A Cash Balance Plan is a type of Defined Benefit Plan. It is not an Individual Account Plan (Defined Contribution Plan) since each Participant's benefits are not determined by the performance of the assets held in an individual account for that Participant. However, it LOOKS a lot like an Individual Account Plan (such as a Profit Sharing Plan) because the benefits are related to a Hypothetical Cash Balance Account, with Hypothetical Employer Contribution Allocations and Hypothetical Interest Credits added each year. The Hypothetical Interest Credits are based on an Actuarial Assumption specified in the Plan Document, and are not related to the actual earnings of the Trust.
Because a Cash Balance Plan exhibits some characteristics of both Defined Benefit Plans and Defined Contribution Plans, it is often called a hybrid plan. This makes it both easier and harder to understand. It is easier for Participant's to think that they fully understand the Plan, but it is actually more complex and therefore more probable that they do not fully understand it.
The benefit paid from the Cash Balance Plan is not simply the Hypothetical Cash Balance Account. (Which is why it is called a hypothetical account.) Instead, the Hypothetical Account balance must be converted into an annuity payable at Normal Retirement Age. This future benefit can then be converted into a current Lump Sum Benefit. The resulting Lump Sum Benefit may be either equal to or greater than the Hypothetical Cash Balance Account.
Regulatory Status of Cash Balance Plans
Cash Balance Plans have frequently been in the news (see news link below), which can give a potential plan sponsor pause when considering this type of plan. T he main controversy, however, relates to the conversion of Traditional Defined Benefit Plans to Cash Balance Plans. Because the benefit structures of these two types of plans differ, certain employees do better under the new plan structure while others fared better under the old plan structure. While an employer always retains the right to reduce benefits in a retirement plan and even to terminate the plan, careful communication of such changes is crucial. In any case, most of our plans are newly adopted plans, not conversions.
The other source of news regards the calculation of lump sum benefits payable from the plan. The issues are complex, but our plan design, fashioned in keeping with court rulings, seeks to minimize the difference between Hypothetical Account Balance and the lump sum calculated. For more information, see discussion of the Whipsaw Effect.
The issues facing plans newly adopted by small employers are significantly different from the headline-making issues of larger plans. In any event, the IRS routinely issues favorable determination letters approving the form of Cash Balance Plans that we have designed as a qualified retirement plans (see sample determination letter). There is always the additional requirement that plans must be operated according to the plan document and the regulations. This includes the need to demonstrate on an annual basis that the plan is nondiscriminatory in practice under Code sections 410(b),401(a)(4), and other statutes.
There are already nondiscrimination regulations in place with which Cash Balance Plans must comply. The IRS issued additional proposed regulations in December 2002, then withdrew those proposed regs in June 2004. Congress has repeatedly drafted legislation covering Cash Balance Plans, but it has repeatedly stalled. It is likely that in some coming year, the law or regulations affecting Cash Balance Plans will be modified in some manner, but this can only be expected to affect the plans prospectively. There is quite a lot of strength in numbers, with about 20% of all defined benefit plans being in the form of Cash Balance Plans.
For additional insights, see links below to information from the Department of Labor, the IRS, and other external sites.
Which Employers Can Benefit from a Cash Balance Plan?
Like all other Defined Benefit Plans, a Cash Balance Plan can provide the largest benefits to employees nearest to retirement age, and in particular, Highly Compensated Employees can be targeted to receive higher benefit levels than other employees.
At the same time, a basic Cash Balance formula seeks to give a level-percent-of-pay benefit to all rank-and-file employees.
These two features form a powerful combination for targeting higher benefit levels to certain specified employees, while controlling the cost of the other employees. This benefit structure must be shown to be nondiscriminatory, based on IRS regulations, by demonstrating that statistical groups of employees receive "comparable" benefits when evaluated under complex formulas that account for current ages and future benefit levels. Hence the name: "New Comparability Cash Balance Plans."
