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Is a Cash Balance Plan or Defined Benefit Plan Right for Your Company?

By Michael Nedreski

Navigating the array of retirement plans as a business owner requires informed decision-making. The tug-of-war between a cash balance plan and a defined benefit plan is a crucial choice that holds lasting implications. In this guide, we shed light on this dilemma, presenting the critical insights you need to steer your company toward a strategy that aligns with your goals.

Traditional Defined Benefit Plan

A defined benefit plan (commonly called a DB plan) is a traditional pension plan that guarantees a specific retirement benefit amount to the employee based on a predetermined formula. Annual contributions to a DB plan are actuarially determined in order to meet the minimum funding requirements necessary to produce the guaranteed benefit in retirement.

Here are some of the pros and cons.

Defined Benefit Pros

1. Attractive benefit: Offering a DB plan can be a powerful tool for attracting and retaining employees since a DB plan offers guaranteed income in retirement.
2. Predictable costs: Unlike other retirement plans, such as a 401(k), a defined benefit plan has predictable costs. As the employer, you are responsible for funding the plan based on a formula, and the benefit payout is determined in advance. This can help with budgeting and cash flow planning.
3. High contribution limits: DB plans have higher contribution limits than other retirement plans. Rather than being subject to a contribution limit, DB plans are subject to a benefit limit. Employers will contribute the actuarially necessary amount to produce the guaranteed annual retirement benefit. In 2023, the annual benefit limit is $265,000 which means employers can contribute much higher amounts than the overall limit of $66,000 (or $73,500 if over the age of 50) for defined contribution plans. 

Defined Benefit Cons

1. Investment risk: DB plans can be expensive to administer since the employer is fully responsible for funding the plan. Employers are on the hook for investment performance and may be required to contribute more to each employee's account if the plan's investments do not perform as expected.
2. Complexity: DB plans are more complex than other retirement plans, and the rules and regulations can be difficult to navigate. Business owners will likely need to hire a professional to help with plan administration and compliance.
3. Limited flexibility: DB plans offer limited flexibility compared to other retirement plans. Business owners cannot reduce contribution amounts or change the benefit formula without making significant plan amendments. Additionally, contributions are required every year even if the business cash flow or revenue declines.

Cash Balance Plan

A cash balance plan is a type of defined benefit plan that combines features of a DB plan with features of a 401(k) plan. A cash balance plan is commonly referred to as a hybrid plan. It offers a guaranteed retirement benefit like a DB plan, but the benefit amount is determined by a stated account balance at the time of retirement, rather than a stated retirement benefit amount. Here are some of the pros and cons of cash balance plans:

Cash Balance Plan Pros

1. Easier to understand and administer: While both a DB plan and a cash balance plan require actuarial calculations to determine funding requirements and benefit amounts, cash balance plans are simpler in design and do not require the same level of ongoing maintenance as DB plans. Cash balance plans operate more like a defined contribution plan, with individual account balances and annual contributions made by the employer. This makes it easier for employees to understand their benefits and for the employer to administer the plan.
2. Can be combined with a 401(k): Cash balance plans can be designed to meet the specific needs of the employer and their employees and can also be combined with a 401(k) to maximize savings even more. A business owner may choose to offer a more generous retirement benefit to long-term employees or those with higher salaries by adjusting the contribution formula for those individuals. This level of flexibility is not possible with a DB plan.
3. Lower costs: Cash balance plans are typically less expensive to set up and administer than DB plans because cash balance plans do not require the same level of ongoing funding and investment management. Instead, the employer contributes a set amount each year to each employee's account, which is invested and grows tax-free until retirement.

Cash Balance Plan Cons

1. Lower contributions (depending on age): Cash balance plans have lower contribution limits than DB plans. This means that business owners may not be able to contribute as much to their own retirement accounts as they could with a defined benefit plan. Cash balance plans are designed to provide age-weighted benefits, which means that older employees typically receive larger benefits than younger employees. As a result, the contributions required to fund the plan are generally lower than those required for a traditional defined benefit plan, which provides uniform benefits to all participants.
2. Limited flexibility: While a cash balance plan offers more flexibility than a traditional defined benefit plan, it is still more restrictive than a 401(k) plan on its own. The employer is responsible for funding the plan based on a formula, and the employee cannot make contributions.
3. Less tax deductibility: Depending on the average age of the participants in your plan, a cash balance plan may provide fewer tax benefits than a DB plan. This is tied to the contribution limits, which are uniform across all age levels in a DB plan and age-weighted in a cash balance plan. Since contributions are tax-deductible for the employer, lower contribution levels can reduce the overall tax savings associated with the plan. This can be particularly challenging for high-income business owners who may be looking for ways to minimize tax liability.

Making the Right Choice

When it comes to retirement planning, there's no one-size-fits-all answer. Weighing the merits of a defined benefit plan against a cash balance plan demands a thorough examination of your business's dynamics, objectives, and workforce. Partnering with professionals, like those at White Oak Wealth Partners, can provide a tailored analysis that guides you toward a choice that serves your business's future and empowers your employees' retirement aspirations. To get started, contact us by calling 814-835-4551, emailing MICHAEL.NEDRESKI@LPL.COM, or scheduling an appointment here.

About Michael

Michael Nedreski is managing partner at White Oak Wealth Partners, a specialized financial lifestyle and wealth management firm serving entrepreneurs, business owners, executives, and their families. Mike has 30-plus years of experience in the financial services industry and is committed to serving his clients through holistic financial planning, disciplined investment strategies, and proactive personal service. Mike and his team are continuously looking for innovative and proactive ways in which to serve their clients, acting as their independent wealth coach and personal CFO. 

A native of Erie, Pennsylvania, Mike began his career in the financial services industry in 1988. He has earned the Chartered Retirement Planning CounselorSM (CRPC®) conferred by College for Financial Planning and Life Underwriting Training Council Fellow (LUTCF) designations. Mike is also an active member of the Financial Services Institute (FSI) and Financial Planning Association (FPA).

When not working, Mike enjoys spending time with his wife, Amy, and their seven children. He volunteers in his community and at his church and his children's schools. An outdoors enthusiast, Mike loves hunting, fishing, golfing, and spending time near or on the water. He also enjoys working out and watching some of his favorite sports teams, the Pittsburgh Pirates and the Cleveland Browns. To learn more about Michael, connect with him on LinkedIn.

This information was developed as a general guide to educate plan sponsors, but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations.