By now you may understand that defined benefit plans are a great tax and retirement tool. But you may have heard how great cash balance plans are. So what is the difference? Are they the same thing? In this post, we will look at the defined benefit vs cash balance plan.
So first let’s take a look at a defined benefit plan. A defined benefit plan (often called just a “DB plan”) typically provides a monthly benefit payable upon retirement. The plan document states a benefit formula that describes the amount of benefit to be paid.
In addition, the document contains provisions describing the age that the benefit will be paid and the form(s) in which the benefit can be paid. The plan is funded using a method chosen by the plan actuary, using assumptions picked such that they will reasonably fund the retirement benefit.
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In other words, the actuary needs to determine an annual contribution to the plan such that there will be enough money at retirement age to pay for the monthly benefit. Based upon the assumptions and method chosen, there is a minimum funding requirement each year.
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What is the difference between a cash balance plan and a defined benefit plan?
OK so now that we have discussed what a defined benefit plan is let’s take a look at cash balance plans. The truth is that a cash balance plan is a type of defined benefit plan. I typically use the phrases interchangeably. But that isn’t completely accurate. There are some key differences.
So even though a cash balance plan is a type of defined benefit plan it is really called a “hybrid” plan. The plans have features of both defined benefit and defined contribution plans.
A cash balance plan is a defined benefit plan, because the benefit is not determined solely by the account balance for each participant. However, to a participant, it appears to work much like a defined contribution plan because a hypothetical account balance is maintained for each participant. This hypothetical account balance is not an allocated share of the plan’s assets; rather it is an accounting device.
The plan provides for a specified accrual to this account (as a percentage of pay) and a specified rate of interest earnings to be credited to the account each year.
Advantages of cash balance plans?
We will typically use a cash balance plan for smaller companies and defined benefit plans often work better for larger companies. Defined benefit plans can also work better under certain circumstances like prior service adjustments.
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So let’s take a look
- Value stated like a 401k. The benefit in a cash balance plan is stated in such a way that the participant can easily understand its value.
- Easier to understand. Participants may more easily project lump-sum distribution amounts in a cash balance plan.
- Lump sums. Providing lump sums makes the pension benefit more transportable when employees change jobs. (Traditional plans do not always offer lump sums).
- Easily amended. If an employer already sponsors a traditional defined benefit plan, but would prefer an account balance based benefit, the existing defined benefit plan can be amended. Terminating the defined benefit plan in order to establish a profit sharing plan could involve significant complexity if the defined benefit plan is overfunded or underfunded.
- Funding flexibility. A new cash balance plan can be appealing in a company with two owners or partners of different ages with similar compensation since each can receive comparable accruals each year (as they would under a defined contribution plan). Yet they can enjoy the tax benefits of the higher contribution levels permitted under a defined benefit plan. Under a traditional defined benefit plan, the older owner or partner generally would receive accruals with significantly higher value.
- Easy termination process. An advantage to the sponsor of a cash balance plan is the transparency of the since participants receive their account balance and the amount received will not increase unexpectedly due to a drop in interest rates.
Cash balance Plan Formula
In a cash balance plan, the pay formula determines the amount of money credited to an employee’s account each year. The pay formula typically consists of two components: an employer contribution and a guaranteed rate of return.
- Employer contribution: The employer contribution is a fixed amount to the employee’s account each year. This contribution is typically a percentage of the employee’s salary, and the employer sets it.
- Guaranteed rate of return: The guaranteed rate of return is the rate of return that the employer guarantees on the employee’s account balance. This rate is typically based on a formula that includes a fixed interest rate and other factors, such as the yield on long-term corporate bonds.
The pay formula for a cash balance plan is usually expressed as a percentage of the employee’s salary. For example, an employer may contribute 5% of the employee’s salary to their account each year, plus a guaranteed rate of return of 3%. In this case, the pay formula would be 8% (5% + 3%).
It is important to note that the pay formula for a cash balance plan can vary from one plan to another. Employers can customize the pay formula to meet the needs of their business and their employees. Employees should carefully review the terms of their cash balance plan to understand the pay formula and the potential impact on their retirement benefits.
Defined benefit plan formula
A defined benefit plan formula is a mathematical equation used to determine the amount of retirement benefits an individual participant in the plan will receive. The formula typically takes into account factors such as the participant’s salary, years of service, and age at retirement. An example of a defined benefit plan formula is:
Benefit = (Average Salary) x (Years of Service) x (Benefit Factor)
Where the benefit factor is a percentage determined by the plan sponsor.
Defined benefit vs cash balance plan
So, there you have it. We have discussed some of the key differences between the two types of plans. But for the average person looking to set up a plan, these differences should not be too important. They are very important for the third-party administrator and actuary, but not so much for the average business owner.
