It should be no surprise that we’re big fans of retirement plans. In this post, we will review the cash balance plan vs. a traditional pension plan. This issue comes up a lot.
The typical pension structure or cash balance plan will give you much higher than contributions than any type of defined contribution plans. This is especially true if you’re looking to contribute $100,000 a year or more.
We will point out a few differences with these plans. But there are more similarities than there are differences. It’s just a matter of selecting a plan that works best for you and your situation. Let’s jump in.
What is a cash balance plan?
A cash balance plan is a defined benefit pension plan that combines elements of traditional defined benefit plans with those of defined contribution plans, such as 401(k)s. In a cash balance plan, the employer contributes a fixed amount, or “cash balance,” to an account for each employee, earning a guaranteed return rate. The employee’s account balance is portable and can be taken with them if they leave the company.
Cash balance plans can be an attractive retirement benefit option for professional practices such as law, accounting, and consulting firms. These practices often have a high percentage of highly compensated employees, and cash balance plans can provide a way to offer a retirement benefit that is disproportionately favorable to these employees.
To establish a cash balance plan for professional practice, the employer must work with a TPA to develop the plan document, choose investment options, and enroll employees. It is essential to carefully review the plan’s terms and ensure it complies with all relevant laws and regulations.
Employees in professional practice will need to contribute a portion of their salary to the cash balance plan, and the employer will make additional contributions based on the pay formula for the plan. The investment gains and losses on the account balance are tax-deferred, allowing employees to save on taxes until retirement.
A cash balance plan can be a valuable retirement benefit option for professional practices, offering security, portability, and potential for higher returns.
What is a traditional pension plan?
A traditional pension plan is a type of retirement plan that provides a guaranteed income to employees during their retirement years. Also known as a defined benefit plan, a traditional pension plan is sponsored by an employer and is designed to provide retirement benefits based on a formula that considers factors such as the employee’s length of service, age, and salary history.
Under a traditional pension plan, the employer is responsible for contributing funds into a pension fund, which is then invested to generate returns. These returns are used to pay out retirement benefits to employees who are eligible to receive them. The retirement benefit amount is predetermined based on the formula, and the employee does not have to contribute to the plan.
One of the critical features of a traditional pension plan is that the employer bears the investment risk. If the investments do not perform as expected, the employer is still responsible for paying out the promised benefits to retirees. Another feature is that the benefits are generally paid out in the form of a lifetime annuity, which means that the retiree will receive a regular monthly payment for the rest of their life.
What are the plan differences?
When most people think of a traditional pension plan, they are actually thinking of a defined benefit plan. These plans were historically set up by large companies with thousands of employees. The intent was to provide them with an income stream upon retiring.
Many people need to realize, though, that a cash balance plan is actually a type of defined benefit plan. As such, cash balance plans are driven by many of the same rules and requirements. They act like social security because you get a consistent income stream until you pass away.
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Cash balance plans have been more common in recent years than traditional pension plans. This is because many companies have terminated or gone away from large pension plans. This is because there are cost uncertainties, and the company guarantees the payment stream. This puts the financial risk on the company.
For this reason, many companies have shifted to defined contribution plans. With a defined contribution plan like a 401(k), the company will make a matching contribution to the plan. That is their only financial outlay. It is the participant’s requirement to manage the funds and distribute them upon retirement. Once the company makes the employer contribution, they no longer have a financial commitment to the employee.
Is a cash balance plan better than pension?
Cash balance plans have become popular in recent years with small businesses. While they act very similarly to a traditional pension plan, they have a few benefits and differences compared to a traditional pension structure.
- Cash balance plans are called hybrid plans because they present themselves like a defined contribution plan. In fact, each plan participant has a stated account balance. When they leave the company, they can take that balance with them and roll it over into an IRA, assuming they are fully vested.
- Cash balance plans tend to have more flexible funding requirements. The plan can be customized using an employee, pay credit, and interest credit. As a result, the company can customize these plans more than a traditional pension.
