetical cash balance accounts are just a bookkeeping measure used to keep track of each participant’s accrued benefits. They do not directly tie to the actual plan assets.

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A cash balance plan is a type of defined benefit plan. The accrued benefits are not solely determined by the value of assets in a specific allocated account. As a defined benefit plan, the company contributions will be calculated using actuarial assumptions. The underlying asset value will generally differ from the sum of all the participant accounts.

Here is another calculation of the pay formula in the table below:

Beginning of the year$60,000
Interest crediting rate in plan document5%
Pay credit10% of pay
End of year$73,000

How does the cash balance plan formula work?

Should the cash balance plan be a converted from an existing defined benefit plan, the participant’s account balance would be the sum of the former accrued benefit plus any earned benefit from “post” conversion service that uses the cash balance plan formula. Conversions must also preserve any accrued benefit with the future service creating cash balance account additions using pay credits and interest credits.

Cash balance plans require companies to optimize investments for the benefit of the plan participants. The investment strategies and goals should be carefully analyzed (at a minimum on an annual basis) to determine any shortfalls. Companies should avoid unanticipated contributions or shortfalls by doing thorough research on asset allocation, pay credits, and interest crediting rate.

A new cash balance plan (one that is not a converted) can fortunately grant past service credit that would be in the form of an opening cash balance account. This can be a tremendous benefit in the first year of set up.

What about the interest rate?

Plans do have a stated interest rate credit. In reality, the plan sponsor can invest the assets as they see fit. As long as there is not too much volatility in the investment returns, there will not be that much of an impact on annual contribution amounts.

But be careful with big swings. If the plan invests in speculative stocks and suffers a big decline, you will generally see larger contributions in future years. On the contrary, if there are large investment returns the result may be lower future contributions.

How to calculate a cash balance plan contribution:

  1. Start with the beginning account balance

    Your starting account balance is critical because your interest crediting rate is applied against this amount. Your final valuation reports from the prior year will contain all account information.

  2. Determine the interest crediting rate

    Most interest crediting rates are 5%. This rate is standard because it is most representative of market returns and also will help pass testing when additional employees are involved. Multiply the beginning balance times this amount with a 1 in front. For example, 1.05.

  3. Obtain the W2 compensation

    Assuming the company is a C-Corp or an S-Corp, you need to obtain the W3 (a summary of the W2s). This will have all employee compensation and becomes a basis for the pay credit calculation. Compensation must be analyzed first before you apply the pay formula.

  4. Determine the annual pay credit

    This is specified in the plan document and will usually be a set percentage of pay. In most cases this will be a nominal amount like 4%. What is the pay formula used in a cash balance plan?

  5. Calculate the final amount

    The ending balance is calculated as follow: (Beginning balance × 1.05) + (W2 compensation × 4%). This assumes that all employees are eligible and included in the calculation and the pay formula.

What investments are suitable in a cash balance plan?

The investment options available in a cash balance plan are typically limited to low-risk, fixed-income investments, such as bond funds and stable-value funds. This is because cash balance plans are defined benefit pension plans, which means that the employer is responsible for funding the retirement benefits promised to employees. As a result, the plan’s investments are typically focused on preserving capital and providing a stable, predictable rate of return.

Here are some common investment options in a cash balance plan:

  1. Bond funds: Bond funds invest in a diversified portfolio of fixed-income securities, such as corporate bonds, government bonds, and municipal bonds. Bond funds offer a relatively stable rate of return and can be a good option for cash balance plans.
  2. Stable value funds: Stable value funds are a type of investment vehicle that seeks to provide a steady, predictable rate of return by investing in a diversified portfolio of fixed-income securities and other low-risk investments. Stable value funds can be attractive for cash balance plans due to their relative stability and low risk.
  3. Money market funds: These funds invest in short-term, highly liquid debt securities, such as treasury bills and commercial paper. Money market funds offer a low level of risk and can be a good option for cash balance plans.

Overall, the investment options available in a cash balance plan are typically limited to low-risk, fixed-income investments that are designed to preserve capital and provide a stable, predictable rate of return. It is important for employers and employees to carefully review the investment options available in the plan and consult with a qualified financial professional to determine the best investment strategy for their needs.

Bottom line

So there you have it. The cash balance plan formula is spelled out in plain english. Don’t be intimidated. Setting up a plan may be a great business and retirement decision for you.

Just make sure that you discuss and review with your CPA and TPA so that you can adequately plan your contribution. As always, if there are any questions that you may have, we’re here to help.

Paul Sundin

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