When it comes to planning for retirement, employees and employers have several options to choose from. Whatever choice they make, they must be well aware of the pros and cons.
This article will discuss the difference between cash balance plans and traditional plans. Keep reading if you are an employer or an employee.
Two popular types of retirement plans are cash balance plans and traditional plans, such as defined benefit pension plans and defined contribution plans. Each plan has its own benefits and drawbacks, and it’s crucial to understand the distinctions between them to make an informed decision.
Calculation of Benefits
One of the key differences between cash balance plans and traditional plans is how benefits are calculated. In a traditionally defined benefit pension plan, retirement benefits are computed based on a formula that considers the employee’s years of service and final average pay. The benefits are then paid out as a fixed payment for the rest of the employee’s life.
In contrast, a cash balance plan computes retirement benefits according to the account balance that matures over time. The employer contributes a specific amount of money each year to the employee’s account, along with a guaranteed interest rate. The account balance then grows based on these contributions and the interest earned on them.
How Benefits Are Paid
Another distinction between cash balance plans and traditional plans is how benefits are paid out. In a traditional pension plan, benefits are typically paid out in the form of a monthly payment for the rest of the employee’s life.
In a cash balance plan, on the other hand, the employee has the option to receive the account balance as a chunk sum payment or as a pension payment that provides a fixed payment stream over the employee’s lifetime.
One advantage of cash balance plans over traditional plans is that they provide employees with more transparency and control over their retirement savings. Employees can see the growth of their account balance over time and have a better understanding of how their retirement benefits are being calculated. This can provide employees with more peace of mind, knowing that their retirement benefits are not at risk of being impacted by market volatility.
Traditional plans, on the other hand, may offer more predictable retirement benefits for employees. Because the benefits are calculated based on a formula, employees have a better idea of what their retirement benefits will be when they retire. Additionally, traditional pension plans provide a fixed payment stream over the employee’s lifetime, providing them with a stable source of income in retirement.
However, traditional plans also have some potential drawbacks. They may be less flexible than cash balance plans, as employees may not have the option to receive their benefits as a lump sum payment or as an annuity. Traditional plans may also be subject to market volatility, as the benefits are often tied to the performance of the plan’s investments.
Another benefit of cash balance plans is that they offer higher contribution limits than other retirement savings plans. A cash balance plan can provide a tax-efficient way to save for retirement for highly compensated employees who may be subject to contribution limits in other plans. Additionally, the contributions to a cash balance plan are tax-deductible for employers, making it an attractive option for businesses looking to provide retirement benefits for their employees.
Another advantage of traditional plans is that they are typically less expensive for employers to set up and maintain than cash balance plans. They also require fewer ongoing administrative costs to ensure compliance with federal regulations.
In conclusion, both cash balance plans and traditional plans have their own set of advantages and disadvantages. Cash balance plans offer more transparency and control over retirement savings, as well as higher contribution limits and more flexibility in how benefits are paid out.
Traditional plans may offer more predictable retirement benefits and may be less expensive for employers to set up and maintain. Ultimately, the choice between these plans will be anchored on the specific needs and goals of the employer and employees. It’s crucial to carefully consider the costs and potential drawbacks of each plan before making a decision.