A cash balance plan is a defined benefit plan that has some common characteristics of a defined contribution plan. But it varies significantly from a defined contribution plan in that there is no set annual funding amount.
Each participant has a notional account showing pay credits and interest credits. The plan mimics an account balance but is legally a defined benefit plan.
Employers fund benefits using actuarial calculations. Contributions vary based on salaries, demographics, and interest rate assumptions. This structure provides employers with contribution flexibility. However, it also means no predetermined annual funding amount exists.
How does a cash balance plan work?
Many people considering a defined benefit plan assume they work like a defined contribution plan. But the two plans work very differently.
A defined contribution plan actually defines the contribution. It is a set amount mandated by the IRS each year. Assuming a bill a company has is qualified to contribute, they may do so. That contribution has no impact on future years’ contributions.
However, a defined benefit plan works very differently. There is a defined benefit that the employee will earn at retirement. This benefit is based largely on years of service and compensation amount. Therefore, it will vary from year to year. But because it’s a moving target, your contributions become a moving target as well.
Additionally, actuaries will provide clients with a funding range each year. This includes a minimum contribution, along with a target and maximum. Clients can fund anywhere in the range, but that does not change the final benefit.
As such, if someone contributes a significant amount in one year, then the contributions will decrease in subsequent years, given the same benefit. You can see with a defined benefit plan why we always say every dollar you contribute today is one less dollar that you can contribute in the future.
Role of Actuarial Funding Requirements
Cash balance contributions are determined by actuaries. They consider participant age, compensation, and investment return expectations. Each year, they calculate a funding range. This includes a minimum required contribution and a maximum deductible contribution.
Employers must contribute at least the minimum required to comply with IRS rules. Contributing less risks plan underfunding and penalties. Employers may contribute more, up to the maximum allowed. This creates contribution flexibility rather than fixed annual amounts.
Cash balance plan contributions adjust with business performance. Strong profits may encourage higher contributions for tax deductions. In weaker years, employers may contribute only the minimum. This flexibility helps manage cash flow.
Investment performance also impacts contribution amounts. Poor returns may require higher funding to cover promised benefits. Strong returns may reduce contribution requirements. Contributions remain dynamic and responsive to changing markets.
What about investment returns?
Investment returns play a significant role in determining required contributions to a cash balance plan. When investment returns fall short of the assumed rate, the plan’s funding level decreases. This shortfall creates a funding gap that must be filled by the employer. As a result, contributions in subsequent years typically increase to restore the plan’s financial position.
Conversely, strong investment returns can reduce the employer’s funding burden. When returns exceed actuarial assumptions, the plan accumulates assets more quickly than expected. This surplus reduces the need for future employer contributions. In some cases, employers may contribute closer to the minimum required, preserving business cash flow.
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Because of these fluctuations, contributions to cash balance plans are never fixed or predictable. Employers must remain flexible and responsive to changing market conditions. Poor returns can force higher contributions, while strong markets provide some relief. This dynamic illustrates why cash balance plans require ongoing actuarial oversight and careful planning.
Example of Variable Contributions
Consider a 55-year-old business owner earning $300,000 annually. An actuary may calculate a contribution range of $100,000 to $200,000. The employer may choose any contribution within that range. The next year, funding may change based on new assumptions.
This demonstrates the plan’s adaptability. Employers can maximize deductions in profitable years. During leaner years, they may fund closer to the minimum. This adaptability makes cash balance plans appealing.
Key Considerations for Employers
- Key Considerations for Employers
- Annual actuarial valuations drive contribution adjustments.
- Actuarial funding rules create minimum and maximum contribution ranges.
- Contributions change based on business profits and market returns.
- Older, higher-paid owners often require larger contributions.
- IRS compliance depends on meeting minimum funding requirements.
- Employers can choose higher funding to maximize tax deductions.
- Contributions must remain flexible to maintain plan sustainability.
| Feature | Cash Balance Plan | 401(k) Plan |
|---|---|---|
| Contribution Determination | Actuarially calculated range | Employee deferrals and employer match |
| Annual Funding | Variable, no set amount | Fixed limits defined by IRS |
| Flexibility | Contributions adjust to business and markets | Predictable annual contribution caps |
| Primary Driver | Age, compensation, actuarial assumptions | Employee elections and IRS limits |
| Tax Deduction Potential | Much higher contribution limits | Lower overall contribution capacity |
Bottom Line
Cash balance plans offer employers significant flexibility. Unlike 401(k)s, contributions are not fixed annually. Instead, actuaries determine a range each year. This ensures the plan remains adequately funded.
Employers benefit from flexible contributions. They can increase funding in strong years and reduce funding in weaker years. This structure supports tax planning opportunities. It also aligns retirement contributions with business realities.
