America is obsessed with saving for retirement. You hear about it every day. Social Security will be kaput in the next few decades, and if you don’t save enough for old age, a daily diet of cat food, misery, or worse awaits. Thankfully, we have 401(k)s, 403(b)s, and pension plans to help us save. Cash balance plans (CBPs) are another leg of that retirement savings regimen.
They’re popular with small-business owners who are responsible for funding and running the plans for both themselves and their employees. What’s unique about CBPs is that they offer savers (namely procrastinators, older folks, and high earners) a quick and simple way to build a sizable nest egg while getting an income-tax reduction to boot.
Today, CBPs hold more than $1 trillion in assets, making them a key part of America’s retirement savings system.
What Is a Cash Balance Plan and How Does It Work?
A cash balance plan is a retirement savings tool that works basically like a pension or a defined-benefit plan. The employer credits a worker’s account based on a predetermined percentage of their annual compensation plus a guaranteed interest rate. The money is then pooled with other participants and invested.
At retirement, you receive a guaranteed, a specified amount of money, regardless of how well the markets perform.
The company shoulders the risk, not you. CBPs operate a bit like 401(k)s in that you get an individual portfolio account plus monthly and annual statements describing the account’s growth and value.
At retirement, the account balance can be rolled over into a traditional individual retirement account (IRA), turned into an annuity, or cashed out. If a worker, for example, chooses an annuity and retires at age 65 with $100,000, he or she can expect an annual payout of $8,500 for life.
There’s also another similarity to 401(k)s: The plans are portable. This means that the employee can transfer the account to an IRA after moving to a new employer. And there’s no law against having both a 401(k) and a CBP.
What Makes CBPs Superior to 401(k)s?
With a 401(k), each pay period, you make tax-deferred contributions that are invested in the stock, money-market, and bond markets. Hopefully you’ll get a company match (typically 15 cents for every $1) and/or a fixed contribution.
But here’s where CBPs trump 401(k)s: Employees don’t make contributions. The employer does.
That alone is a huge, generous benefit. And for those lucky enough to have both a CBP and a 401(k), not being burdened with CBP contributions means you’re free to funnel more of your paycheck into your 401(k).
Also keep in mind that 401(k)s are at the mercy of the markets, which means there are no guarantees. You shoulder the risk, not your employer. If the stock market implodes, so does your account balance.
Another advantage CBPs have over 401ks is that the employer contribution amount is much higher. With a CBP, the rate ranges typically from 5 to 8 percent, and on top of the employer contribution credit, the CBP account holder also receives an interest rate typically around 5 to 6 percent.
Who’s Best Suited for a CBP?
These retirement plans offer Americans a special opportunity to sock away huge amounts of money in a relatively short period of time while getting a tax break. CBPs are popular with older business owners who’ve neglected their own retirement savings over the years.
There are two top features: First, the older you get, the more you can contribute annually. And second, folks 60 years and older can contribute more than $200,000 pre-tax! That’s big, and it puts 401(k)s to shame, as they allow combined total annual employer-employee contributions — for those older than 50 — of only $63,500.
Those who work in professional services like doctors, lawyers, and accountants are drawn to CBPs because they typically earn six-figure salaries and are therefore eligible to receive bigger contributions from their employers.
It’s important to keep in mind that CBPs are skewed toward older workers. The plans reflect a worker’s average salary over his or her full career at the business. That means a CBP is a less effective option for a 30-year-old employee pulling in a low annual salary than for a 50-year-old who’s much more experienced and earning top-dollar.
The advantages of CBPs are clear — generous contribution limits, double-whammy saving opportunity (can have both a 401(k) and CBP), and tax minimization (the account grows tax-deferred, but the annual contribution could lower the amount income subject to taxes).
Even large corporations and state governments are setting up CBPs because they are less costly than traditional pension plans.
However, CBPs don’t work for every small business. It’s super crucial that the company has a constant, reliable cash flow and is profitable. When business owners set CBPs for themselves, they usually do so for their employees, as well. That’s a big cost for any business.
Another cost for business owners is investment risk. Remember that the company shoulders the risk, yet at the same time is obligated to pay out a guaranteed amount of money at retirement. If the company’s investments lose money, the business owners must find other ways to cover those losses and pay the retirement guarantees.
Lastly, CBPs have higher costs than 401(k)s when it comes to actuary expenses, investment-management fees, and administration costs.
How Business Owner Can Set Up a Cash Balance Plan
It’s highly recommended that business owners use a financial adviser or certified public accountant to help navigate the process. Setting up the plan typically costs around $5,000.
The plan, which is a legal document, outlines the function, contributions, and interest rates. An actuary designs and certifies the plan’s funding annually; third-party administration manages the plan and ensures the business is financially viable to make the yearly contributions as well as payouts. If trouble arises, a CBP can be shuttered and the plan’s assets distributed.
Annual administration expenses can range into the low double digits.
Meanwhile, investment-management fees typically range from 0.25 percent to 1 percent. Those costs can add up for a small business.
For the small-business owners who for years plowed their hearts and souls (and life savings) into their babies as they understandably neglected their own retirements, a cash balance plan seems like a godsend.
CBPs allow them to divert large sums of money from the businesses to help them catch up while getting a tax break. CBPs are also a great way to retain and attract talent, especially when a business offers its employees both a 401(k) and a CBP. Talk about supercharging retirement savings.