The design of a retirement plan program requires a thorough analysis of the needs and resources of the client as well as a careful analysis of the options available under various types of plans. For a small employer, the choice between a defined benefit plan and a defined contribution plan is often a difficult one. In addition, there are several "hybrid" plan designs. A hybrid plan design combines some of the features of a defined benefit plan with some of the features of a defined contribution plan. One such hybrid plan is a cash balance plan.

A cash balance plan is a defined benefit plan that provides benefits to employees by reference to a hypothetical account balance. Contributions to the hypothetical account are based on a percentage of compensation, a multiple of age and service points, or other objective criteria. In addition, the hypothetical account is credited with interest based on some outside index, such as the yield on one-year Treasury securities, or an amount defined in the plan. Thus, a cash balance plan is designed to look like a defined contribution plan, with contributions and earnings credited to a participant’s account, but has the promised-benefit feature of a defined benefit plan through the interest rate credit and benefit guarantee.

This article will address the various characteristics of cash balance plans. In addition, this article will address the design options and considerations with respect to a cash balance plan.

Defined Contribution Plan Characteristics

Employers and participants often prefer a defined contribution plan because it is easy to understand the benefits they provide. With a profit sharing plan for example, a participant receives an allocation, usually a percentage of his or her compensation, which is invested and increases or decreases based on the returns of such investment. A cash balance plan is similar. Each year, a participant receives a hypothetical contribution to his or her account based on his or her compensation for that year, or some other objective criteria. The account accumulates with interest each year, as defined in the plan document. A simple cash balance plan could provide hypothetical contributions each year of 5 percent of pay and hypothetical interest credits of 8 percent. In such a plan, a participant’s hypothetical account balance will grow as follows:

An important part of any retirement program is helping employees to understand the value of their benefits under the plan. A cash balance plan helps employees see something they are already familiar with, an account balance. In contrast, defined benefit plans are often misunderstood by employees because many do not understand the value associated with a monthly benefit payable at retirement age.

Similar to a defined contribution plan, a cash balance plan usually pays benefits in a lump sum at termination of employment. Under a traditional defined benefit plan, benefits are often not payable until the participant reaches normal retirement age, and then only in the form of an annuity. It can be costly for an employer to find past participants once they reach the plan’s normal retirement age. Thus, under a cash balance plan, the administrative burden of keeping track of former employees is reduced.

Defined Benefit Plan Characteristics

While the benefits provided participants is similar to a defined contribution plan, a cash balance plan is a defined benefit plan. Thus, it has many of the characteristics of a traditional defined benefit plan. For example, benefits must be definitely determinable. This is accomplished in a cash balance plan by defining the contribution credits and interest credits in the plan document. Thus, unlike a profit sharing plan, contributions are not made at the employer's discretion.

Like the sponsor of a defined benefit plan, the sponsor of a cash balance plan assumes the plan’s investment risks. Since the interest credits to a participant’s hypothetical account are defined in the plan document, the investment risk is borne by the employer. To the extent actual investment returns exceed or fail to meet such hypothetical credits, the sponsor must decrease or increase contributions accordingly.

Cash balance and traditional defined benefit plans differ in one major way. A traditional defined benefit plan typically defines the benefit at retirement as a function of average monthly compensation or service, or both. This benefit is usually payable for the participant’s lifetime on attainment of the plan’s retirement age. In contrast, a cash balance plan defines the benefit at retirement as an accumulation of contribution credits and interest credits at retirement age, which is usually payable as a lump sum. To illustrate this difference, consider the following example.

A defined benefit plan has a benefit formula of 2 percent of final three-years average pay times years of service. An employee with 35 years of service and $20,000 average compensation will receive $14,000 a year on reaching retirement age (2% x $20,000 x 35). An actuarially equivalent lump-sum benefit at retirement would be approximately $138,000. If instead the employer sponsored a cash balance plan providing a 5 percent of compensation credit for each of the employee’s 35 years of service, the employee would have an account balance at retirement of $140,000 (if the plan provided a 7 percent interest credit).

