Cash Balance Pensions: Pros, Cons for Small Biz

Cash balance pension plans are defined benefit pension plans with a bit of a 401(k) twist. In a cash balance pension plan, the employer credits each participant’s account with a set percentage of their annual compensation, plus a set interest rate. 

As with any defined benefit pension plan, the investment risk is all on the employer. Unlike with a 401(k), participants are not impacted by fluctuations in the stock market. Each plan participant has her own account, much like a 401(k) or profit sharing plan. An actuary is used to maintain the accounts and generate annual participant statements. (See also: Pension Advance Firms: What You Should Be Wary Of.)

One aspect that makes a cash balance plan attractive to a small business owner, especially one who is older and perhaps behind on his retirement savings, is the high contribution levels that increase as you get older.

For example, for a 65-year-old in 2018, his maximum contribution could be as high as $275,000. In addition, he can still contribute an additional $24,500 to a 401(k) plan if desired. For a business owner who is behind on his savings for retirement, who wants a maximum tax deduction and who has the available cash flow, a cash balance plan can be an excellent solution.

Cash balance plans now account for about 25% of all defined benefit plans according to pension consultants Kravitz Inc. Additionally, the number of cash balance plans have been growing in recent years. Much of this growth is being fueled by solo business owners and high-earning professionals such as doctor groups, law firms and other professionals. (See also: How the Self-Employed Can Prepare for Retirement.) 

For these high-earning baby boomers, the cash balance plan can be the best of all worlds. The high contribution limits offer large tax deductions and for those who are behind in their retirement savings, a nice chance to catch up.

Cash balance plans, however, are not cheap for businesses with employees. The employer contributions in a typical 401(k) plan might run around 3% to 4% of compensation. In a cash balance pension, plan these costs might run in the 5% to 8% range. Participant accounts will receive an annual interest credit which may be a fixed rate of 5% or a variable such as the interest rate on the 30-year Treasury.

Initial setup costs will generally run between $2,000 and $5,000. Each year an actuary must certify that the plan is properly funded. This brings the annual administration costs into the range of $2,000 to $10,000.

Each participant has their own account, much like in a 401(k) plan. At retirement, participants can take their payments as an annuity or, in some plans, there is an option to take a lump-sum distribution that can be rolled over to an IRA. (See also: Can I Deduct my IRA Contribution on My Tax Return?)

Cash balance plans can provide financial advisors with some excellent financial and retirement planning options for their clients. For high-earning solo professionals, these plans can serve the dual purpose of ramping up their retirement savings and providing a higher tax deduction than most other retirement plan alternatives. The benefits for older clients who may not have saved enough are tremendous. Upon retirement, they can take the money as a monthly annuity or roll it over to an IRA. 

The professional practice must have the cash flow to fund these plans on a consistent basis and must be willing to make contributions for their other employees beyond the owners and other professionals. That said, these plans can be ideal for professional groups such as a law firm or a doctor’s group. They can also work well for manufacturers, distributors and other companies. In terms of a business, the same principles apply. The plan can allow the owner and key executives to put away large sums for retirement. This works again as long as the owner(s) are willing and the business is able to support ongoing contributions to the rank and file workers. 

Cash balance plans offer a degree of portability when employees leave the company as long as they are vested in the benefit. Like a regular pension plan, in the event that the employer has financial difficulty, the benefits of the participants are insured by the Pension Benefit Guaranty Corp.  up to their maximum monthly benefit limits.

Cash balance pensions are one of the fastest growing segments of small business retirement plans. They offer the opportunity for business owners to ramp up their retirement contributions and to receive a sizable tax deduction. These plans can be a viable alternative for the right business. (See also: Retirement Planning for Small Businesses.)