What Is a Cash Balance Pension Plan?

Quick Answer

A cash balance pension plan is a type of defined benefit retirement savings plan where a set percentage of your yearly salary is contributed to your account by your employer.

A lady, facing away from the camera, sitting on a boat floating in clear blue water surrounded by 5 other boats and the mountain

A cash balance pension plan is a type of defined benefit retirement plan where your employer contributes a set percentage of your yearly salary to your account. It can be one way to ensure you're on the path to living your best life when you retire. Find out how cash balance pension plans work and how they are similar (and different) from other types of retirement plans.

How Does a Cash Balance Pension Plan Work?

In general, there are two types of pension plans: defined contribution plans and defined benefit plans.

  • A defined contribution plan is a type of pension plan that specifies the amount you and your employer will contribute to your retirement account.
  • A defined benefit plan provides a set, predetermined benefit at retirement.

Cash balance pension plans are a type of defined benefit retirement plan. With these plans, you, as an employee, are promised a specified benefit at retirement. Employers create a separate hypothetical account for each employee that builds value evenly and usually at the same pace for all employees—whether you've been on the job for one year or 50 years.

These plans are intended to provide you with a guaranteed source of income when you retire, and can be taken in a lump sum or as annuity payments. If you decide to receive a lump-sum distribution, you may have the option to roll it over into an individual retirement account (IRA) or another employer's plan if your cash balance plan accepts rollovers.

Based on the structure of your employer's cash balance pension plan, your account is credited every year with a pay credit—the percentage of your pay paid into your account each year by your employer. You also earn interest credits, at a fixed or variable rate, paid out at a rate tied to an index.

The amount you receive is typically determined by your salary, how long you work, and pay and interest credits. Any increases or decreases in your plan's investments won't directly affect the benefit amounts you're promised.

As an example, let's say your employer offers a 5% pay credit, and you make $100,000 annually. This credit would be worth $5,000 per year. Your plan also earns an interest credit at a fixed rate of 5% per year. Based on these credits, your balance increases year over year. This is the formula used to calculate your annual benefit amount:

Annual Benefit = (Salary x Pay Credit) + (Account Balance x Interest Credit)

Unlike other retirement accounts—like a 401(k)—where you, your employer or both make contributions to your plan and any changes in an investment's performance may cause you to earn or lose money, your employer bears the risk of gains or losses in investments with cash balance plans. So, any change to the performance of the investments doesn't affect your benefit amount, and you will still get the promised amount at retirement.

Cash balance pension plans are also recognized by the IRS as qualified retirement plans. That means you benefit from tax benefits and protections that follow IRS guidelines and federal laws. Plus, the benefits in most cash balance plans are also protected, to a certain degree, by federal insurance provided by the Pension Benefit Guaranty Corporation (PBGC).

Cash Balance Pension Plans vs. Traditional Pension Plans

Both cash balance and traditional pension plans are required to provide benefit payments for life. However, cash balance pension plans specify the benefit based on a specific account balance, whereas a traditional defined benefit plan typically pays out a series of monthly payments for life beginning at your retirement.

With a traditional pension plan, your benefit is determined by a formula that rewards you for working longer, so the longer you work, the larger your monthly payment. That's because the formula for a traditional pension gives heavier weight to your average salary over the last few years of employment.

On the flip side, with a cash balance plan, even if you're the youngest employee at the company, you get the same benefit as the oldest employees. Instead of using the highest few years of compensation, a cash balance plan averages all the years you are with a company, including the ones where you earn the lowest wage. In other words, your distributions typically increase as your compensation increases with a cash balance plan.

What's the Difference Between a Cash Balance Plan and a 401(k)?

Besides differing on the type of contribution you'll receive at retirement, a traditional 401(k) plan and a cash balance plan differ in a variety of ways.

  • Lifetime annuities: Cash balance plans must offer employees the option of converting their plan benefits into lifetime annuities. This is not a requirement for 401(k) plans.
  • Employee participation: Generally, employees do not have to contribute part of their wages to a cash balance pension plan. On the other hand, when you participate in a 401(k) plan, your participation does depend on you making contributions to your plan.
  • Employer risks: Unlike 401(k) plans, where employees often choose their own investments and therefore bear the risks and rewards of those choices, cash balance plans are typically managed by your employer, who carries all the risks.
  • PBGC federal guarantee: As a defined benefit plan, your guaranteed benefits are insured by the PBGC and governed by the Employee Retirement Income Security Act of 1974, or ERISA. If your plan is discontinued because of insufficient funds or the company falls on hard times financially and the promised benefits cannot be paid out, the PBGC becomes the trustee of the plan and pays your benefits up to set limits defined by law. Meanwhile, the Federal Deposit Insurance Corporation (FDIC) insures 401(k) accounts.
  • Contribution limits: Employers are allowed to contribute up to $245,000 per year in 2022 to an employee's cash balance plan. With a 401(k), employees are limited to a contribution of $20,500, or $27,000 for those 50 and older.

Pros and Cons of Cash Balance Plans

According to Federal Reserve Board economists, 25% of all employees in defined benefit plans are enrolled in cash balance pension plans. They offer a number of key benefits for employees, but they also come with a few disadvantages.

Pros

  • Benefits mobile employees: Cash balance plans may be better if you change jobs often. That's because these plans offer you several options, like allowing for the easy transfer of pension benefits to your new employer when you switch jobs. Or, you can leave your assets in the plan where you will continue to earn interest credits, roll over your balance into an IRA or elect an annuity. Once you're fully vested, after three years of tenure with the company, you are guaranteed full benefits even if you change employers before reaching your retirement age.
  • Lump-sum payouts: Unlike traditional defined benefit plans, cash balance plans are more likely to make lump-sum distributions.
  • Rollover opportunities: If you receive a lump-sum distribution, you can typically roll it over into an IRA or another employer's plan if that employer's plan accepts rollovers.
  • Pay and interest credits: With a cash balance plan, you make no contributions to the plan from your wages. Instead, your employer contributes a pay credit, which is typically a percentage of your salary, and an interest credit, which may be a fixed rate or variable rate.
  • High contribution limits: As noted above, cash balance plans allow for higher annual contributions compared with a 401(k) or a similar defined contribution plan.

Cons

  • Distributions are taxable: Any money you take in the form of a distribution from your cash balance plan is considered part of your taxable income at retirement.
  • Contribution limits: Although employer contribution limits on cash balance plans are higher than on some other retirement plans, they are still capped at $245,000 in 2022 and $265,000 in 2023.
  • No employee contributions: Cash balance plans do not allow for employee contributions, so your money may grow slower than with other retirement plans with employer match.
  • Early withdrawal penalty: To withdraw money from your cash balance plan, you'll have to wait until you reach retirement age or 59½. If you take an early withdrawal before you turn 59½, you have to pay taxes on the amount withdrawn, plus pay a 10% early withdrawal penalty.

The Bottom Line

Cash balance pension plans are gaining popularity with employers aiming to attract (and keep) employees. They are also attractive to employees who may not plan to stick with one employer for their entire career.

Just like investing in your retirement is an excellent long-term financial strategy, keeping up to speed on other aspects of your financial health are essential to having enough money for years to come. One sure way to protect your credit in the build-up to retirement and beyond is monitoring your credit for free through Experian.