CASH-BALANCE plans Better options for retirement

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Image of coins CASH-BALANCE plans Better options for retirement
By Matthew Tuttle, CFP, MBA

When you hear the phrase “cash-balance pension plan,” you may recall the controversy and resulting court case concerning IBM and its workers.

When, in the year 2000, IBM attempted to switch its employees from its traditional defined-benefit pension plan to a cash-balance plan in order to save money, its workers attacked the change, claiming older workers would be shortchanged by the transition to a cash-balance plan and, therefore, discriminated against.

The IBM situation ended up in court. In 2003, the U.S. District Court for the Southern District of Illinois ruled in favor of the older workers. But in August 2006, the Seventh Circuit Court of Appeals ruled “an employer is free to move from one legal plan to another plan, provided that it does not diminish vested interests — and this [IBM’s] transition did not.”

The IBM case created interest and fear in cash-balance plans. But what many people do not realize is that in the right situation, this type of pension plan is a good solution for employees and employers.

Cash-balance plans typically work well for:

• Professional practices and profitable small businesses with stable earnings;

• Companies with two to 25 employees; and

• Companies in which there is a spread between either the ages of the owners and employees or the salary of the owners and employees.

Traditionally, when small-business owners, such as you, have wanted to install a retirement plan for their businesses, they had two options: defined-contribution plans (such as a 401(k), profit sharing, money purchase, SEP, or SIMPLE plans) or defined-benefit plans.

Defined-contribution plans limit the cost of contributions for employees and the tax-deductible contribution for the business owner ($45,000 in 2007).

Defined-benefit plans allow a large contribution for the owner, but can also mandate large contributions for employees.

Cash-balance plans provide a third option, with potentially large tax-deductible contributions for the owner and low contributions for employees.

Image chart of Pension Programs

BEST OF 2 WORLDS

A cash-balance plan is a hybrid retirement plan designed to combine the best features of defined-contribution and defined-benefit plans. Like a defined-contribution plan, employees have their own accounts with contributions based on compensation and interest, which are credited each year based on a formula specified in the plan document.

And like defined-benefit plans, the retirement benefit is the greater of the benefit that can be provided by the employee’s account or a minimum benefit, as described in the plan document.

Contributions to cash-balance plans come solely from the practice owner; employees cannot contribute their own funds.

The chart (“Comparison of Pension Programs”) gives an example of the benefits of a cash-balance plan. In the example, XYZ Chiro-practic has two owners, ages 45 and 48. They also have five staff people of varying ages and salaries. XYZ wants a retirement plan that allows the maximum benefit to the owners while minimizing employee costs.

The chart compares the tax-deductible contribution for a profit-sharing plan, defined-benefit plan, and cash-balance plan.

In this example, the cash-balance plan allows the owners a tax-deductible, retirement-plan contribution of more than $90,000 each and low contributions for employees. In fact, 91 percent of all contributions to the plan goes to the two owners, as opposed to 69 percent in the other plan designs.

WHAT IS NEEDED

What is a cash-balance plan?

There are two general types of pension plans — defined-benefit plans and defined-contribution plans.

In general, defined-benefit plans provide a specific benefit at retirement for each eligible employee, while defined-contribution plans specify the amount of contributions to be made by the employer (or employee) toward an employee’s retirement account.

In a defined-contribution 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 the account.

A cash-balance plan is a defined-benefit plan that defines the benefit in terms more characteristic of a defined-contribution plan. In other words, a cash-balance plan defines the promised benefit in terms of a stated account balance.

To set up a cash-balance plan, you need a plan administrator and/or actuary to do the plan design and keep the plan records. The actuary determines the amount that has to be put into the plan each year, and the plan administrator keeps the records of individual employee accounts and files the required forms with the IRS.

Although a cash-balance plan looks similar to a defined-contribution plan, there is one big difference: Each employee has a guaranteed cash balance in retirement regardless of how the plan’s investment performs. Therefore, you need to take care when choosing plan investments. You cannot take too much investment risk.

Cash-balance plans can be combined with defined-contribution plans and can work particularly well with 401(k) plans. Combining a cash-balance plan with a 401(k) can get you a larger tax-deductible contribution than a 401(k) plan alone, while allowing the 401(k) plan to hold riskier investments and the cash-balance plan to hold less risky investments.

These plans are sure to become more popular as more and more chiropractic practices and their advisors begin to understand them.

How do cash-balance plans differ from 401(k) plans?

Cash-balance plans are actually a type of defined-benefit plan. In contrast, 401(k) plans are a type of defined-contribution plan.

Typical cash-balance plans differ from 401(k) plans primarily in four ways:

1. Participation. Participation in typical cash-balance plans generally does not depend on workers to contribute part of their compensation to the plan; however, participation in a 401(k) plan does depend, in whole or in part, on an employee choosing to make a contribution to the plan.

2. Investment risks. The investments of cash-balance plans are managed by the employer or an investment manager appointed by the employer. The employer bears the risks and rewards of the investments.
Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants.
In contrast, 401(k) plans often permit participants to direct their own investments within certain categories. Under 401(k) plans, participants bear the risks and rewards of investment choices.

3. Life annuities. Unlike many 401(k) plans, cash-balance plans are required to offer employees the ability to receive their benefits in the form of lifetime annuities.

4. Federal guarantee. Since they are defined-benefit plans, the benefits promised by cash-balance plans are usually insured by a federal agency — the Pension Benefit Guaranty Corporation (PBGC).
If a defined-benefit plan is terminated with insufficient funds to pay all promised benefits, the PBGC has authority to assume trusteeship of the plan and to begin to pay pension benefits up to the limits set by law.
Defined-contribution plans, including 401(k) plans, are not insured by the PBGC.

Matthew Tuttle, CFP, MBA, is president of Tuttle Wealth Management, LLC, a wealth-management firm based in Stamford, Conn. He can be reached at 203-564-1956 or by e-mail at matthew@matthewtuttle.com.

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