Secure 2.0 Act May Breathe New Life Into Cash Balance Plans
Cash Balance Plans: The Basics
A cash balance plan is a cross between a traditional defined benefit pension plan and a defined contribution plan, such as a 401(k). Generally, employers will contribute a set portion of a participant’s salary to the plan each year (known as the “pay credit,” which is usually equal to between 5% and 8% annually), and the participant’s account will also be credited with an interest credit each year.
Because the employer is required to contribute each year, the cash balance plan is ideal for very small businesses with few employees, so long as the business is sufficiently established to make the required payment each year (contributions on behalf of non-highly compensated employees will also be required).
The interest credit may be variable (for example, it may be tied to a stock index or plan assets) or fixed — but the employer was not permitted to vary the pay credit between employees. The employer assumes the investment risk associated with this investment credit, so that if the plan provides for a 5% annual investment credit and assets earn only 3% during the year, the employer may be required to contribute more to the plan.
When the participant retires, he or she receives an annuity based upon the amounts that have been credited to his or her account or has the option of taking a lump sum. These “accounts” are hypothetical in that the plan assets are not actually segregated into individual accounts, as they are in the case of a 401(k) plan.
Cash balance plans are technically defined benefit plans, so the annual total contribution limit for defined contribution plans does not apply. Instead, the contribution limit for cash balance plans is based on the amount that a participant may receive at retirement and will vary based upon age. An actuary can calculate backward (using the plan’s interest credit rate) from the benefit amount to determine each individual participant’s contribution level.
In general, the cash balance plan option is particularly attractive because the contribution limit will be much higher than the annual defined contribution plan limit.
Conclusion
Because of the most recent changes, cash balance plans may now be a viable option for a wider range of employers. Employers with frozen cash balance plans may also be interested in unfreezing these plans going forward.
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