There are two general types of pension plans — defined benefit plans and defined contribution plans. In general, defined benefit plans provide a specific benefit at retirement for each eligible employee.
Defined contribution plans specify the amount of contributions to be made by the employer toward an employee’s retirement account. In a defined contribution plan, the actual amount of retirement benefits provided to an employee depends on the amount of the contributions as well as the gains or losses of the account.
A cash balance plan is a defined benefit plan which defines the retirement benefit in terms more characteristic of a defined benefit plan. In other words, a Cash Balance Plan defines the promised benefit in terms of a stated account balance.
How do Cash Balance Plans work?
In a typical Cash Balance Plan, a participant’s account is credited each year with a “pay credit” (such as 5 percent of compensation from his or her employer) and an “interest credit” (either a fixed rate or a variable rate which is linked to an index such as the one-year Treasury bill rate).
Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks are borne solely by the employer.
When a participant becomes entitled to receive benefits under a Cash Balance Plan, the benefits received are defined in terms of an account balance. For example, assume a participant has an account balance of $100,000 when he or she reaches age 65. If the participant decides to retire then, he or she would have the right to an income annuity based on the account balance.
In many Cash Balance Plans, the participant could instead choose (with consent from his or her spouse) to take a lump sum benefit equal to the $100,000 account balance. If the lump sum distribution is chosen, generally you can be rollover into an IRA so there isn’t a taxable event.
The benefits in most Cash Balance Plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation.
How do Cash Balance Plans differ from traditional pension plans?
Both traditional defined benefit plans and Cash Balance Plans are required to offer payment of an employee’s benefit in the form of a series of payments for life. Traditional defined benefit plans define an employee’s benefit as a series of monthly payments for life to begin at retirement, but Cash Balance Plans define the benefit in terms of a stated account balance.
How do Cash Balance Plans differ from 401(k) plans?
Cash Balance Plans are defined benefit plans. In contrast, 401(k) plans are a defined contribution plan. There are four major differences between typical Cash Balance Plans and 401(k) plans:
- Participation – Participation in typical Cash Balance Plans generally does not depend on the workers contributing part of their compensation to the plan; however, participation in a 401(k) plan does depend, in whole or in part, on an employee choosing to make a contribution to the plan.
- Investment Risks – The employer or an investment manager appointed by the employer manages the investments of cash balance plans. Increases or decreases in plan values do not directly affect the benefit amounts promised to participants. By contrast, 401(k) plans often permit participants to direct their own investments and bear the investment risk of loss.
- Life Annuities – Unlike 401(k) plans, Cash Balance Plans are required to offer employees the choice to receive their benefits in the form of lifetime annuities.
- Federal Guarantee – Since they are defined benefit plans, the benefits promised by Cash Balance Plans are usually insured by a federal agency, the Pension Benefit Guaranty Corporation (PBGC). If a defined benefit plan is terminated with insufficient funds to pay all promised benefits, the PBGC has authority to assume trusteeship of the plan and begin to pay pension benefits up to the limits set by law. Defined contribution plans, including 401(k) plans, are not insured by the PBGC.
Is there a federal pension law that governs Cash Balance Plans?
Yes. Federal law, including the Employee Retirement Income Security Act (ERISA), the Age Discrimination in Employment Act (ADEA), and the Internal Revenue Code (IRC), provides certain protections for the employee benefits of participants in private sector pension plans.
If your employer offers a pension plan, the law sets standards for fiduciary responsibility, participation, vesting (the minimum time a participant must generally be employed by the employer to earn a legal right to benefits), benefit accrual and funding. The law also requires plans to give basic information to workers and retirees.
The IRC establishes additional tax qualification requirements, including rules aimed at ensuring that proportionate benefits are provided to a sufficiently broad-based employee population.
The Department of Labor, the Equal Employment Opportunity Commission (EEOC), and the IRS/Department of the Treasury have responsibilities in overseeing and enforcing the provisions of the law. Generally, the Department of Labor focuses on the fiduciary responsibilities, employee rights, and reporting and disclosure requirements under the law, while the EEOC concentrates on the portions of the law relating to age discriminatory employment practices. The IRS/Department of the Treasury generally focuses on the standards set by the law for plans to qualify for tax preferences.
Are there requirements that apply if my employer converts my current plan to a Cash Balance Plan?
Yes. However, employers are not required to establish pension plans for their employees because the private pension system is voluntary. In addition, employers are allowed substantial flexibility in deciding whether to terminate or amend their existing plans. Therefore, employers generally may change by plan amendment their traditional pension plans and the benefit formulas they use.
Federal law does place restrictions on plan changes generally. Advance notification to plan participants is required if, as a result of the amendment, the rate which may be earned to pay benefits in the future is significantly reduced. Additionally, there are other legal requirements which have to be satisfied, including prohibitions against age discrimination.
There is much more to know about Cash Balance Plans, for a personal consultation, please contact us.