What Is a Cash Balance Plan?

Whether you’re a plan sponsor or a financial adviser, you want to know all of the options available for retirement planning and how plans will work for your clients and beneficiaries. However, many have questions about the design, management, and benefits of more sophisticated programs, especially when it comes to cash balance plans.

Cash balance plans, while complex, offer unique advantages that blend the predictability of defined benefit (DB) plans with the flexibility and familiarity of defined contribution (DC) plans like IRAs and 401(k)s. Whether you're an employer looking to improve your retirement benefits or an employee evaluating your retirement options, it’s crucial to know how cash balance plans work — and how sponsors and beneficiaries can get the most out of these plans.

With a clear understanding of cash balance plans, you can provide increased clarity and support for employees and clients as they navigate retirement planning, alongside a retirement plan that advances their retirement needs and goals.

Key Takeaways

• Cash balance plans are hybrid retirement plans that blend the high contribution limits of defined benefit plans with the clear account structure of defined contribution plans.

• Cash balance plans ensure guaranteed benefits, predictable growth and expenses, and tax-deferred savings, offering employers and employees a secure and flexible retirement plan.

• October Three specializes in designing tailored cash balance and hybrid pension plans that align with business needs and employee retirement goals.

What Is a Cash Balance Plan?

A cash balance plan (CBP) is a hybrid retirement plan that combines elements of both DB and DC plans — offering greater flexibility than a traditional DB plan while allowing for higher contribution limits and a predictable annual expense for employers.

In a cash balance plan, each participant has an individual account that is credited with employer contributions, which are typically a percentage of the employee’s salary plus interest earnings. While cash balance plans appear similar to a 401(k), they are structured like traditional defined benefit plans, which means they provide benefits based on salary and service years.

However, unlike traditional DB plans, cash balance plans represent these benefits as an account balance similar to a bank account instead of an annuity that’s paid out when a participant retires. As a result, participants always know the exact value of their benefits, just like they would with a DC plan.

How Does a Cash Balance Plan Work?

In a cash balance plan, the employer establishes each participant’s account, which grows annually through company contributions and interest credits.

A typical plan offers two types of credits: pay credits, which are a percentage of the participant's salary or a fixed amount, and interest credits, which are typically tied to a fixed rate or a market-related index such as the 10-year Treasury yield.

Unlike a 401(k) in which the employee bears the investment risk, employer sponsors assume all investment risks in a cash balance plan. This structure ensures that employees receive a guaranteed retirement benefit, regardless of market performance.

Cash balance plans provide a predictable growth trajectory and a substantial benefit that can be distributed as a lump sum or converted into a traditional lifetime annuity upon retirement.

Who Can Offer a Cash Balance Plan?

Any business entity, regardless of its size, can establish a cash balance plan. These plans are particularly advantageous for business owners, executives, and other high earners because of their large contribution limits.

By design, cash balance plans must cover at least 40% of non-excludable employees or 50 participants, whichever is fewer, to meet nondiscrimination requirements. Often plans work in conjunction with a 401(k) or profit-sharing plan with employer contributions to satisfy these requirements.

Are Cash Balance Plans Similar to 401(k) Plans?

Cash balance plans and 401(k) plans share similarities in terms of account visibility and the potential for lump-sum distributions. However, they differ significantly in their operation and benefit structure.

Cash balance plans are not subject to the same contribution limits and rules as 401(k)s. While 401(k) plans limit the amount participants can contribute to $23,000, or $30,500 for those aged 50 or older, cash balance plans allow for higher contribution limits that increase as participants age and earn more.

In a 401(k), accounts are primarily funded by employee contributions with optional employer matching. Likewise, employees are responsible for choosing investment options in a 401(k) and bear investment risks that directly affect the performance and final value of their retirement funds.

But in cash balance plans, employers fully fund plans, manage investments, and assume all investment risks — and participants are provided a guaranteed payout regardless of market conditions. Cash balance plans also offer the option of receiving benefits as a lifetime annuity, which is not typically offered in 401(k) plans.

What Are the Benefits of a Cash Balance Plan?

Cash balance plans integrate the high contribution limits of DB plans with the straightforward, account-based format of DC plans. This hybrid format offers several distinct benefits that can be particularly attractive to both employers and employees, including:

Income deferral opportunities

Contributions to cash balance plans are made on a pre-tax basis, which means taxes on these amounts are deferred until they are distributed upon retirement. This can result in significant tax savings, especially for participants who are in a higher tax bracket during their working years compared to retirement.

Improved flexibility

Cash balance plans offer flexible payout options, such as lump-sum distributions that can be rolled over into other retirement accounts like IRAs, or converted into a lifetime annuity to provide steady, sustained income in retirement. This flexibility allows participants to plan their retirement income according to personal financial needs and goals.

