Cash balance plans
Cash balance plans are the most popular type of "hybrid" defined benefit (DB) plans. They express benefits in terms of a single lump sum payment - just as defined contribution (DC) plans do. Hybrid plans can take several forms, including:
"cash balance" plans with individual accounts that grow with pay and interest credits, and
"pension equity" or "life cycle" plans with lump sums based on pay and years of service.
Cash balance plans are an excellent solution for professional firms that:
want to set aside (and deduct) more than $45,000 for owners or partners,
want to retain a link between owners' contributions and benefits,
have a reliable earnings stream, and
can afford a generous contribution to employees (usually 5% to 7½% of pay).
Traditional defined benefit plans are often a good choice for single-owner firms - but they don't work well for multiiple-owner firms because there's no direct link between owners' contributions and the benefits they receive. Partners can end up subsidizing each other's benefits. A cash balance plan solves that problem: owners' contributions are directly reflected in their own account balances, just as they are in a DC plan.
Here's an example of a simple cash balance plan. It's a defined benefit plan, so tax deductions are not subject to the $45,000 DC plan limit. In only ten years, the account balances can grow to more than $1 million. This is not an extreme example: contributions can be as high as $100,000 or even $200,000 in a year. And, within limits, a cash balance plan can be on top of a profit sharing and 401(k) plan.
See plan description above Introduction to cash balance plans
|
|
Age |
Service |
Salary |
Projected Cash Balance |
|
|
First Year Credit |
After Ten Years |
Minimum Contribution |
Maximum Deduction |
|
Owner |
55 |
20 |
$225,000 |
$90,000 |
$1,081,000 |
|
|
|
Employee |
40 |
10 |
50,000 |
5,000 |
68,000 |
|
Employee |
30 |
5 |
30,000 |
3,000 |
41,000 |
|
|
|
Total |
|
|
$305,000 |
$98,000 |
|
$61,400 |
$99,500 |
|
% of Payroll |
|
|
|
32.1% |
|
20.1% |
32.6% |
Cash balance pay credits are 10% of pay for all employees, plus an additional 30% for owners.
Assumptions: Expected retirement age of 65, investment returns of 4%, cash balance interest credits of 4%, and 3% annual pay increases.
As with any other defined benefit plan, contributions above the minimum generate credits that reduce future years' minimums - without reducing the maximum deduction.
Cash balance plans have received some negative publicity in recent years. Some of it is deserved - because of poorly handled transitions from traditional defined benefit plans - and some of it is not. For more details, take a look at the article "Friend or Fraud?".
Defined Benefit plan
