Cash Balance Pension Plans

This is a type of defined benefit plan that looks like a defined contribution plan. Each participant has a hypothetical account balance which represents a combination of pay credits and interest credits. A pay credit is a percentage of the participant's compensation for the current year, or a flat dollar amount. The interest credit is a stated investment gain. It can be a fixed percentage up to 6% per year, but it can also be based on market indexes or in some cases the actual return on investments of the pension trust.

In companies that want to make large tax deferred contributions to the owners, the cash balance plan is often combined with a profit sharing/401(k) safe harbor plan. With the proper demographics, this combination tends to level the cost for non-owner employees and significant;y reduce those costs relative to having just a cash balance plan. In these combination plans, the pay credit to an owner might be expressed as 50% of compensation or $125,000. Pay credits for other employees are typically much lower. In order to satisfy complex rules relating to discrimination in the amount of benefits, non-owner employees often receive profit sharing contributions in the range of 5%-7.5% of compensation. Sometimes testing requires even larger profit sharing contributions for non-onwer employees.

For an owner around age 40, pay credits can start at around $100,000 per year. For an onwer in the early 60's, the amount can be as high as $250,000.

Many of the considerations that apply to a defined benefit plan also apply to cash balance plans and cash balance/defined contribution combination plans.

Here are a few key points:

Behind the scenes, a cash balance plan is a defined benefit plan. Thus, maximum accumulations and maximum deductions, as well as minimum funding are determined from a defined benefit perspective "behind the scenes." This is true even though a participant has a hypothetical account.

Recent changes in the law make cash balance plans an attractive alternative to traditional defined benefit in many cases.

In the past, cash balance plans worked better than traditional defined benefit plans when there were multiple owners of different ages who want to equalize benefits, or have their relative benefits satisfy a certain relationship.

In a traditional defined benefit plan, a participant's current lump sum value is the actuarial equivalent of an accrued monthly benefit starting at retirement age. As interest rates change, so does the amount of the lump sum. In addition, the lump sum amount does not correlate well with plan assets.

Cash balance plans can allow the hypothetical account (sum of pay credits and interest credits) to equal the lump sum value of the benefit. No more obtuse calculations with floating interest rates.

More recently, the IRS has pronounced that cash balance plans can be stated on "pre-approved" documents. The transition process will take place over seeral years, but the net effect is that there will be no more costly individually drafted plans and IRS submissions for cash balance plans. Prior to this IRS change in position, cash balance plan documents could be an expensive propostion.

Like regular defined benefit plans, in combination situations, the plan does not need to cover all employees and those who are covered besides owners, can be given relatively low pay credits. The profit sharing component is used to satisfy the actuarial non-discrimination testing.

If a cross-tested profit sharing is in place and works well, so will the cash balance plan. It should be considered if the principal(s) would like tax deferred income significantly in excess of the $52,000/$57,500 limits (for 2014).