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October 27, 2018 | Retirement Plans
It’s best to start this discussion with an illustration. If you were given a choice between the following two pension plans, which one would you choose?
Plan A |
Plan B |
“If you work here for 30 years you’ll accrue a benefit equal to 3 and 1/3% of your average earnings for each year of paritcipation at age 65.” |
“You’ll get 18% of pay into your ‘account’ each year and it will earn interest at a rate of 4.5% annually.” |
Plan A is a traditional final average pay defined benefit plan; and Plan B is a cash balance plan. But, actuarially speaking, the two plans depicted above are exactly the same in terms of the monthly benefit payable at age 65. Plan B is unquestionably easier to understand and communicate – which is one of the reasons why cash balance plans are the fastest-growing sector of the defined benefit plan market. At the end of 2001, there were 1,477 Cash Balance plans in the United States, representing 3% of all Defined Benefit plans, while at the end of 2017 there were 18,698 (excluding single-participant plans), representing 40% of all Defined Benefit plans1
A cash balance plan is actually a type of defined benefit plan, but has significant differences. A traditional “final average pay” defined benefit plan pays benefits based on a formula that accounts for average compensation and years of service. A cash balance plan, by contrast, pays benefits based on a hypothetical individual account that earns a specified rate of interest. Additions are made each year by the employer based on a percentage of current pay, and, as the illustration above shows, the benefit is very easy to communicate to employees.
Small business owners may have spent most of their working years investing in their business and not focused on retirement savings. As a result they have “catching up” to do. A cash balance plan can provide meaningful benefits to non-owners, while maximizing benefits for the owners – so long as certain non-discrimination testing is satisfied.
Cash balance plans are particularly popular at employers with fewer than 100 employees. As of 2016:
Most advisors have many clients who are small business owners and have concerns about retirement savings options. Understanding the basics of cash balance plans can help advisors differentiate themselves in the marketplace and assist their clients in reaching a secure retirement.
1Private Pension Plan Bulletin, Abstract of 2017 Form 5500 Annual Reports, Data Extracted on 07/19/2019. Employee Benefits Security Administration, Department of Labor. Excludes plans covering only one participant (https://www.dol.gov/sites/dolgov/files/EBSA/researchers/statistics/retirement-bulletins/private-pension-plan-bulletins-abstract-2017.pdf).”
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