Last Updated on February 12, 2024 by Amrita
A cash balance pension plan is a retirement savings plan that falls under the category of defined-benefit plans. These plans are typically sponsored by employers and provide employees with a set percentage of their yearly compensation, along with interest charges, to be contributed into their account. This type of plan offers the option for participants to receive a lifetime annuity upon retirement.
Unlike defined-contribution plans, the investment risk for a cash balance pension plan is carried by the employer, and any changes in the portfolio do not affect the final benefits received by the employee. This provides more security and stability for employees as they approach retirement age.
Additionally, with a cash balance pension plan, employers are responsible for all profits and losses in the invested portfolio, relieving employees of any potential financial risks. Ultimately, a cash balance pension plan serves as a valuable retirement benefit for employees, offering a steady and secure source of income during their golden years.
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How Does Cash Balance Pension Plan Work?
A cash balance pension plan works by combining elements of both defined-benefit and defined-contribution plans. Like a defined-contribution plan, the employer contributes a set amount to the employee’s individual account each year, usually based on a percentage of their salary.
This contribution is then invested professionally, and the employee is promised a specific benefit at retirement. However, unlike a traditional defined-benefit plan, the benefit is stated in terms of a 401(k)-style account balance instead of a monthly income stream.
This means that changes in the value of the investments do not affect the promised benefit, as it is based on a fixed percentage of the employee’s salary. As the employee continues to work for the company, their account balance grows with additional contributions and interest credits.
At retirement, the employee can choose to receive either a lump sum or monthly annuity payment based on their accumulated account balance. This hybrid structure of cash balance pension plans offers employees more flexibility and control over their retirement savings while still providing a promised benefit from their employer.
Cash Balance Pension Plan Pros And Cons
Pros:
- Ability to receive a lump sum: One of the main advantages of a cash balance pension plan is that employees have the option to receive a lump sum payout when they retire. This can be beneficial for those who want to invest the money in traditional preservation instruments like government bonds or money market funds.
- Rollover option: Another advantage is that employees have the ability to roll over their lump sum payout into another retirement account, such as an IRA or another pension plan. This gives them more options and control over their retirement savings.
- Lower risk: Cash balance plans typically have a lower risk compared to other types of retirement plans such as 401(k) or defined benefit plans. This is because the employer bears the investment risk and is responsible for ensuring that the promised benefits are paid out.
- Guaranteed benefits: Cash balance plans also offer participants guaranteed benefits, regardless of market performance. Unlike 401(k) plans where the final account balance is dependent on investment returns, cash balance plans provide a set amount that will be paid out in retirement.
- Tax-deferred contributions: Like traditional 401(k) plans, cash balance pension plans offer tax-deferred contributions. This means that employees won’t have to pay taxes on their distributions until they make withdrawals or take a lump sum payment. This can be advantageous for those who expect to be in a lower tax bracket during retirement.
- No contribution limit: Unlike IRAs and 401(k)s, cash balance pension plans do not have contribution limits. The amount an employee can contribute depends on factors like income, age, and the target date and balance of the fund.
Cons:
- Taxable distributions: While the tax-deferred aspect of this plan is a benefit, it’s important to note that employees will still have to pay taxes when they withdraw money from the plan. This can significantly reduce the amount of retirement income.
- No employee contributions: Only employers contribute to cash balance pension plans, so employees are not able to add any of their own capital from their wages. This limits the control and involvement employees have in their retirement savings plan.
- High costs to maintain: The costs of maintaining a cash balance pension plan are typically higher compared to other retirement plans. This is because an actuary is needed to ensure the plan remains adequately funded, which translates into higher costs for employers.
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Conclusion | Cash Balance Pension Plan Pros And Cons
In the end, the decision to choose a cash balance pension plan or not depends on individual circumstances and retirement goals. While it offers many advantages, such as the ability to receive a lump sum and lower risk, etc, it also comes with limitations.
is important for employees to carefully weigh the pros and cons before making a decision and consult with a financial advisor if needed. Regardless of which retirement savings option is chosen, you must start saving early and consistently to secure a comfortable retirement. So, you should always be aware of all the available options before finalizing your retirement plan.
