With so much talk of the demise of defined benefit retirement plans, many people are surprised to learn that there is one type that is growing faster than even 401(k) plans. In 2015, the most recent year for which IRS data is available, 401(k) plans grew at a rate of 3% while cash balance plans grew 17%. (1)
Cash balance plans are growing so fast, in fact, that they have increased from making up less than 3% of defined benefit plans in 2001 to comprising over 34% now. Their growth is being driven by small businesses, who sponsor 92% of the cash balance plans in existence.
What is it that’s driving the popularity of cash balance plans? Could your clients and their companies benefit from sponsoring a cash balance plan? Let’s take a look at the pros and cons of cash balance plans so that you can see for yourself:
Higher Administrative Fees Than 401(k) Plans
When compared to 401(k) plans, cash balance plans are more costly for employers. One of the reasons for this is that, unlike a 401(k) plan, an actuary must certify each year that the plan is properly funded. Other administrative fees include setup fees, annual administration fees, and investment management fees. (often based on assets)
Higher Company Contributions Than 401(k) Plans
Another reason cash balance plans are more expensive for the sponsors than 401(k) plans is that they have to contribute more per employee. In a typical 401(k) plan, the company only contributes 3%-4%, if anything at all. Cash balance plans tend to require contributions of 5% to 8% per employee, and they are not optional.
Sponsor Carries More Investment Risk
With a 401(k) plan, the sponsor provides the employee access to the plan and perhaps matches contributions, but that is the extent of their responsibility. If markets go down and accounts lose money, it is on the employee, not the employer.
With a cash balance plan, the sponsor guarantees a specific rate of return. They pay this interest credit every year regardless of how much the investments actually earn. This can be helpful in up years where investments earn more than the company must pay. However, when markets are down, it is on the employer to bear the loss and continue making the same interest credit payment.
Switching From Traditional Pension Plans Negatively Impact Older Employees
Traditional pension benefits are usually based on the final working years of a participant. Cash balance benefits are based on all working years. Since an employee’s final working years tend to be when they are paid the most, a traditional pension that only takes those years into account will offer a higher benefit. If transitioned from a traditional pension to a cash balance plan at the end of their career, an employee can end up with lower benefits than they had planned for.
Can Be Combined With A 401(k)
One nice thing about a cash balance plan is that they don’t require you to pick and choose between retirement plans. They can be combined with 401(k) plans, allowing business owners and their employees to both save more for retirement. This can be very helpful for higher income earners who may not be able to save enough in a 401(k) alone to continue their current lifestyle into retirement.
More Straightforward For Employees
It is often hard for employees with a defined benefit plan to understand and plan for the benefit they will receive in retirement. A cash balance plan makes that much easier by communicating benefits to employees in the form of an account balance. Just like with a 401(k), an employee can look and see an exact dollar amount assigned to their name. Having concrete numbers also allow employees to make better predictions for their future retirement.
Contributions to a cash balance plan reduce adjusted gross income. With so many taxes based on adjusted gross income, business owners can realize significant tax savings. Especially with the high contribution limits, your clients’ use of a cash balance plan could have a huge impact on their overall tax bill.
Allow Older Business Owners To Save More (2)
Perhaps one of the greatest benefits of a cash balance plan is the amount it allows older business owners to save towards retirement. Between both employer and employee contributions, the 401(k) contribution limit is $55,000 for 2018.
Unlike a 401(k), cash balance contribution limits increase with age. As long as your client is over 33, he or she will be able to contribute more to a cash balance plan than a 401(k). A 50-year-old client would be able to set aside $141,000 and a 70-year-old can set aside up to $311,000. And remember, not only do these contributions increase retirement savings, but they lower adjusted gross income and therefore the related taxes as well.
How We Can Help
If you have clients who are business owners, starting a cash balance plan may be a great way for them to reduce their current tax liability while increasing their retirement savings. Especially your clients who have high incomes and are older or behind on their retirement saving. If you have questions about how a cash balance plan can benefit your clients and their businesses, email me today at firstname.lastname@example.org.
About Kenny Phan
Kenny Phan is a Managing Partner at FinancialFocus Retirement Plan Services, a 3(16) fiduciary. He works as a pension specialist who partners with financial professionals to design and implement pension plans. His area of expertise is customized defined benefit, defined contribution, and 401(k) plans. Serving financial advisors and businesses in the greater Phoenix area, he is supported by FinancialFocus Retirement Plan Services. Together, they provide comprehensive plan design consultation, administration, document installation, compliance testing, as well as IRS and DOL reporting for qualified retirement plans.