Maximizing Cash Balance Plans: Strategies For Savvy Investors

Cash balance plans are a type of pension plan that can be a great way to boost your financial security and lower your tax liability. They are defined benefit plans, but they resemble defined contribution plans, gaining the name hybrid plans. In this type of plan, employers make regular contributions, and the funds are then invested in the stock market. The benefits of these plans are stated in terms of a 401(k)-style account balance rather than a monthly income stream. This means that participants receive a set percentage of their yearly compensation plus interest charges.

There are two common types of cash balance plans: market-based and traditional. Traditional cash balance plans involve participants getting pay credits, and the plan grows these credits through interest credits. These interest payments are either fixed or tied to a bond index. Market-based plans, on the other hand, are more complex and can result in losses.

When it comes to investing a cash balance plan, it's important to remember that these funds should be invested more conservatively than other retirement accounts. A common investment approach is to have a portfolio mix of stocks and bonds, with a stock allocation ranging from 25% to 70%. It's also crucial to monitor plan investments and review them annually with a financial advisor to ensure they are on track.

While cash balance plans offer a great way to save for retirement, they may not be suitable for everyone. They are typically combined with a 401(k) plan and are often used by business owners to boost retirement savings and reduce taxable income.

Understand the difference between a cash balance plan and a traditional pension plan

Understanding the difference between a cash balance plan and a traditional pension plan is essential if you want to know how to invest a cash balance plan.

A cash balance plan is a defined-benefit pension plan, which means that the employer credits a participant's account with a set percentage of their yearly compensation plus interest. The funding limits, requirements, and investment risk are based on defined-benefit parameters. The final benefits received by the participant upon retirement or termination are not affected by changes in the portfolio, and the company bears all ownership of profits and losses.

A traditional pension plan, on the other hand, generally uses a few years of an individual's highest compensation to determine their monthly benefit upon retirement. In contrast, a cash benefit pension plan uses the total number of years an individual has been with the company. This means that the longer someone stays with the same company, the more their pension will likely be with a traditional pension plan, whereas a cash balance plan is based on a simple average of every year's salary.

Another difference is that cash balance plans do not have contribution limits because the employer funds them to meet a specific account balance at an employee's planned retirement date. This is not the case with traditional pension plans, which often have contribution limits.

In terms of investment risk, the employer bears the risk in a cash balance plan, whereas, with a traditional pension plan, the employee often bears the risk as they choose how the plan invests.

Both cash balance plans and traditional pension plans have their advantages and disadvantages, and the best option for an individual will depend on their specific circumstances and goals.

Know the benefits of a cash balance plan over a 401(k) plan

A cash balance plan (CBP) is a defined-benefit plan that offers several advantages over a 401(k) plan. Here are some of the key benefits:

• Guaranteed Benefits: In a CBP, the employer bears the investment risk and is responsible for ensuring that employees receive the promised benefit amount, regardless of market performance. On the other hand, in a 401(k) plan, the employee bears the investment risk as they choose how the plan invests, and the benefit amount is not guaranteed.
• Higher Contribution Limits: CBPs do not have contribution limits because the employer funds them to meet a specific account balance at the employee's retirement. People aged 60 and above can contribute well over $300,000 annually in pretax contributions to a CBP.
• Tax Advantages: Contributions to CBPs are tax-deductible, and taxes on the funds are deferred until withdrawals are made. This can result in significant tax savings, especially for those in higher tax brackets during their contributing years.
• Lifetime Annuity Option: CBPs are required to offer employees the option to receive their benefits in the form of lifetime annuities, whereas 401(k) plans do not have this requirement.
• Federal Guarantee: As defined-benefit plans, CBPs are typically insured by the Pension Benefit Guaranty Corporation (PBGC). This means that if a CBP is terminated with insufficient funds, the PBGC can assume trusteeship and pay pension benefits up to the legal limits. Defined contribution plans, such as 401(k) plans, do not have this federal guarantee.
• No Employee Contributions Required: CBPs are funded entirely by the employer, so employees can benefit from them without contributing their own capital. This is in contrast to 401(k) plans, where employee contributions are typically required for participation.
• Portability: If an employee leaves their job, they can take the vested portion of their CBP with them and roll it into another retirement account. This flexibility provides employees with more control over their retirement savings.

While CBPs offer these advantages, it's important to note that they also have some drawbacks, such as higher costs to maintain and the need to compensate for market volatility by adjusting retirement contributions. Ultimately, the best retirement plan for an individual will depend on their specific preferences, goals, expected tenure with an employer, and current income.

