So, you’re considering setting up a new retirement plan. You’ve heard about traditional defined benefit plans and cash balance plans. But what is the difference? Which plan is best for you?
The first thing to understand is that a cash balance plan is a type of defined benefit plan. So, both plans largely play by the same rules. However, there are some nuanced differences in the formula calculations and how the contributions are presented to participants.
There are certainly pros and cons of each plan design. This article discusses several reasons why cash balance plans are typically preferred over a traditional defined benefit plan design. In fact, we will discuss 7 reasons why cash balance plans are typically the better option for most businesses.
Historically, cash balance plans were more expensive to administer compared to traditional defined benefit plans. But that is not the case anymore. Until plan year 2015, the IRS did not allow cash balance plans to use a “volume submitter” or “prototype” structured plan document.
As such, all cash balance plans were deemed “Individually Designed” and were required to be restated and individually submitted to the IRS for approval once every five years instead of the current requirement of once every six years. As a result, administration costs were higher for individually designed plans and more restatement fees.
In addition, cash balance plans used to carry higher administration fees compared to defined benefit plans because they can require annual nondiscrimination testing to pass testing. They must certify to the IRS that any non-highly compensated employees (NHCEs) are receiving a “fair” benefit amount from the plan.
Most traditional defined benefit plans use what is considered a less flexible safe harbor benefit formula that typically allows larger contributions to employees but will not require much annual nondiscrimination testing to be performed. In the vast majority of situations, the lower fees of a safe harbor traditional defined benefit plan are not offset by the higher employee contributions. This is one big advantage of the cash balance plan.
Custom Group Structure
A big advantage of cash balance plans is that each individual or category of participants can have their own “group” with a custom formula applied. For example, you plan document might say that an owner receives 100% of compensation, then break out managers as a separate group and give them 10%. Lastly, you could give 2% of any remaining participants.
But you can take it one step further. Let’s say your assistant has been with you for 20+ years and you want to reward them for their dedicated service to you. You could put them in their own separate group and give them a 15% pay credit.
As you can see, this provides maximum flexibility in contribution levels and plan customization. Of course, the plan still needs to pass final nondiscrimination testing.
Unfortunately, traditional defined benefit plans don’t allow the carve out of separate groups. It’s one size fits all for the most part.
Age Sensitivity and Disparity
The initial critical demographic to consider is the owner’s age compared to the participants. Define benefit plans (including cash balance plans) are primarily driven by age and compensation. So, they like owners that are older and higher compensated compared to employees that are younger with lower wages. This disparity is typically required to make the economics work.
In fact, these plans are more effective when the business owners are at least ten years older than the youngest employees. The larger the disparity, the better.
The significant difference results from the cost of the oldest employees. With a cash balance plan, the oldest employees can receive (in some situations) the same benefit as the youngest employees. This is typically a percentage of pay or possibly even a flat dollar amount. It is called a “meaningful benefit.”
In a traditional defined benefit plan, the oldest employees cost far more than the youngest employees and don’t increase the amount the owners can put away for themselves. There’s another advantage to the cash balance plan.
Funding for Non-Owner Employees
Most traditional defined benefit plans may utilize a safe harbor formula that substantially avoids nondiscrimination testing. But the downside is that they usually require more money allocated to employees.
This design does not sit well with many small business owners, even though it can provide for lower administration fees. Most owners will gladly pay more for administrative fees when they are allowed a substantial reduction to the employee allocation.
A safe harbor formula means that the same formula binds each employee as any other employee. Some common examples of safe harbor formulas could be:
8% times the high 3-year average W2 compensation multiplied times years of service up to 12 and 300% of high 3-year average compensation reduced by years of service less than 20.
Sort of complex? This can get challenging not just for the employer but for the employee as well. Understanding final benefit amounts can be complicated.
Compare the above formula with the following example cash balance plan formulas:
The owners receive an annual pay credit (or allocation) of $200,000 in a cash balance plan. Non-owner participants receive 2% of compensation in a cash balance plan and 7% in the 401(k) profit-sharing plan.
The owners receive an annual pay credit (or allocation) of 100% of compensation in a cash balance plan. Non-owner employees receive $1,500 in a cash balance plan and 7% of compensation in a 401(k) profit-sharing plan.
Both traditional defined benefit plans and cash balance plans can provide the same maximum contribution amounts. If no safe harbor formula is utilized, both plans can allocate the same employee costs.
