Nowadays, many companies provide their employees with a retirement plan to help them save for their old age. Importantly, these retirement plans can take numerous forms such as 401(k) plans and pension plans. However, today, we will focus only on the cash balance pension plan. If you wonder whether this plan is suitable for you, this article can answer your question.
List of Contents
- What Exactly Is a Cash Balance Pension Plan?
- Working Principles of Cash Balance Pension Plan
- How Are Cash Balance Pension Plans Regulated?
- Advantages of a Cash Balance Plan
- Disadvantages of a Cash Balance Plan
What Exactly Is a Cash Balance Pension Plan?
A cash balance pension plan is a defined-benefit pension plan that includes the option of a lifelong pension. The company credits a participant’s account with a specified proportion of their yearly pay plus interest charges under a cash balance plan. The financing restrictions, funding needs, and investment risk are all determined by defined-benefit criteria. Changes in the portfolio have no effect on the participant’s ultimate benefits upon retirement or termination, and the corporation owns all gains and losses in the portfolio.
Working Principles of Cash Balance Pension Plan
In a cash balance pension plan, when a business provides it, they contribute to an account on each employee’s behalf. Thus, an employee is guaranteed those contributions, known as the pay credit, as well as a specific amount of interest credit at either a fixed or variable rate. Since this is a type of defined benefit plan, the actual investment returns for the account are immaterial.
For instance, assume a corporation has a cash balance pension plan in which an employee was offered a 5% pay credit on their salary. A $5,000 pay credit would be given to an employee earning $100,000 per year. Moreover, assume an employee additionally receives a 5% fixed-rate interest credit. Their account rises each year based on the following formula:
Annual Benefit = (Wage x Pay Credit) + (Balance x Interest Credit)
Importantly, the employee will be assured a particular account amount when they retire. The account balance guaranteed to them will be determined by their years of service with the company, their compensation during their working years, and market interest rates. Additionally, they will then either get an annuity sum payment for their whole account amount or a monthly annuity based on their balance.
How Are Cash Balance Pension Plans Regulated?
Cash balance pension plans, like other employer-sponsored retirement plans, are governed by the Employee Retirement Income Security Act (ERISA). Furthermore, the Age Discrimination in Employment Act (IDEA) and the Internal Revenue Code also apply to them (IRC). Significantly, the rules governing cash balance pension plans provide participation, vesting, benefit accrual, financing, and legal duty criteria. Each pension plan is required by law and by standards to operate in the best interests of its participants. Furthermore, plans must disclose basic information about the plan to both employees and retirees.
Advantages of a Cash Balance Plan
The responsibility of investing is on the employer.
A pension company makes a guarantee to its employees that it will look after them in their old age. Therefore, it is employer’s responsibility to make investments in your pension fund. While some pensions let employees make additional contributions to the pension system, the employer is still required to make contributions. They must be capable of giving their employees the promised retirement income.
The employer takes the investment risks.
Employees who have pension plans can relax a little bit since the company bears the burden of investing and managing any possible hazards. Additionally, the corporation will probably conduct extensive studies to safeguard that money because it must pay for the retirements of numerous people. Moreover, the fact that the employer is in charge of making wise investments is a benefit of pensions. Thus, the employer is responsible for ensuring that funds from the company are invested to provide good returns.
Disadvantages of a Cash Balance Plan
There is a possibility of a company’s failure.
If your employer goes broke or suffers serious financial trouble, it may have an impact on your pension. This type of serious financing shortage may not even be the outcome of a company collapse. These concerns might also be caused by sharp losses in the general stock market. Moreover, when your employer declares bankruptcy or runs out of funds, it will be unable to pay full pension payments. Normally, you would still get something, but it could be far less than you expected.
Investments are not subject to employee control.
The most important point is that a pension does not provide you any control over the investments made with your money. Besides, you have to remember that the company is responsible for a decent trade-off. They are responsible for ensuring that the money promised to you will be there when you retire. Therefore, there is a good chance that the employer would make an effort to invest the money prudently.
Accessibility is difficult.
Another disadvantage of pension plans is their lack of accessibility. Your pension is held in trust by your employer until the day you retire. If you are in an emergency situation and want a large sum of money, your pension will not assist you. Therefore, you should have a separate emergency fund with enough money to cover a big home repair or other unanticipated expenditure.
Pension plans are still narrowly used.
The person that receive the benefits is only those working in state and local government employment. They will have the best chance of receiving a defined benefit retirement plan. According to the U.S. Bureau of Labor Statistics Employee Benefits Survey, only 37% of those who worked in state and local government had access to a plan.
In short, while the cash balance pension plans has advantages and disadvantages, it is still critical to prioritize retirement savings regardless of the type of plan that is most suitable to you. If your company provides a cash balance pension plan, you should definitely take advantage of it. If no such plan is available, a 401(k) or even an IRA can still assist you in planning for a financially secure retirement. If you are interested, you can read more details in the related articles.
A cash balance pension plan is a type of defined benefit plan in which the employer credits a participant’s account with a set percentage of their annual salary plus interest. The account balance rises over time and offers a lump-sum payment at retirement.
Employers can decide who is eligible for their Cash Balance Plan based on age, years of service, and salary, among other things. However, they must follow anti-discrimination regulations that involve barring particular employment groups.
401(k) plans are defined contribution plans, whereas Cash Balance Plans are defined benefit plans. Unlike 401(k) plans, Cash Balance Plans do not require employee contributions to join. In addition, the company takes the investment risk in a Cash Balance Plan, while the employee takes the risk in a 401(k) plan.
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Read more: Retirement Planning