Cash Balance Plan vs. Traditional Pension Plan: What’s the Difference?

Bottom Line Up Front

• Both cash balance plans and traditional pension plans are defined benefit plans, but they present retirement benefits in different ways.
• Both plans place funding responsibility and investment risk on the employer.
• Both plans offer valuable retirement and tax advantages, but the account-based design has made cash balance plans the preferred defined benefit plan for many modern businesses.

What’s the difference between cash balance plans and a traditional pension plan

A cash balance plan (CB Plan) is a type of defined benefit pension plan. Both promise retirement benefits funded by the employer, but a cash balance plan presents those benefits as a hypothetical account balance, while a traditional pension typically presents the benefit as a future monthly retirement payment based on a formula.

Understanding the relationship between cash balance plans and traditional pension plans

Many business owners think of cash balance plans and traditional pension plans as entirely different retirement plans. In reality, both are defined benefit plans, meaning the employer is responsible for funding a promised retirement benefit. They also share many of the same advantages, including potentially significant tax deductions and the ability to help owners and employees build retirement security.

So why do CB plans dominate so many retirement planning conversations among small business owners today?

The answer comes down to practical rather than financial differences. While both plans can deliver similar retirement and tax benefits, CB plans present those benefits in a way that is generally easier for employees to understand, easier for employers to communicate, and better aligned with the expectations of today’s workforce.

In many ways, a CB plan is less of a replacement for a traditional pension and more so a modernized version of one.

How cash balance plans and traditional pension plans are similar

Before examining the differences between traditional pension plans and CB plans, it’s important to understand just how much they have in common. Both are defined benefit plans, meaning the employer is responsible for funding a promised retirement benefit and ensuring the plan remains adequately funded over time.

Both traditional pension plans and cash balance plans:

• Are defined benefit plans
• Are funded by the employer
• Require actuarial oversight
• Place investment risk on the employer
• Can potentially provide significant tax deductions
• Can be offered alongside a 401(k)

Both plan types require annual require actuarial valuations to determine funding requirements and ensure promised benefits remain adequately funded. The calculations help employers satisfy regulatory requirements while keeping the plan on track to deliver its promised benefits.

These shared characteristics from the foundation of each plan’s retirement and tax advantages. In many respects, the two plans operate more similarly than differently. The biggest distinction is not how the plans are funded or administered, but how employees and business owners experience and understand the benefits being provided.

Understanding that distinction helps explain why CB plans have become the more popular defined benefit design for many modern businesses.

At a glance, both plans share many of the same characteristics. The biggest differences lie in how retirement benefits are presented and how participants experience those benefits.

How Benefits Are presented to employees

One of the most significant differences between traditional pension plans and cash balance plans is how benefits are presented to participants.

Traditional pension plans typically provide retirement income based on a formula that considers factors such as years of service and compensation. A common pension formula might look something like this:

Annual Pension = Years of Service x Multiplier x Final Average Salary

Under this approach, employees are promised a future monthly retirement benefit. While that promise can be valuable, many employees find it difficult to determine what the benefit is worth today or how it compares to other retirement savings vehicles.

CB plans take a different approach. Instead of emphasizing a future monthly benefit, participants are shown a hypothetical account balance that grows over time. Each year, the employer credits the participant’s account with a pay credit, which may be based on a percentage of compensation. For example:

• 25% of pay for owners
• 3% of pay for the other employees

The account also receives an annual interest credit, which may be a fixed rate or tied to an approved index such as U.S. Treasury securities.

It’s important to note that while the Cash Balance plan presents the participant’s accrued benefit as a lump sum they are entitled to elect an annuity form of payment upon retirement as this is ultimately a defined benefit pension plan.

Although the account balance is hypothetical and participants do not direct investments as they would in a 401(k), the account-style presentation makes the benefit easier to visualize and track. Employees can see a growing balance on their statements, making the retirement benefit feel more tangible than a promise of future monthly income.

For employers, that difference in presentation can make retirement benefits easier to communicate to employees.

benefit portability and employee mobility

Another important distinction between traditional pension plans and cash balance plans is how benefits are perceived and managed when an employee leaves the company.

In a traditional pension plan, a vested employee generally retains the right to receive their accrued retirement benefit in the future. However, the value of that benefit may not be immediately clear. Because the benefit is typically expressed as a future monthly payment beginning at retirement age, employees may have difficulty understanding what they have earned or how much the benefit is worth today.

Cash balance plans present the vested benefit as a hypothetical account balance, making it easier for employees to see and understand the value they have accumulated. Depending on the plan’s provisions, departing employees may be able to take a lump-sum distribution, roll the balance into an IRA or another qualified retirement plan, or convert the benefit into an annuity.

The distinction can be especially meaningful in today’s workforce, where employees are more likely to change jobs multiple times during their careers. While both traditional pension plans and cash balance plans provide vested retirement benefits, the account-based design of a cash balance plan often makes those benefits easier to understand, manage, and appreciate after separation from service.

For employers, that greater transparency can help employees recognize the value of the retirement benefits being offered.

Who bears the investment risk?

Investment risk is handled similarly under both traditional pension plans and cash balance plans because both are classified as defined benefit plans.

