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Cash balance pension plans are growing in popularity, but I don’t know much about them. How is a cash balance plan different from a traditional defined benefit pension plan?

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 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. As of July 2014, cash balance plans made up 25% of the defined benefit plan market, up from 2.9% in 2001.

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 2013:

• 89% of cash balance plans are sponsored by employers with fewer than 100 employees;
• 78.5% of cash balance plans have 24 or fewer participants;
• 53% of cash balance plans are sponsored by medical, dental, scientific, technical, and legal firms.

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.