Cash Balance Plans: What Employees and Employers Should Know

Retirement planning can feel complicated, but cash balance plans make it simpler. They combine the clarity of an account balance with the guarantees of a traditional pension, giving employees predictable growth and employers a powerful tool for recruiting and retention. Whether you’re an employee looking at retirement options or an employer designing benefits, understanding how cash balance plans work can help you make smarter financial decisions.

What is a Cash Balance Plan?

A cash balance plan is technically a defined benefit pension, but it looks and feels like a defined contribution account. Each eligible employee has a “hypothetical account” that grows through:

• Pay credits: Employer contributions each year, usually a flat amount or a percentage of pay.
• Interest credits: A guaranteed growth rate, fixed or linked to an index like U.S. Treasury yields.

Even though the employee’s have a “hypothetical account,” the plan’s assets are pooled and managed by the employer. The employer guarantees the account’s growth, absorbing investment and longevity risk.

How Cash Balance Plans Work

• Participation: Eligibility rules vary, and participation is governed by the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code.
• Accrual: Each year, a employee’s hypothetical account is credited with the plan’s pay credit and interest credit.
• Vesting: An employee becomes entitled to the plan benefit by satisfying the plan’s vesting schedule. Many plans use a three-year cliff schedule where employees become fully vested after three years.
• Investments: Employees do not select investments; the employer and plan fiduciaries manage the portfolio.
• Benefit Options: Upon termination of employment, an employee can typically take the vested balance as a lump sum, roll it over to an IRA or another employer plan, or elect an annuity.

How Cash Balance Plans Compare to 401(k)s and Pensions

Traditional Pension

• Traditional pensions promise a monthly annuity based on service and pay.
• Cash balance plans express that same promise as an account balance that can be paid as a lump sum or converted to an annuity.
• In both plans, the employer bears investment and longevity risk.

401(k)

• 401(k) benefits depend on employee contributions, employer matches, and investment returns.
• Cash balance plans are funded by the employer.
• Employees do not see market volatility reflected directly in their account balance as the rate of interest that is credited to an account is defined by the plan rather than market performance.

Tax Advantages of a Cash Balance Plan

Cash balance plans offer significant tax benefits for both sides.

For Employers

• Contributions are tax-deductible, helping reduce taxable income.
• Higher contribution limits than 401(k)s, especially for older employees.
• Often exempt from Social Security and Medicare taxes (FICA).

For Employees

• Contributions and interest grow tax deferred.
• Employer contributions are usually exempt from FICA.
• Vested balances can be rolled over to maintain tax-deferred status.
• Taxes are due upon withdrawal, often in retirement when employees may be in a lower bracket.
• Withdrawals taken before age 55 after leaving an employer may be subject to additional taxes and penalties.

Pros and Cons of Cash Balance Plan

Employees

• Pros: Predictable growth through interest credits, potential for larger benefits than a standalone 401(k), portability to an IRA or new employer plan, optional lifetime annuity.
• Cons: No control over investments; interest credit may lag market returns (or exceed them in weaker years); distribution timing and interest rate environment can affect lump sum versus annuity value; benefits and vesting depend on plan rules—leaving early may reduce the employee’s account balance.

Employers

• Pros: Clear, attractive benefit that aids recruiting and retention; flexible plan design with budgeting options to match workforce goals; addresses employee preference for portable benefits compared with traditional annuity-only pensions; when paired with a 401(k), can accelerate tax-deferred retirement savings and pass nondiscrimination tests.
• Cons: Employer bears funding, investment, and interest rate risk; requires actuarial valuations, compliance with ERISA, and ongoing administration; Pension Benefit Guaranty Corporation (PBGC) premiums and potential insurance costs; communication must be clear to prevent misunderstandings or concerns about “wear away” when converting from traditional pensions.

What Happens When Employees Change Jobs or Retire

When employees leave or retire, they have several options:

• Lump Sum: Roll over the vested account balance to an IRA or another employer plan to defer taxes.
• Annuity: Convert the balance to a lifetime monthly income. The payout depends on the employee’s account balance and annuity conversion factors, including interest rates and mortality assumptions.
• Taxes:
  • Distributions are taxable if not rolled over.
  • Required minimum distributions apply at a certain age if funds remain in an IRA or qualified plan.
  • Timing matters, interest rates and plan rules influence the relative value of a lump sum versus an annuity. Higher market rates generally reduce the lump sum needed to fund a given annuity, and lower rates increase it.

Practical Decisions That Shape Employee and Employer Outcomes

Employers can tailor cash balance plans to workforce goals:

• Pay credits by age or time of service: Helps retain employees and meet nondiscrimination rules.
• Interest credit structure: Fixed or market-linked rates affect both perceived value and employer risk.
• Integration with 401(k): Provides guaranteed growth through the cash balance plan and investment flexibility through a 401(k).
• Communication and education: Clear explanations of hypothetical accounts, vesting schedules, and distribution options help employees make informed decisions.

Ready to Build a Cash Balance Plan That Works

Cash balance plans give employees predictable growth and portability while helping employers offer a clear, valuable benefit. CBIZ can help you design, manage, and maintain a plan that works for your business and your team.