Tax-deductible contributions

Employers benefit from tax deductions on contributions made to cash balance plans. These deductions are taken dollar for dollar against ordinary income, which can significantly reduce a company’s tax liability. Moreover, the growth of these contributions is tax-deferred, compounding the financial benefits over time.

Lump sum payouts

Participants have the option to receive their benefits in a lump sum, which provides opportunities to reinvest these funds in a manner that suits their retirement planning and financial needs.

Transparency

The account balance format of cash balance plans provides greater transparency compared to a traditional defined benefit plan. Cash balance plans allow participants to easily understand and track their retirement benefits so they know the exact amount of their benefits at any given time.

What Are the Contributions to a Cash Balance Plan?

Cash balance plans are funded through two types of employer contributions: pay credits and interest credits. Because contributions and credits compound annually, benefits in the account accumulate over time.

Contribution amounts

In a cash balance plan, the plan sponsor pays in a fixed dollar amount or a set percentage of an employee’s compensation. These contributions are meticulously calculated and credited annually to each participant’s account as dictated by the plan's formula.

These contributions are affected by various factors including employee age and salary, and are structured to comply with rigorous non-discrimination testing to ensure fairness across all levels of employees. Contributions made to the accounts of highly compensated individuals like business owners and executives must be proportional to those made for other employees to maintain equity and compliance.

Because cash balance plans are designed to ensure maximum allowable income at retirement, annual contributions can increase as participants age. In fact, contributions reach as high as $400,000 as participants near retirement age, depending on a person’s income. You can use October Three's Cash Balance Calculator to find out how much you could contribute to a cash balance plan.

Interest amounts

Interest credits in a cash benefit plan can be a fixed interest credit tied to a market index such as the 30-year Treasury yield, or, more commonly, a variable rate interest credit. These credits are based on the investment return of the underlying plan assets.

If the plan’s actual earnings surpass the guaranteed interest rate, the surplus is used to offset future employer contributions, which ensures that the employee’s account balance grows consistently as planned without direct impact from market volatility. This design helps provide a stable growth trajectory.

Who Is the Beneficiary in a Cash Balance Plan?

Beneficiaries in a cash balance plan are typically employees of the sponsoring company, including owners and executives. The plan can be designed to favor key employees with higher contributions while still providing meaningful benefits to other staff, ensuring compliance with IRS nondiscrimination rules. This targeted benefit structure makes cash balance plans particularly appealing for businesses looking to provide enhanced retirement benefits to critical personnel.

Who Manages the Investments in a Cash Balance Plan?

The investments of a cash balance plan are managed by trustees and investment advisors appointed by the sponsoring company. Since these plans are not participant-directed, the investment risk and management responsibility lie entirely with the employer. This centralized management can lead to more strategic, long-term investment decisions that support the plan’s defined benefits.

What Can Be Tax-Deferred Under a Cash Balance Plan?

In cash balance plans, both the contributions made by the employer and the interest credits added to individual accounts are tax-deferred. This tax deferral extends until the benefits are distributed, typically at retirement, allowing the plan's investments to grow without immediate impact from taxes. This can significantly enhance the value of the retirement benefits over time.

October Three’s Approach to Cash Balance Pension Plans

Cash balance plans offer increased reliability, greater flexibility, and long-term growth to facilitate a seamless journey to retirement readiness — if employers understand how to effectively design, manage, and optimize these hybrid plans. At October Three, we specialize in simplifying the complexities of retirement programs and streamlining plan management to design plans that offer predictable costs, reduce risks, and maximize benefits for your company and employees. Learn how October Three can help craft customized cash balance and hybrid retirement plans tailored to meet your unique financial needs and employees’ retirement goals.

Cash Balance Plan FAQs

If an employee quits, what happens to the cash balance plan?

When an employee leaves the company, they are entitled to the vested portion of their cash balance plan, which can be rolled over into another retirement account or taken as a lump sum, depending on the options provided by the plan.

Are cash balance plans insured?

Yes, cash balance plans are insured by the Pension Benefit Guaranty Corporation (PBGC), which provides enhanced protection should a plan sponsor fail to meet its financial obligations. Plans are also safeguarded under the Employee Retirement Income Security Act (ERISA), which protects benefits from bankruptcy, lawsuits, and creditors.

How are taxes deducted for contributions to a cash balance plan?

The tax deduction for contributions depends on the structure of the sponsoring entity. Contributions for non-owner employees are typically deductible for the company, while owner contributions may be deductible on a personal basis, depending on the company’s tax status.

Can employees make contributions to a cash balance plan?

No, contributions to cash balance plans are exclusively employer-funded, allowing participants to focus on managing their other retirement assets.