Learn how to set up a cash balance plan

Setting up a cash balance plan involves complex legal and actuarial considerations, so it is generally advisable to seek professional assistance from an actuary or third-party administrator. However, if you want to set up a cash balance plan yourself, here are the steps you need to take:

• Get a financial or tax advisor as they can help you navigate the process. They will collect relevant employee information, such as ages and salaries, to calculate the amount to be contributed to the plan for business owners, executives, and employees. The IRS requires that a plan passes non-discriminatory testing in terms of favouring owners and key employees.
• Draft the plan document. Put together a legal document outlining all the plan details, the contributions to be made, and the interest rates. The document should be signed by the end of a tax year that the company wants to take the deduction.
• Make the required contributions by the due date of your tax returns. If an extension is obtained, contributions should be made no later than eight and a half months after the year ends.
• Establish a monitoring process to ensure that your business will be able to meet the yearly contributions. Continuously review the returns made by plan assets and make decisions to change the interest rate, amend or freeze the plan before it becomes a liability to the employer.
• Find a quality third-party administrator (TPA) to help manage the plan. This is an organisation specialised in offering services to other companies on pension plans. Managing all plan activities may be a challenging task, so it is recommended to have an actuary involved.

A cash balance plan is a great pension option for your company, offering accelerated retirement savings and increased tax deductions. However, it may not be the best option unless you make a constant cash flow or profit margins annually.

Understand the role of a financial advisor in setting up a cash balance plan

Understanding the role of a financial advisor is crucial when setting up a cash balance plan. While some business owners manage their own cash balance plan investments, seeking professional advice can be invaluable. A financial advisor can guide you through the complexities of retirement planning, ensuring you make the most of tax advantages while staying compliant with regulations.

Retirement Planning Expertise:

Financial advisors are skilled professionals who help individuals and business owners make informed decisions about their money. They provide valuable insights on saving for retirement, putting money aside, and investing for the future. When it comes to setting up a cash balance plan, they can educate you on the intricacies of this retirement plan option.

Tax Advantage Guidance:

One of the most significant advantages of cash balance plans is their tax benefits. Financial advisors can help you navigate and maximize these tax advantages. They will work with you to understand your tax situation and make recommendations to reduce your tax burden. This includes advising on tax-deductible contributions, tax-deferred growth, and the tax implications of withdrawals or distributions.

Investment Strategy:

Financial advisors play a crucial role in developing investment strategies for cash balance plans. They guide their clients on allocating assets across various investment options, such as stocks, bonds, mutual funds, or other investment vehicles. Advisors consider the client's risk tolerance, investment horizon, and financial goals when constructing these investment strategies.

Regulatory Compliance:

Setting up a cash balance plan requires adhering to various regulatory requirements. Financial advisors ensure that the plan complies with laws and regulations, such as those outlined by the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code (IRC). They work closely with plan sponsors and administrators to design and implement the plan while staying within the legal framework.

Plan Design and Implementation:

Financial advisors collaborate with plan sponsors, trustees, or employers to design and implement the cash balance plan. They help determine the plan's formula, considering factors such as employee years of service, compensation, and desired benefits. Advisors also assist in calculating the required contributions and ensuring the plan remains adequately funded.

Communication and Education:

Effective communication is a vital aspect of a financial advisor's role. They educate employees about the cash balance plan, explaining its features, eligibility requirements, contribution limits, and benefit calculations. Advisors ensure that participants understand the plan's complexities and feel confident about their retirement savings.

In summary, a financial advisor plays a pivotal role in setting up a cash balance plan by offering expertise in retirement planning, tax strategy, investment allocation, regulatory compliance, plan design, and employee communication. Their guidance helps business owners and employees navigate the complex world of retirement planning while maximizing the benefits of their cash balance plan.

Explore the investment options available within a cash balance plan

A cash balance plan is a defined-benefit pension plan, often used by business owners to lower their tax liability and boost their retirement savings. It is important to note that a cash balance plan is not a typical investment account, and the investment options available depend on whether the plan is a market-based or traditional plan.

In a traditional cash balance plan, participants receive "pay credits", which are often a percentage of their yearly compensation, and the plan grows these credits through "interest credits". These interest payments are either fixed or tied to a bond index, meaning that if the market is down, the funds in the plan will also decrease. Therefore, this type of plan is not suitable for most participants and can result in losses.

On the other hand, market-based cash balance plans are more flexible and allow investment in a wider range of assets. These include:

• Exchange-traded funds (ETFs)
• Mutual funds
• Stocks
• Bonds and fixed-income investments
• Real estate
• Private loans and notes
• Certificates of deposit
• Conservative index funds
• Cryptocurrency

When investing assets in a cash balance plan, it is recommended to take a conservative approach and maintain a diversified portfolio to minimise risk. This is because, in a cash balance plan, the employer bears the investment risk and is responsible for ensuring the employee receives the promised amount.

Frequently asked questions