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A defined benefit plan promises a benefit and the employer bears the investment risk, with contributions actuarially determined. A cash balance plan is a defined benefit plan expressed as a hypothetical account balance.
Uncommon in general employment and very much alive for one specific client: the older, high-earning business owner with few employees.
The fundamental difference
| Defined contribution | Defined benefit | |
|---|---|---|
| What is promised | A contribution | A benefit at retirement |
| Who bears investment risk | The employee | The employer |
| Contribution | Fixed or discretionary | Actuarially determined |
| Account balance | Real and individual | Notional; assets are pooled |
| Insured by the PBGC | No | Generally yes |
| Administration | Simple | Actuarial, and costly |
The row that matters is who bears investment risk. Everything else follows from it, including why employers moved away from these plans.
Cash balance plans
A defined benefit plan wearing defined contribution clothing. Each participant has a hypothetical account credited with a pay credit and an interest credit each year.
It looks like an account balance to the employee and is legally a defined benefit plan, so the employer bears the investment risk and the contribution is actuarially determined.
Because the contribution is whatever is actuarially required to fund the promised benefit - and with fewer years to retirement, that is a much larger number than the 401(k) annual additions limit permits. Deductible contributions well into six figures are possible.
The suitable client
- A business owner in their fifties or later.
- High and stable income, since contributions are largely mandatory.
- Few employees, or employees who are younger and lower paid.
- A desire for a large deduction beyond what defined contribution plans allow.
- Tolerance for actuarial administration costs.
The stability point is the constraint. A defined benefit contribution is not discretionary in the way a profit-sharing contribution is, and a bad year does not remove the obligation.
Combining plans
A cash balance plan is frequently paired with a 401(k) and profit-sharing plan, subject to combined deduction limits.
That pairing is what produces the very large deductible contributions professional practices use, and a question describing a practice owner wanting to shelter several hundred thousand dollars is describing this combination.
Traditional defined benefit formulas
Unit benefit - a percentage of pay per year of service. Flat percentage - a percentage of final average pay. Flat amount - a fixed dollar figure.
Unit benefit formulas favor long service. Final average pay formulas favor late-career earnings growth, which is why they suited a career employee and why they became expensive.
Contribution and benefit limits are indexed annually and several were changed by recent legislation. Confirm the current figure against the IRS before relying on it.
Common questions
What is a defined benefit plan?
A plan promising a specified benefit at retirement, with the employer bearing the investment risk and contributions determined actuarially rather than being a fixed percentage of pay.
What is a cash balance plan?
A defined benefit plan expressed as a hypothetical account balance, credited with a pay credit and an interest credit each year. Legally defined benefit, with the employer bearing investment risk.
Why do older business owners use them?
The contribution is whatever is actuarially required to fund the promised benefit. With fewer years to retirement that figure is far larger than defined contribution limits allow.
Who is a poor candidate?
Anyone with variable income, since contributions are largely mandatory, and businesses with many older highly paid employees, since the plan must fund benefits for them too.
Can you combine a cash balance plan with a 401(k)?
Yes, subject to combined deduction limits. That pairing is what produces the very large deductible contributions professional practices use.