Market Based Cash Balance Plans: What Are They?
A market-based cash balance plan (MBCBP) is a type of defined benefit pension plan that acts somewhat like a defined contribution plan. It combines features of both traditional pension plans and more modern 401(k) plans, offering a balance between the predictability of a pension and the portability of a 401(k). Here’s an overview of how these plans generally work:
Credit Balances:
Participants in a MBCBP receive a hypothetical account balance, which is credited each year with a pay credit (a percentage of their annual salary) and an interest credit. Unlike traditional cash balance plans, where the interest credit is typically a fixed or predefined rate, the interest credit in market-based plans is linked to the performance of specific investments, often mirroring the returns of certain market indexes.
Investment Risk:
The unique aspect of a market-based plan is that the interest credits are tied to the performance of the investments chosen by the employer or plan sponsor. This means that the account balances can fluctuate based on market conditions, unlike traditional cash balance plans where fluctuations are typically smoothed out. It shifts some of the investment risk from the employer to the employee, similar to a 401(k) plan, but within the framework of a defined benefit plan.
Benefits at Retirement:
Upon retirement, employees are entitled to receive their account balances, which can be taken as a lump sum or converted into an annuity. This provides a clear, account-statement-like format of benefits, making it easier for participants to understand how much they have saved for retirement.
Portability:
Like 401(k) plans, MBCBP’s are portable. This means that if an employee leaves the company, they can roll over their balance into an IRA or another employer's plan, which is a significant advantage over traditional pension plans that often have complex vesting schedules and benefits that are more difficult to transfer.
Plan Funding:
Employers are still responsible for funding the plan, and they bear the financial risk of ensuring there are sufficient assets to meet the plan obligations. This funding requirement is subject to regulatory minimums and can vary with market performance, which can increase the financial management burden on the employer compared to traditional defined contribution plans.
Regulatory Compliance:
Market-based cash balance plans must comply with various federal regulations, including those enforced by the IRS and the Department of Labor. These regulations ensure that the plans are equitable and adequately funded.
Market-based cash balance plans offer a modern twist on retirement savings by providing a hybrid solution that can be more attractive to both employers and employees, particularly in volatile economic times.
What Is The Difference Between A 401k And A Cash Balance Plan?
The difference between a 401(k) and a cash balance plan lies primarily in their structure, benefits, and how contributions and payouts are handled. Both are types of retirement plans, but they cater to different needs and preferences.
1. Plan Type and Structure
401(k) Plan: This is a type of defined contribution plan. Employees contribute a portion of their salary (on a pre-tax or post-tax basis, depending on the type of 401(k)), often with employer matching contributions. The benefits available at retirement depend on the contributions made and the investment performance of those contributions.
Cash Balance Plan: This is a type of defined benefit plan, which means it provides a guaranteed benefit at retirement. Each participant has an individual account that is credited each year with a pay credit (such as a percentage of their annual salary) and an interest credit, which is usually a fixed rate or linked to an index.
2. Contributions
401(k) Plan: Contributions are typically made by the employee, with the option for additional matching contributions from the employer. The total contribution limit is significantly higher, allowing for substantial annual contributions.
Cash Balance Plan: The employer makes most contributions, which are predetermined by a formula. This formula might include a percentage of each employee's salary plus an interest credit rate.
3. Investment Risk
401(k) Plan: The investment risk is borne by the employee. The value of the account can fluctuate based on the investment choices, which are usually selected by the employee from options provided by the employer.
Cash Balance Plan: The investment risk is generally borne by the employer, as the benefits are defined and guaranteed regardless of the plan's investment performance. Any underperformance in investments typically requires additional contributions by the employer to make up the shortfall.
4. Payouts at Retirement
401(k) Plan: The payout at retirement depends on the amount accumulated in the employee's account, which reflects contributions made by and on behalf of the employee plus or minus investment gains or losses.
Cash Balance Plan: The payout is defined by the plan terms and is not directly dependent on the investment performance. At retirement, employees usually receive the balance in their account either as a lump sum or as an annuity.
5. Portability
401(k) Plan: Highly portable. Employees can roll over their 401(k) into another employer's 401(k) plan or into an Individual Retirement Account (IRA) when they change jobs.
Cash Balance Plan: While also portable, the portability might be slightly more complex compared to 401(k) plans. Employees can still roll over their balance into an IRA or another qualified plan but might face more restrictions depending on the plan's terms.
6. Suitability
401(k) Plans: Suitable for employees looking for flexibility and control over their retirement savings and investment choices. They are also beneficial in settings where employers want to offer a benefit but minimize their financial obligations regarding contributions.
Cash Balance Plans: Often preferred by employers who wish to provide a more traditional pension-like benefit with defined outcomes, and are particularly favored in environments where attracting and retaining top talent is necessary and employers are willing to assume more financial responsibility for funding retirement benefits.
Choosing between a 401(k) and a cash balance plan typically depends on the financial goals and circumstances of the employer and employees, as well as the level of investment risk they are prepared to handle.
Takeaway
Market-based cash balance plans offer a unique blend of predictability and flexibility in retirement planning, making them an attractive option for both employers and employees, especially in today's volatile economic climate. By understanding the differences between market-based cash balance plans and other types of retirement accounts, such as 401(k)s, individuals and companies can make more informed decisions about how to structure their retirement benefits to meet their specific needs and goals. These plans not only facilitate a clearer understanding of retirement savings but also adapt to the modern workforce's mobility, providing a portable and secure method to save for the future.
