What is the difference between a cash balance plan and a 401(k) 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. A 401(k) plan is a defined contribution plan that allows employees to make contributions on a pre-tax or even after-tax basis, depending on the plan rules.

How does a cash balance plan work?

In a cash balance plan, each participant has an individual account balance that is credited with a fixed percentage of their pay each year, as well as additional credits based on the investment returns on the plan’s assets. The employer may also make contributions to the plan on behalf of the employee.

When an employee retires or leaves the company, they can typically choose to receive their benefits in the form of a lump sum payment or an annuity. An annuity is a payment that is made to the employee on a regular basis, typically monthly, for a specified period of time or for the remainder of the employee’s life.

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The benefits that are paid out from a cash balance plan are typically based on the employee’s account balance at the time they retire or leave the company. This balance is calculated by adding up all the contributions that have been made to the account, as well as any investment returns earned on those contributions.

It is important to note that the terms and conditions of a cash balance plan can vary, and it is important for employees to understand the specific details of their plan. Employees should also be aware that cash balance plans are subject to certain legal requirements, including minimum funding requirements and vesting schedules.

What is the difference between a cash balance plan and a 401(k) plan?

Here are some key differences between a cash balance plan and a 401(k) plan:

  1. Employer contributions: In a cash balance plan, the employer must contribute a fixed amount, or “cash balance,” to an account for each employee, which earns a guaranteed rate of return. In a 401(k) plan, the employer may make matching or non-elective contributions, but these contributions are not guaranteed.
  2. Employee contributions: Employees in a cash balance plan do not contribute to their own account. In a 401(k) plan, employees can choose to make contributions on a pre-tax or after-tax basis, subject to certain limits.
  3. Investment options: Cash balance plans typically offer a limited range of investment options, and the investment earnings are credited to the account balance based on a guaranteed rate of return. 401(k) plans generally offer a broader range of investment options, and the investment earnings are credited to the account balance based on the performance of the investments.
  4. Portability: Cash balance plans offer portability, which means that employees can take their account balance with them if they leave the company. 401(k) plans offer portability, but the account balance may be subject to vesting requirements.
  5. Complexity: Cash balance plans can be complex and may involve many legal and regulatory requirements. 401(k) plans are generally less complicated and may be easier to administer.

Overall, cash balance plans and 401(k) plans are both retirement benefit options that offer advantages and disadvantages for both employers and employees. Employers and employees should carefully consider these plans’ features and terms to determine which is best suited to their needs.

What is an actuary?

What does a cash balance plan actuary do? A cash balance plan actuary is a professional trained in evaluating financial risks and designing, implementing, and administering pension and other employee benefit plans. Actuaries use mathematical and statistical techniques to assess the financial implications of different plans and investments and recommend appropriate courses of action.

In the context of a cash balance plan, a cash balance plan actuary may be responsible for many tasks, including:

  1. Evaluating the financial risks associated with the plan, including the impact of plan design and investment options on the plan’s funding levels and long-term sustainability.
  2. Develop and test plan designs to ensure they meet the legal and regulatory requirements of cash balance plans.
  3. Recommending appropriate investment options for the plan and monitoring the performance of the plan’s investments.
  4. Calculate the plan’s pay formula, which determines the employer’s contribution to each employee’s account balance.
  5. Providing ongoing support to the plan administrator and employer in the plan’s administration, including preparing and reviewing actuarial reports, analyzing plan data, and responding to employee inquiries.

Overall, a cash balance plan actuary plays a critical role in designing and administering a cash balance plan, providing expertise and guidance on financial and actuarial matters related to the plan.

Bottom Line

A cash balance plan can be a good option for retirement planning for several reasons:

  1. Portability: Employees can take their account balance with them upon leaving the company, which is not always possible with traditional defined benefit pension plans. This can be especially helpful for employees who change jobs frequently.
  2. Predictability: The fixed credits that are added to a participant’s account balance in a cash balance plan can provide a level of predictability in terms of retirement savings. This can be helpful for employees who want to have a clear idea of how much they will have saved for retirement.
  3. Employer contributions: Employers typically contribute to cash balance plans, which can help employees save more for retirement. These contributions can be a significant source of retirement income for employees.

Overall, a cash balance plan can be a useful tool for retirement planning, especially for employees who value predictability in their retirement savings. It is important for employees to understand the terms and conditions of their cash balance plan, as well as the potential risks and benefits of participating in the plan.

Paul Sundin

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