In each case, the employer is responsible for funding the promised benefits and bears the risk that plan investments may not perform as expected. If investment returns fall short of expectations, the employer may be required to make additional contributions to help keep the plan adequately funded.

Employees, on the other hand, are generally insulated from day-to-day market fluctuations and do not make investment decisions for plan assets. That is one of the defining characteristics of a defined benefit plan.

Although a CB plan may resemble a 401(k) because participants see a hypothetical account balance, the underlying economics are very different. Participants do not choose investments, and their retirement benefit is not directly tied to performance of a personal investment account. The employer remains responsible for delivering the promised benefit.

As noted above, the interest crediting rate is often fixed, providing the employer with greater cost certainty. As such, the investment allocation model is usually to a targeted rate of return (e.g., 5%) so that they’ll usually use a more conservative portfolio to mitigate contribution volatility.

This distinction highlights an important theme: cash balance plans may change how benefits are presented, but they do not change who bears the investment risk.

tax benefits of cash balance plans and traditional pensions

Both traditional pension plans and cash balance plans can provide substantial tax deductions and retirement funding opportunities for business owners. Employer contributions are generally tax-deductible, allowing business owners to reduce current taxable income while setting aside money for future retirement needs.

Because contribution limits are determined using actuarial assumptions, including participant demographics, retirement age, and interest rates, allowable contributions can vary significantly from one business to another. An actuary works alongside the plan’s third-party administrator, CPA, and financial advisor to determine appropriate annual funding levels.

One of the primary advantages of defined benefit plans is their ability to support larger retirement contributions than many defined contribution plans, particularly for older business owners who are approaching retirement. This can make either a traditional pension plan or CB plan an attractive option for owners who want to accelerate retirement savings after years of focusing on growing their business.

In many cases, these plans can also be paired with 401(k), creating an opportunity for even greater retirement savings and tax deductions. For profitable businesses with consistent cash flow, the combination of a defined benefit plan with a 401(k) can become a powerful retirement and tax-planning strategy.

These advantages are not unique to CB plans. Both traditional pension plans and CB plans can offer significant tax benefits. The growing popularity of CB plans is often driven less by tax considerations and more by how the retirement benefit is structured and communicated.

Why cash balance plans became more popular

If traditional pension plans and cash balance plans share so many similarities, why have CB plans become the preferred defined benefit design for many businesses?

The answer largely reflects changes in the modern workforce.

Traditional pension plans were developed during a time when employees often spent decades with a single employer and expected retirement benefits to be delivered primarily through a future monthly pension payment. Today’s workforce is more mobile, and all employees are increasingly accustomed to seeing retirement savings expressed as account balances through vehicles such as 401(k) plans.

Beyond that, legislation that clarified age discrimination rules allowed Cash Balance plans to serve a wider audience. Additionally, financial advisors have learned that these plans provide a great vehicle to allow their business owner clients to achieve significant tax deductions and accumulate material retirement savings in the 10-15 years prior to their retirement.

As a result, CB plans have become a popular way for employers to deliver the advantages of a pension plan in a format that feels more familiar to modern workers.

And in our experience working with closely held businesses and professional practices, business owners often prefer CB plans because the account-based format is easier for employees to understand and easier to explain during benefit discussions.

choosing the right defined benefit plan for your business

Cash balance plans and traditional pension plans are often presented as competing retirement strategies, but that comparison can be misleading. A CB plan is not an alternative to a pension plan, but rather is a type of pension plan. Both are defined benefit plans that place funding responsibility and investment risk on the employer while providing employees with a promised retirement benefit.

The similarities between the two plans are significant. Both can offer valuable retirement security, substantial tax deductions, and opportunities for business owners to save aggressively for retirement. Both can also be paired with a 401(k) to create a more comprehensive retirement program.

The key difference is how the benefit is structured and communicated. Traditional pension plans express retirement benefits as future monthly income, while CB plans present benefits as an account-style balance that employees can more easily see, understand, and manage throughout their careers. Although that distinction may seem minor, it has had a major impact on how employees perceive retirement benefits and how employers communicate them.

For many small business owners, that shift in presentation is what makes cash balance plans appealing. They provide man of the same advantages associated with traditional pension plans while offering a design that aligns more closely with the expectations of today’s workforce. As a result, cash balance plans have become the preferred defined benefit plan design for many modern day businesses.

Frequently Asked Questions

Is a cash balance plan a pension?
Yes. A cash balance plan is a type of defined benefit pension plan governed by the same general IRS and ERISA rules as a traditional pension plan.

Is a cash balance plan better than a traditional pension?
Not necessarily. Both can provide valuable retirement benefits and tax deductions. Cash balance plans are often preferred because participants can more easily understand their account balance.

Who bears the investment risk with a cash balance plan?
The employer. Even though participants see an account balance, employers remain responsible for funding promised benefits.

Can you have a cash balance plan and a 401(k)?
Yes. Many businesses pair a cash balance plan with a 401(k) to increase retirement savings and tax deductions.

Can employees roll over a cash balance plan?
Generally yes. Many participants can roll a lump-sum distribution into an IRA nor another qualified retirement plan after leaving employment, depending on the plan provisions.