PENSION DYNAMICS C O R P O R A T I O N Benefit BENEFIT DYNAMICS www.PensionDynamics.com Insights “Manage your Benefits... Protect your Future” A non-technical review of qualified retirement plan legislative and administrative issues January 2011 they generate determine a participant’s ultimate retire- Cash Balance Plans 101 ment benefit. Cash balance plans have enjoyed a recent resurgence A defined benefit (DB) plan promises a benefit using in popularity. However, these plans, which can provide a formula that is usually based on compensation and tax-deductible benefits as much as five times greater years of service. For example, a DB plan might provide than 401(k) profit sharing plans, have actually existed an annual benefit equal to 1% of average compen- for
more than 30 years. When the Pension Protec- sation for each year of service. If a participant has tion Act of 2006 (PPA) resolved much of the legal average compensation of $65,000 over 10 years with uncertainty of these plans, small and large companies the company, the annual benefit is equal to $6,500 alike showed a renewed interest. According to a recent ($65,000 x 1% x 10 years of service) for the rest of the research report, the number of cash balance plans in- participant’s life. creased by more than 23% from 2006 to 2007 and more than 75% of existing cash balance plans are sponsored Rather than limiting contributions, the IRS limits the by companies with fewer than 50 employees. maximum annual benefit a DB plan can provide to a par- ticipant to $195,000 per year. The contribution is a func- What is a Cash Balance Plan? tion of how much is needed to fund the promised benefits. Before answering this question, some general back- While there are a number of variables, the following table ground information helps put the discussion in context. summarizes the tax-deductible contributions to fund A defined contribution (DC) plan, such as a 401(k) maximum benefits for DB participants of different ages: profit sharing plan, dictates the contributions that go AgeContribution into the plan each year. Contributions, which are usu- 35 $29,000 40 $40,800 ally discretionary, include employee salary deferrals, 45 $59,400 employer matching contributions and employer profit 50 $91,100 55 $153,900 sharing contributions. The maximum amount a par- 60 $195,500 ticipant can receive in a DC plan each year is $49,000 65 $245,600 for those under age 50 and $54,500 for those age 50 or The employer is said to bear the investment risk because older. These contributions and the investment returns the higher the return on investment, the lower the portion of the funding that must come from the com- plans can only use a “market rate of return.” Examples pany and vice versa. To the extent a DB plan is not fully of market rates include the 30-year Treasury rate; the funded, contributions are generally required each year. interest rate on long-term, investment-grade bonds; a stock market index such as the S&P 500; or the actual A cash balance plan is a type of plan that is sometimes rate of return of the plan’s investments. referred to as a hybrid plan, because...
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