Frequently Asked Questions about Cash Balance Pension Plans
What is a cash balance pension plan?
There are two general types of pension plans-Defined Benefit Plans and Defined Contribution Plans. In general, defined benefit plans provide a specific benefit at retirement for each eligible employee, while defined contribution plans specify the amount of contributions to be made by the employer toward an employee’s retirement account. In a defined contribution plan, the actual amount of retirement benefits provided to an employee depends on the amount of the contributions as well as the gains or losses of the account.
A cash balance plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance.
How do cash balance pension plans work?
In a typical cash balance plan, a participant’s 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). Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer.
When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance. For example, assume that a participant has an account balance of $100,000 when he or she reaches age 65. If the participant decides to retire at that time, he or she would have the right to an annuity. Such an annuity might be approximately $10,000 per year for life. In many cash balance plans, however, the participant could instead choose (with consent from his or her spouse) to take a lump sum benefit equal to the $100,000 account balance.
In addition to generally permitting participants to take their benefits as lump sum benefits at retirement, cash balance plans often permit vested participants to choose (with consent from their spouses) to receive their accrued benefits in lump sums if they terminate employment prior to retirement age.
Traditional defined benefit pension plans do not offer this feature as frequently.
For more about vesting and distribution of benefits see What You Should Know About Your Pension Rights.
If a participant receives a lump sum distribution, that distribution generally can be rolled over into an Individual Retirement Account (IRA) or to another employer’s plan if that plan accepts rollovers. See IRS Publication 575 Pension and Annuity Income: Rollovers or Publication 590 Individual Retirement Arrangements (IRAs): Traditional IRAs – Can I Move Retirement Plan Assets? for more information.
The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through the Pension Benefit Guaranty Corporation. For more information about this protection, see Your Guaranteed Pension.
How do cash balance plans differ from traditional pension plans?
While both traditional defined benefit plans and cash balance plans are required to offer payment of an employee’s benefit in the form of a series of payments for life, traditional defined benefit plans define an employee’s benefit as a series of monthly payments for life to begin at retirement, but cash balance plans define the benefit in terms of a stated account balance. These accounts are often referred to as hypothetical accounts because they do not reflect actual contributions to an account or actual gains and losses allocable to the account.
How do cash balance pension plans differ from 401(k) plans?
Cash balance plans are defined benefit plans. In contrast, 401(k) plans are a type of defined contribution plan.
There are four major differences between typical cash balance plans and 401(k) plans.
- Participation. Participation in typical cash balance plans generally does not depend on the workers contributing part of their compensation to the plan; however, participation in a 401(k) plan does depend, in whole or in part, on an employee choosing to make a contribution to the plan.
- Investment Risks. The investments of cash balance plans are managed by the employer or an investment manager appointed by the employer. The employer bears the risks and rewards of the investments. Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. By contrast, 401(k) plans often permit participants to direct their own investments within certain categories. Under 401(k) plans, participants bear the risks and rewards of investment choices.
- Life Annuities. Unlike many 401(k) plans, cash balance plans are required to offer employees the ability to receive their benefits in the form of lifetime annuities.
- Federal Guarantee. Since they are defined benefit plans, the benefits promised by cash balance plans are usually insured by a federal agency, the Pension Benefit Guaranty Corporation (PBGC). If a defined benefit plan is terminated with insufficient funds to pay all promised benefits, the PBGC has authority to assume trusteeship of the plan and to begin to pay pension benefits up to the limits set by law. Defined contribution plans, including 401(k) plans, are not insured by the PBGC.
The PBGC may be contacted at:
Pension Benefit Guaranty Corporation
1200 K Street NW
Washington, DC 20005-4026
Is there a federal pension law that governs cash balance plans?
Yes. Federal laws, including the Employee Retirement Income Security Act (ERISA), the Age Discrimination in Employment Act (ADEA), and the Internal Revenue Code (IRC), provide certain protections for the employee benefits of participants in private sector pension and health benefit plans.
If your employer offers a pension plan, the law sets standards for fiduciary responsibility, participation, vesting (the minimum time a participant must generally be employed by the employer to earn a legal right to benefits), benefit accrual and funding. The law also requires plans to give basic information to workers and retirees. The IRC establishes additional tax qualification requirements, including rules aimed at ensuring that proportionate benefits are provided to a sufficiently broad-based employee population.
The U.S. Department of Labor, the Equal Employment Opportunity Commission (EEOC), and the Internal Revenue Service (IRS) have responsibilities in overseeing and enforcing the provisions of these laws. Generally, the U.S. Department of Labor focuses on the fiduciary responsibilities, employee rights, and reporting and disclosure requirements under the law, while the EEOC concentrates on the portions of the law relating to age discriminatory employment practices. The IRS generally focuses on the standards set by the law for plans to qualify for tax preferences.