The ERISA consultants at the Columbia Management Retirement Learning Center Resource Desk regularly receive calls from financial advisors on a broad array of technical topics related to IRAs and qualified retirement plans. A recent call with an advisor in Kentucky is representative of common inquiry related to cash balance defined benefit plans. The advisor asked:
“Some of my business-owner clients have mentioned they would like to contribute more than $50,000 annually to a retirement plan and have asked about cash balance plans. Can you give me a brief rundown on cash balance plans and who would be the most likely candidates for them?”
Highlights of Discussion
The following is a general discussion. Business owners that want to establish a retirement plan should do so only after thorough discussions with their tax advisors and/or legal counsel.
- A cash balance plan, also sometimes referred to as a hybrid plan, is a type of DB plan that looks a little like a DC plan. Like a traditional DB plan, the employer bears the investment risks on plan assets and guarantees a determinable benefit to eligible participants.
- Where a cash balance DB plan resembles a DC plan is the allocation formula and the promised benefit, which is stated in terms of a hypothetical account balance. These accounts are hypothetical because they do not reflect actual contributions to an account or actual gains and losses allocable to the account.
- In a typical cash balance plan, a participant's hypothetical account is credited each year with a pay credit (such as 5% percent of compensation from his or her employer) and an interest credit (either a fixed rate or a variable rate that is linked to an index such as the one-year Treasury bill rate).
- In a cash balance plan, the sponsoring employer does not make contributions to accounts for individual participants. Instead, the employer makes contributions to the plan’s trust as a whole, based on the minimum funding requirements for DB plans. Since cash balance DB plan contributions must equal what is needed to fund the promised benefits, they are not limited by the per-participant annual maximum contribution amounts that apply to DC plans (i.e., $52,000 or $57,500 for those ages 50 and greater). Therefore, required contributions to a cash balance DB plan can be substantially more than those for a DC plan.
- Cash balance plans are popular among law firms, medical groups and professional firms like CPAs, architects and consultants.
- Key considerations when contemplating a cash balance DB plan include the following. The more “yes” responses the greater the possibility that a cash balance DB plan would be a good fit:
- Does the business have a consistent, profitable history?
- Will the employer have significant and consistent cash flow moving forward?
- Does the business have a large budget that can support plan contributions?
- Does the business already maximize its contributions to a DC plan?
- Do the business owners or partners want to accelerate their ability to save for retirement?
- Are there multiple owners or partners?
- Do the highly compensated employees wish to contribute more than the defined contribution annual limit allows?
- Is there a low ratio of non-highly compensated employees to highly compensated employees?
- Are the highly compensated employees older than the non-highly compensated employees on average?
- Is the company relatively small in size (e.g., fewer than 20 eligible employees)?
Conclusion
According to the 2014 National Cash Balance Research Report, cash balance DB plans now make up 25% of all defined benefit plans, up from 2.9% in 2001. These hybrid plans can be the right fit for certain businesses that have precise goals and meet certain criteria.
The Columbia Management Retirement Learning Center Resource Desk is staffed by the Retirement Learning Center, LLC, a third-party industry consultant that is not affiliated with Columbia Management. For informational purposes only. Please consult a tax advisor or attorney for specific tax or legal needs. © 2014 Columbia Management Investment Advisers, LLC. Used with permission.
