Underfunded Cash Balance Plan: What is it and How to Correct

By now you probably understand why cash balance plans can be such great retirement vehicles. But you may have heard that they can become underfunded and overfunded. Specifically, underfunded cash balance plans can often be an issue.

With the growth in cash balance plans in recent years, funding issues can often arise. It’s critical that the administrator and CPA review the plan to make sure that funding is in line.

This post will address underfunded plans. In addition, will give you some options to resolve the funding issue. Let’s jump in.

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What makes a cash balance plan so special?

Cash balance plans have gained popularity for several reasons:

  1. Portability and Flexibility: Cash balance plans offer more portability and flexibility compared to traditional defined benefit plans. Participants have individual accounts that they can take with them if they change jobs or retire early. This portability makes cash balance plans attractive to mobile workforces and individuals seeking greater control over their retirement savings.
  2. Hybrid Structure: Cash balance plans are a hybrid between defined benefit and defined contribution plans. They provide the security of a guaranteed benefit, like a traditional pension, but also allow participants to track the growth of their individual accounts, similar to a 401(k) plan. This hybrid structure can appeal to both employers and employees, as it balances risk and provides retirement income stability.
  3. Age-Neutral Design: Unlike traditional defined benefit plans, cash balance plans are age-neutral in their benefit structure. Instead of heavily favoring long-term employees, they provide benefits that grow with each year of service, regardless of age. This design can be appealing to younger employees and those who may not have long careers with a single employer.
  4. Contribution Flexibility: Employers have more flexibility in setting the contribution levels for cash balance plans. They can contribute a fixed percentage of an employee’s salary, which provides predictability and control over retirement plan costs. Additionally, employers can adjust the interest credit rate to manage plan funding levels and meet their financial objectives.
  5. Tax Advantages: Cash balance plans offer tax advantages for both employers and employees. Employer contributions are tax-deductible, and the plan’s investment earnings grow tax-free. Employees can also benefit from tax-deferred growth on their individual account balances until retirement.
  6. Supplementing Retirement Savings: Cash balance plans can serve as a valuable tool for high-income individuals to supplement their retirement savings. Since contributions are based on a percentage of salary, those with higher incomes can accumulate significant retirement assets within the plan.

Overall, cash balance plans provide a balance between the security of a defined benefit plan and the flexibility and portability of a defined contribution plan. These features have contributed to their popularity among employers and employees seeking retirement plan options that meet their diverse needs.

What is an underfunded cash balance plan?

An underfunded cash balance plan is a type of retirement plan with insufficient funds to meet the promised benefits to participants. A cash balance plan is a specific defined benefit pension plan that combines elements of both traditional pension plans and defined contribution plans.

In a cash balance plan, an employer contributes a percentage of an employee’s salary into an individual account, along with an annual interest credit based on a specified rate or an investment performance. The account balance grows over time, similar to a defined contribution plan like a 401(k).

However, the employer guarantees a specific payout upon retirement, usually expressed as a percentage of the final average salary. When a cash balance plan is underfunded, the plan’s assets are insufficient to cover the accumulated benefit obligations to plan participants. This happens due to factors such as poor investment performance, inadequate employer contributions, or unexpected increases in the promised benefits.

What happens if a plan is underfunded?

Underfunding in a cash balance plan can lead to financial challenges for both the plan participants and the sponsoring employer. Participants may receive reduced benefits or face uncertainty regarding the full payment of their retirement benefits. Employers may need to make additional contributions to the plan to address the underfunding, which can strain their financial resources.

Underfunding of pension plans, including cash balance plans, is regulated by government authorities such as the Pension Benefit Guaranty Corporation (PBGC) in the United States. These authorities may impose penalties and require corrective actions to address the underfunding and protect the interests of plan participants.

CalculationAmount
Beginning of year$30,000
Interest crediting rate6%
W2 Compensation$120,000
Pay credit75% of comp
End of year$121,800

Final thoughts

In conclusion, underfunded cash balance plans present significant challenges for both plan participants and sponsoring employers. When a cash balance plan lacks sufficient funds to meet promised benefits, it can lead to reduced retirement benefits for individuals and uncertainty about the full payment of their accrued benefits. This can have a negative impact on employees’ financial security in their retirement years, potentially disrupting their retirement plans and lifestyle.

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For sponsoring employers, underfunding in cash balance plans can create financial burdens. They may be required to make additional contributions to address the underfunding, putting a strain on their resources and potentially affecting their ability to invest in other areas of their business. Additionally, underfunded plans may face regulatory scrutiny and potential penalties, further complicating the situation for employers.

To address underfunded cash balance plans, it is crucial for employers to proactively monitor and manage the funding levels of their retirement plans. Regular assessments, appropriate contributions, and sound investment strategies can help mitigate the risk of underfunding. Similarly, employees should stay informed about the financial health of their retirement plans and engage in retirement planning beyond just relying on employer-sponsored plans, such as building personal savings and exploring other investment options.

Overall, addressing underfunded cash balance plans requires collaboration between employers, employees, and regulatory authorities to ensure the long-term viability and security of retirement benefits. By implementing prudent funding practices, maintaining open communication, and taking proactive measures, the negative impact of underfunding can be minimized, enabling both employers and employees to achieve their retirement goals.

Paul Sundin

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