However, a safe harbor formula must be used if the goal is to save money on the annual administration fees. The proper plan decision depends on the demographics and other requirements of the business owner.
A traditional defined benefit plan often looks great when designing the plan upfront. The employees may be young and the owner will work another ten plus years. However, as the employee demographics change over time, it often takes more work for business owners, CPAs and financial advisors to understand how the changes impact the plan.
With a cash balance plan, we know the asset value and the plan liabilities and how much is allocated to each employee. As a result, it is easier to take on new shareholders or partners, have them retire, and to revise contribution levels as the goals of the business evolve.
Because cash balance plans are a type of defined benefit plan, some planning is required. But as long as the actuary is notified as circumstances change, there are typically amendments that can be taken to ensure the company’s goals are met.
Plan amendments require employee notification, but that is a relatively easy thing to do. Traditional defined benefit plans may also be amended. But as a result of interest rate and demographic risks, meeting the company’s goals is more complicated.
Ease of Understanding
With a traditional defined benefit plan, the benefit is often determined at normal retirement age and is then guaranteed by the company. But, with a cash balance plan, the benefit is normally defined as the actuarial equivalent of accumulating plan contributions and investment gains. The company then guarantees that amount.
Looking to Get $100,000+ Into Retirement?
We’ll show you the #1 tax and retirement strategy!
If the employees are seeking replacement pay at retirement, a traditional defined benefit plan could be easier to understand. But many employees want a lump sum once they retire or are no longer employed by the business.
In this situation, a cash balance plan is more straightforward to understand. Employees in a cash balance plan will receive an annual account statement showing exactly their account balance and show how it changed from the prior year. To participants, it looks more like a profit-sharing plan with the company proving a guaranteed rate of return.
Asset and Liability Concerns
When a company funds a defined benefit plan, the plan has an asset. When an employee accrues a benefit, this creates a liability. Balancing these assets and liabilities can be a challenge.
Any CPA or financial advisor who has worked with cash balance plans will tell you that keeping the business owner happy is critical. The owner typically desires consistent and predictable annual contributions.
The best way to accomplish this is for the financial advisor to try to match the interest crediting rate (usually around 5%). This way, the investment assets increase consistently with the employee accrued benefits.
This is close to impossible in a traditional defined benefit plan because the government requires the interest rates to be set by the free market. A cash balance plan can mitigate this risk. But it will not eliminate them.
Some cash balance plans use a crediting rate that is the yield on the 30-year treasury bond. This is the same for each employee regardless of age, but it typically changes over the year. It helps keep pace with inflation.
However, if the assets are aggressively invested, they can cause significant problems when they overperform or underperform. Traditional defined benefit plans are required to use “417(e) segment rates,” which are determined by the government and depend on age and corporate bond yields. They also change annually, which makes it difficult for employees and companies to understand.
When deciding whether a cash balance plan or a traditional defined benefit plan is the best for you, you have a few issues to consider. You will find that in most situations, the cash balance plan is the best option in most situations.
Here is a quick summary of why it makes the most sense:
- It has a more flexible design. It allows custom pay credits, which can be revised and amended at any point in the future.
- It provides a hypothetical account balance and presents itself to employees more like a profit-sharing plan. This makes it easier to understand and more straightforward.
- It will typically provide lower contributions for non-employee owners compared to a safe harbor traditional defined benefit plan formula.
- Because a cash balance plan is still a type of defined benefit plan, it will give the same overall benefit to owners.
But when it comes to an owner-only plan or a small company with less than 10 employees, we believe that a cash balance plan is typically the superior option.
But traditional defined benefit plans can work in the following situations.
- For younger owners, you can sometimes get a little more into a plan in the first year (especially with front loading). But this is only temporary as the plan will be very shortly overfunded.
- If you have a large business with 100+ employees, you can save some administration fees using a safe harbor formula. However, you’ll need to consider the overall employee contributions. In some cases, when there are larger companies with many owners who desire a plan design that can meet the individual needs of each shareholder without exposing them to cross-testing issues or associated with traditional defined benefit plans.
We find that the cash balance plan is better design for most clients. But every client situation is different, so you’ll need to look at the business owners’ goals and the plan demographics to ensure you make the right decision.
The good news is that either plan will give you substantial contributions. These contributions will drive large tax deductions along with tax deferred growth.
Fortunately, most administrators will run a plan both ways to see what makes sense for you. But we are confident that in most situations the cash balance plan will prevail.