In a cash balance plan, a participant’s account is credited each year with a “pay credit” and an “interest credit.” The “pay credit” is a specified percentage of the participant’s compensation that is deposited into the plan in accordance with the plan document. The “interest credit” is earnings applied to the participant’s account and is either based upon a fixed interest rate or a variable interest rate that is linked to an index, such as the 30-year U.S. Treasury rate. This allows employers a greater ability to predict the cost of their contributions into a cash balance plan as opposed to a traditional defined benefit plan.
A cash balance plan resembles a defined contribution plan because the value of each participant’s benefit is based upon on individual account. The balances in these individual accounts are hypothetical because all of the plan’s assets are held in one large pool of investments and are not segregated between the individual participants, such as in a 401(k) plan. In addition, the value of the assets held by the cash balance plan can be greater than or less than the hypothetical balances assigned to each participant. This is due to the difference between the return on the investments in the plan as compared to the “interest credit” applied to each participant’s account. Like traditional defined benefit plans, the employer is still responsible for ensuring that there is adequate funding into the cash balance plan to ensure that all of the benefits can be paid.
When a participant becomes eligible to receive a distribution under the plan, the participant can receive the distribution in the form of either an annuity payment if the participant has reached retirement age or a lump sum payment, which can be rolled over into an IRA account, or another qualified pension plan. The distributions from a cash balance plan are calculated based upon the participant’s hypothetical account balance. Whereas, the distributions from a traditional defined benefit plan are based upon a defined benefit amount. As a result, there is less investment risk to the employer with a cash balance plan as opposed to a traditional defined benefit plan.
Cash balance plans differ from defined contributions plans in the following ways: