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Defined Benefit & Cash Balance Plans
Defined Benefit Plans
A defined benefit pension plan is a qualified retirement plan to provide pension income to retired employees on the basis of a formula that accounts for a worker’s years of service at a firm and earnings. Distributions are typically made for the remainder of the employee’s life, making the plan similar to an annuity. Contributions are generally made by the employer only, who is responsible for determining what level of contributions is necessary to provide the promised benefits to all current and future employees. Contributions to defined benefits plans are tax-deferred, meaning that neither the employer nor the employee pays tax on the initial contributions or accumulated earnings.
- Compared with other types of retirement accounts, the risk in a defined benefit plan is borne mostly by the employer. If employees live longer in retirement than anticipated, or if the investments financing the employees’ pensions fail to meet expectations, it is the employer’s responsibility to increase contributions so as to make good on the promised benefits.
- Defined benefit plans are more likely to be offered by large employers who are better suited to bear the risk involved, but can be very advantageous for smaller employers as an asset accumulation vehicle.
- Defined benefit plans are insured by the Pension Benefit Guarantee Corporation, a federal entity whose responsibility is to ensure that employees receive a minimum pension benefit in the event that their employer is unable to pay the promised benefits in full.
Cash Balance Plans
A cash balance plan is considered an employer sponsored hybrid defined benefit pension plan. While a traditional defined benefit pension plan provides a monthly benefit at retirement, the cash balance plan expresses the benefit in terms of an “account balance” –very similar to a 401(k) in appearance. As such, it is much better understood & appreciated by employees.
How do cash balance plans work?
A cash balance plan provides each participant a “pay credit” each year, which is added to their “hypothetical account” and also credited a guaranteed rate of interest each year “interest credit”. The Pay Credit is usually some percent of pay or dollar amount and can vary by participant or group (i.e, 25% of pay to owners & 3% of pay to others). The Interest Credit will normally be a fixed rate such as 5% or tied to an index like US Treasuries. Both the Pay Credit and Interest Credit are defined in the Plan Document.