A cash balance pension plan is a type of defined-benefit retirement account, which means the benefit is the determining factor of the plan and not the premium. Instead of making contributions to a retirement fund that leaves the eventual amount paid on retirement, or the payout, subject to the performance of the fund managers, a cash balance pension plan flips this equation around. Under a cash balance pension plan, contributions are calculated by working backward starting with the estimated retirement income.
The retirement income is calculated using internal company formulas that take factors such as length of service and salary history into account. Using these factors, the company comes up with a retired income benefit for each employee based on the calculations. Using this number, it works backward to determine how much should be put into the accumulated fund to cover this payout. To come up with the size of the annual contribution per employee, most companies hire the services of an actuary, who would use data such as the number of years until retirement, the estimated retirement benefit and an estimated rate of return.
Since the plan is employer-sponsored, there is no need for an employee to make contributions, although this is not prohibited. One of the unique features of a cash balance pension plan is that employees may choose to receive their pension payout either as a series of monthly payments to the employee and spouse until death, or as a lump sum, which is only permitted with spousal authorization, if the insured is married. This stipulation is included to protect both parties as the policy is considered joint with equal rights. To avoid the tax implications of a lump sum payment, US citizens can have the funds transferred into an individual retirement account (IRA).
Cash balance pension plans are often not as popular as other types of retirement savings options because they generally produce lower rates of return. In uncertain economic climates, they can experience a resurgence of interest from both employers and employees. Employees benefit from the fact that cash balance pension plan payouts are not subject to the performance of the overall fund. The employee is guaranteed the dollar amount stated by the company, regardless of the investment performance because the company maintains sole responsibility for the management of the fund. Employers, on the other hand, benefit from the fact that money transferred to a cash balance pension fund is tax deferred, which provides an excellent tax shelter.
In the event that the fund performance is worse than predicted, the company will be required to dip into profits to come up with the excess amount. This means that all the risk is passed on to the company, but it also means that the estimated rate of return is usually more conservative than other types of retirement accounts. In addition to this, cash balance pension funds are also typically insured by a government agency, so in the event the company terminates the plan due to inability to pay, the agency can take ownership and pay benefits up to the limits set up by law.