Like other defined benefit plans, cash balance plans are generally subject to the guarantees and obligations of the Pension Benefit Guaranty Corporation. In addition, contributions are actuarially determined. Thus, contributions will vary from the total of the hypothetical allocations due to investment returns and actuarial assumptions. For example, some cash balance plans enable the employer to leverage investment returns and the assumed interest credited to employees. Stated simply, when calculating the required contribution to the plan, the hypothetical allocation is projected to retirement age imputing the plan’s assumed interest credit. The required contribution is that currently necessary to fund such amount at retirement age imputing earnings calculated at a rate actuarially determined. If the actuarial rate exceeds the assumed interest credit, current contributions will be less than the hypothetical allocations.

Designing a Cash Balance Plan

As with any plan, the most significant design decision is the allocation or benefit formula. A cash balance plan is no different. There are generally four design parameters to consider with any plan:

(i) the formula must satisfy the Code’s non-discrimination requirement;

(ii) allocations on behalf of any one participant must not exceed the maximum allowed under the Code;

(iii) the contribution must be in an amount which is deductible by the employer; and

(iv) the allocation formula must satisfy the Code’s top-heavy minimum contribution requirement, if applicable.

For purposes of illustrating the design considerations of a cash balance plan, throughout the remainder of this article, I will refer to the following employee census:

Non-discrimination. As discussed above, a cash balance plan’s allocation formula must be non-discriminatory. In this regard, the hypothetical allocations provided under a cash balance plan’s benefit formula will be considered non-discriminatory if the formula either: (i) is determined according to a uniform hypothetical allocation formula; or (ii) satisfies a modified general test.

A uniform hypothetical allocation formula generally includes a "pro-rata" allocation formula, under which each participant receives an allocation of the same percentage of compensation, and an "integrated" allocation formula, under which each participant receives an allocation of the same percentage of compensation plus an additional allocation with respect to compensation earned in excess of the taxable wage base (the compensation level at which contributions to social security cease). These allocation formulas are similar to those frequently utilized in profit sharing and money purchase plans. In general, the following illustrates the results of a uniform allocation formula with respect to our sample company:

Often, the greatest design flexibility occurs through a formula that does not constitute a uniform allocation formula, but rather, satisfies the modified general test. The general test permits the employer to design an allocation formula which best fits the employer’s workforce. The formula must be based on objective classifications and the resulting allocation must satisfy a mathematical non-discrimination test. The test is computed, however, after imputing social security benefits and age-based factors. This is similar to a "new comparability" profit sharing plan which relies on the same mathematical test to satisfy the Code's non-discrimination requirements.

While the workings of the general test are beyond the scope of this article, the test will generally permit greater allocations, as a percentage of compensation, to a group of employees who, as a group, are older than the group of employees receiving lesser allocations. The disparity permitted in an individual case depends upon the employee census.

If we assume our sample company wishes to provide a greater allocation for partners, the disparity permitted in a cash balance plan is illustrated by the following plan design. This design would provide a hypothetical allocation of 50% of compensation for partners and 5% of compensation for non-partners. The hypothetical allocations would be as follows:

This design would satisfy the general test based on these facts. Thus, it is a permissible formula in a cash balance plan.

As with any plan design, the design of the cash balance plan must be reviewed on an annual basis. This is especially true if an allocation formula is utilized which satisfies the non-discrimination requirements by satisfying the general test. Any change in the company's workforce could have a significant effect on whether the formula will continue to satisfy the general test.

To further illustrate the design flexibility, assume that HCE1 owns the business and HCE2 is merely a highly-paid employee. The company may wish to design a plan providing greater contributions to HCE1 and lesser contributions to HCE2. A cash balance plan could provide a formula which provided a hypothetical allocation of 60% of compensation for senior partners, which includes only HCE1, and 5% of compensation for all other employees. The hypothetical allocations would be as follows:

Based on the company’s census, the allocation set forth above would satisfy the modified general test. Thus, it is a permissible formula in a cash balance plan.

As discussed above, in addition to the hypothetical allocation, the cash balance plan must provide an earnings credit which is applied to each participant’s hypothetical allocations. If we assume the cash balance plan provides a 5% interest credit, the following chart illustrates the growth of HCE1's account in the cash balance plan providing the hypothetical allocation of 60% of compensation:

The interest credit provided under a cash balance plan need not be a "set" interest rate but could be defined by reference to an index or security. No matter how the interest credit is defined, careful attention must be paid to two issues. First, it must be determined that the rate is reasonable in order for the cash balance plan to be qualified.  Second, a prudent investment strategy must be able to attain such results. Sponsors must keep in mind that contributions are actuarially determined and not merely the sum of the hypothetical allocations for a year. This can be a significant problem if the interest credit applied by the plan exceeds the earnings the plan's actuary is willing to assume in calculating a year's funding requirements. To the extent the plan's interest credit exceeds the actuary's assumed earnings rate, the funding required by the employer will be increased.

Section 415 Limits. A participant’s allocation to any plan are limited by Section 415 of the Code. With respect to a defined contribution plan, allocations cannot exceed the lesser of $45,000 or 100% of a participant’s compensation. Thus under a profit sharing plan, for example, no participant could receive an allocation in any given year in excess of $45,000, even if the employer was willing to make larger contributions.

A cash balance plan is a defined benefit plan. The section 415 limit for a defined benefit plan is an annual benefit commencing at retirement age which does not exceed $175,000. Accruals for a specific plan year are limited to an amount necessary to fund the retirement benefit. For example, a 57 year old can, under certain circumstances, receive an accrual in excess of $160,000 for a plan year, without exceeding the limits of section 415. Thus, the benefits which can be provided under a cash balance plan generally exceed that which could be provided under a defined contribution plan.

Deduction Limits. The Code limits an employer's deductions for contribution to a plan. Contributions to a defined contribution plan are deductible to the extent they do not exceed 25% of compensation otherwise paid to participants. In contrast, contributions to a defined benefit plan are deductible to the extent they do not exceed the section 415 limit discussed above. Thus, contributions are deductible with respect to a cash balance plan to the extent they do not exceed the 415 limit discussed above.

Top-heavy Rules. The plan design last set forth above would no doubt result in the plan constituting a top-heavy plan under the Code. The Code’s top-heavy minimum allocation requirements would require that the accrued benefit on behalf of NHCE1 or NHCE2, the non-key employees, must be at least 2% of compensation. Generally, this is calculated as follows.

In this case, the accrued benefit provided by the hypothetical allocation exceeds the top-heavy minimum. Therefore, no additional allocation is required to satisfy the top-heavy minimum allocation requirement. However, in certain cases, the top-heavy minimum will require additional allocations.

Dual Plan (DB/DC)  Design.  Among the most popular designs is a dual profit sharing and cash balance plan.  There is no combined individual contribution limit.  Thus, a participant can receive the maximum allocation under the profit sharing plan ($45,000) and the maximum accrual under the cash balance plan (amount depends on age, other factors).  In addition, the plans can be aggregated to satisfy the non-discrimination requirements.  Non-highly compensated employees must receive an allocation under either or both plans that is at least a minimum based on the maximum percentage received by any highly compensated employee:

The allocations must satisfy the non-discrimination, so the resulting allocation is similar to that permitted under a new comparability or cross-tested profit sharing plan.  However, the amount of the contributions can be much greater.

Legal Status of Cash Balance Plans

As a result of the Pension Protection Act of 2006, the legal uncertainty regarding cash balance plans has been removed.  The Pension Protection Act of 2006 did impose a few restrictions.  For example, unlike other tax-qualified plans, participants in a cash balance plan must vest in no more than 3 years.

Conclusion

A cash balance plan combines many of the benefits of a defined contribution plan (e.g. the allocation formula of a new comparability profit sharing plan) with the advantages of a defined benefit plan (e.g. increased 415 and deduction limits). For this reason, a cash balance plan is something employer’s should consider in the design of their retirement programs.

© George M. Morrison, 2002; updated 2006