- Cash balance plans will allow the company to break out individual participants or even groups of employees into separate groups. Each group can receive a custom benefit allocation. So you can reward participants in certain groups with higher benefit allocations. This helps the company customize a plan that meets its financial goals.
What are the advantages of a cash balance plan?
A cash balance plan is a defined benefit pension plan that combines elements of traditional defined benefit plans with those of defined contribution plans, such as 401(k)s. Cash balance plans offer some advantages for both employers and employees.
Here are a few of the advantages of a cash balance plan:
| Predictability | Cash balance plans offer employers and employees a predictable, long-term retirement plan. The employer’s contributions to the plan are based on a predetermined formula, which helps to ensure that the plan is financially stable and able to meet its obligations to employees. |
| Portability | Cash balance plans are portable, meaning employees can take their investment balance when they leave the company. This can attract younger employees who may change jobs more frequently. |
| Flexibility | Cash balance plans offer high flexibility, as you can customize them to meet employers’ and employees’ needs. For example, the employer can choose the plan’s pay formula and investment options, and employees can decide how to receive their benefits when they retire. |
Cash balance plans offer many advantages for employers and employees, including predictability, portability, tax benefits, and flexibility. It is critical for employers and employees to carefully review the features and requirements of a cash balance plan and to consult with a qualified professional to determine whether it is the right fit for their needs.
Administrative Plan Costs
Defined contribution plans will have minimal administration costs. For further context, most online brokers, typically compensated through your purchased investments, will assist with opening a Solo 401k. Administration fees will, however, be applied should you have employees (other than a spouse). If so, a third-party administrator is the most inexpensive option. Standard plans will offer a lower administration fee but can require you to provide employees with higher benefits.
| Advantages | Disadvantages |
|---|---|
| Tax-Deferred Investment Growth | Complex Plan Design |
| Rollover to 401(k) or IRA | Mandatory Funding |
| Flexible Contributions ($100k+) | Permanent Plan Rules |
| Large Tax Deductions | High Admin Fees |
In contrast to a defined contribution plan, defined benefit plans require an actuary to assess and certify the annual contribution and the highest deductible contribution. As a result, this causes defined benefit plans to be more expensive (typically costing upwards of $2,000 to $3,000 per year for a smaller plan). This is usually worth the cost if you can deduct over $100,000 annually.
Cash Balance vs. Traditional Pension Plan
Cash balance plans are becoming increasingly popular among employers for a variety of reasons, including:
- Predictable benefits: Cash balance plans provide employees with a predictable retirement benefit, which can be easier to understand and plan for compared to traditional pension plans or defined contribution plans such as 401(k)s. The benefit formula for a cash balance plan is typically based on a percentage of pay and years of service, which allows employees to calculate their expected retirement benefit.
- Portability: Cash balance plans are more portable than traditional pension plans because the benefits are typically paid out as a lump sum at retirement. This means that employees can take their retirement benefits with them if they leave their current employer rather than waiting until retirement age to receive their benefits.
- Low investment risk: Cash balance plans are typically designed to provide a guaranteed return on investment, which means that the employer bears the investment risk rather than the employee. This can be an attractive feature for employers who want to offer a retirement plan that is less risky than a traditional pension plan.
- Tax benefits: Cash balance plans offer tax benefits for both employers and employees. Employers can deduct contributions to the plan as a business expense. Employees can defer taxes on their contributions and investment earnings until retirement, when their tax rate may be lower.
- Higher contribution limits: Cash balance plans allow for higher contribution limits than traditional pension plans or defined contribution plans such as 401(k)s. This can attract high-income employees who want to maximize their retirement savings.
Final thoughts
What if you had a strategy that allowed you to get $3 million into retirement? It might make sense to understand the details.
These plans can be challenging to understand but can be a home run for the right business owner. That’s why we call them the best retirement strategy.
