There are two general types of pension plans: defined benefit plans and defined contribution plans. Defined benefit (DB) plans provide a specific benefit at retirement for each eligible employee, while defined contribution (DC) plans specify the amount of contributions to be made by the employer toward an employee’s retirement account. In a DC plan, the actual amount of retirement benefits provided to an employee depends on the amount of the contributions, as well as the gains or losses of their account.
What Is A Traditional DB Plan?
A traditional DB plan defines the retirement benefit as a monthly annuity based on a formula which is often a percentage of compensation (or average compensation) for each year of service with the employer. A lump sum distribution option may be provided where that payment amount is determined based on mandated fluctuating interest rates set by the IRS.
What Is A Cash Balance Plan?
A cash balance plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In a typical cash balance plan, a participant’s account is credited each year with a “contribution credit” (e.g. 5 percent of compensation from the employer) and an “interest credit” (either a fixed rate, or a variable rate that is linked to an index such as the one-year Treasury bill rate). Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks are borne solely by the employer. That is why these accounts are often referred to as “hypothetical accounts”. When a participant becomes entitled to receive benefits under a cash balance plan, they are often defined in terms of their hypothetical account balance, though an annuity option must also be offered as an option to the participant.
A traditional defined benefit is less expensive to administer, but usually requires larger employer contributions that may fluctuate more dramatically with changes in interest rates; it is also often harder for participants to understand the value of their benefits. A cash balance plan is more expensive to administer, but the employer contribution is more uniform and predictable and it is easier for participants to understand their benefits.
So, What Is The Best approach?
The right plan choice depends on the demographics of the participants and the needs of the plan sponsor. All of the characteristics of these plan types must be considered and given the proper level of importance. For smaller plan sponsors where there is only one company owner and where maximum deductible contributions are desired, a traditional defined benefit is typically the best way to go; the maximum benefit can automatically accrue without the need for incremental amendments. However, if there are at least two owners who are different ages and where equal contributions are desired, a cash balance plan is usually the best option.
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