In a situation where all Non Highly Compensated Employees(NHCEs) are significantly younger than the targeted Highly Compensated Employees(HCEs), a Cash Balance Plan is not necessary: a Traditional Defined Benefit Plan will likely provide the best solution. If, however, there is one or more Non-Highly Compensated Employee who is close to retirement age, and whose relative cost is prohibitive under a Traditional Defined Benefit Plan, then a Cash Balance Plan may provide an appropriate design solution to meet the employer's goals.
In summary, a New Comparability Cash Balance Plan is most useful when the following criteria are met:
a portion of NHCEs are significantly younger than the targeted HCEs
one or more of the NHCEs are approaching retirement age, and are cost-prohibitive under a Traditional Defined Benefit Plan
the contribution/benefit goals of the employer are higher than permitted by a New Comparability Profit Sharing Plan
New Comparability Cash Balance Plans
While most Cash Balance Plans have a uniform formula for the Hypothetical Employer Contribution Allocations (such as 10% of considered compensation), a New Comparability Cash Balance Plan uniquely targets specified Highly Compensated Employees for specified hypothetical allocation amounts, while other employees receive a uniform hypothetical allocation level. The formula for the Highly Compensated Employees and Non-Highly Compensated Employees is chosen so that the resulting benefits pass the general nondiscrimination tests under IRC 410(b) and 401(a)(4).
This formula structure is the same as is used for New Comparability Profit Sharing Plans. The difference is that the Cash Balance Plan is in fact a Defined Benefit Plan, and can permit much larger benefit levels than is possible under the $41,000 Profit Sharing Plan limits.
In order to take advantage of the "cross-testing" feature of the general non-discrimination tests, it is generally necessary to provide an allocation formula of at least 7.5% of pay for Non-Highly Compensated Employees.
If the Cash Balance Plan is Top-Heavy (60% of the benefits go to Key employees), the plan must generally provide Defined Benefit Top-Heavy benefits to Non-Key employees, which may cost as much as 18% of pay, depending on an individuals age.
New Comparability Cash Balance Plan Example
Take an entrepreneur age 46 with 5 employees, one of which is close to his/her age while two are 20 or more years younger.
The table below compares the maximum deductible contribution for 2004 to fund the owner's benefit (retirement age 56) under two alternative plans:
Traditional Defined Benefit Plan (Traditional DBP)
New Comparability Cash Balance Plan (New Comp CBP)
2004 Cost Analysis
Defined Benefit Plan
Cash Balance Plan
* $205,000 is the maximum possible Considered Compensation for all tax-qualified retirement plans for 2004. ** 5 years is the "safe-harbor" limit on the number of years of past service that can be taken into account by a Defined Benefit Plan benefit formula.
It is clear from this comparison that the cost structure of the New Comparability Cash Balance Plan is quite superior to that of the Traditional Defined Benefit Plan for the particular demographics of this prospective plan sponsor.
In fact, with the relative cost level of two employees approaching 40% and 60% of pay, the Traditional DBP simply is not viable alternative at this level of benefits. If instead the employer wants to contribute a much lower amount for his/her own benefit--perhaps 30% of pay ($61,500), the Traditional DBP might become a realistic alternative since the cost of all employees would be similarly reduced (the cost of the most expensive employee would drop to 27% of pay).
By contrast, the New Comp CBP has taken advantage of the employee demographics and reduced the cost of employees to a range of 7.5% to 17% of pay. Also note that the cost of the employees has been reduced from 28% of the total contribution to 14% of the total. However, these attractive results are gained at a certain expense. In fact, there are several cons to the Cash Balance option:
Reduced Benefit: the Owner's contribution level is reduced.
Increased Volatility/Risk: the contribution levels for employees might have to increase in a future year (say to 15% of pay) in order to pass the nondiscrimination test. If an employee leaves, the results of the tests can be dramatically altered.
Higher Expense: the New Comp CBP can cost 2 to 3 times as much as a Traditional DBP to administer.