How Cash Balance Pension Plans Work

Pension plans are incredibly valuable retirement assets, but they can also be incredibly confusing. Cash balance plans are a fairly popular option for many modern-day pensions. We’d like to share the basics of what cash balance plans are and how to get the most out of them.

If your employer offers a cash balance plan, it’s important to know how these plans work so you can maximize your pension payout. We’ll discuss what a cash balance pension plan is and how it compares to other pension plans you may have heard about. We’ll also discuss how to integrate a pension with your other retirement assets and benefits.

What is a Cash Balance Pension Plan?

A cash balance pension plan is a type of defined benefit plan administered by your employer. The main unique component of a cash balance plan is how crediting and reporting work. Instead of waiting to calculate your final average earnings (FAE) at retirement, your retirement benefit is credited each year.

In a cash balance plan, your employer will contribute a certain percentage of your salary to your cash balance plan each year. This “pay credit” usually starts between about 3% to 5%, but it could be more or less. Your contribution percentage is usually tied to years of service at the company, age, or both.

Cash Balance Interest Credits

Your employer also adds additional “interest credits” to the account. This can be a set flat rate or based on a particular investment index (like the 30-year treasury rate). There are many variables and updated guidance on interest crediting rates.

In short, you end up with a hypothetical cash balance used to compute your monthly pension payments in retirement. However, your account balance represents your share of the pool of money held in trust for the pension plan. It’s not an actual account with money in it, like a 401k or IRA.

A Simplified Cash Balance Plan Example

For example, let's assume you had a balance of $100,000 in your cash balance account at the beginning of the plan year. If your employer’s contribution is 5% of your salary of $100,000, they will contribute $5,000. You’d also get an interest credit, which we’ll assume is 5% of your balance, giving you $110,000 in your cash balance plan.

When you’re ready to retire, you can either receive an annuity-style pension (monthly payments) or take it in one lump sum payment. Normally, you can choose from several pension payout options like other defined benefit plans.

The Importance of Being Fully Vested

There are generally many rules around when you’re considered a full plan participant and when you’re considered fully vested. You’ll need to work at your employer for a set number of years (usually 3-5 years) to be fully vested. Each employer also has their definition of what counts as a year of service – often called a year of creditable service.

For instance, your employer may specify the number of months you worked, the number of hours per month, and the total number of hours worked to qualify. It’s also important to note whether those years of service start immediately after you begin working or only after you’re a full plan participant. In other words, check and recheck to ensure you understand what counts and what doesn’t.

Similarities and Differences to Traditional Pension Plans

A cash balance plan functions similarly to defined benefit pension plans once you retire. You’ll receive a monthly payment based on the plan rules for the rest of your life. You may also be able to select a survivorship option as well.

The real difference between a cash balance plan and other annuity-style retirement plans is how your benefit is calculated. In this regard, a cash balance plan is pretty simple. You get a benefit based on the dollar amount of the benefit credited to you.

Other plans will have final average earnings (FAE) calculated based on years of service, salary, and other factors. The cash balance plan credits an amount annually throughout your career – not just at the end. In short, a dollar figure can be calculated for either type of plan, but you’re able to see this dollar figure as you go with a cash balance plan.

Comparison to 401(k) plans.

It’s important to note that the cash balance plan is not your 401k and is completely separate. You can contribute directly to your 401k, but you cannot contribute to the cash balance plan. Only your employer can contribute to your cash balance plan.

However, you can still contribute to your 401k each year regardless of what happens with your cash balance plan. Depending on your goals, putting some money in your 401k is probably a good idea. We’re pretty sure you won’t be upset if you end up with “too much” money in retirement.

Maximizing Your Cash Balance Plan Payout

One of the main ways to maximize your pension payout is to understand your plan’s details. You’ll need to know the crediting, vesting schedule, payout options, and what counts as creditable service.

It’s also really important to start researching whether a lump sum makes sense or not. In theory, there’s no “free lunch” here, but there are some ways to maximize your specific situation.

Timing Your Retirement for Maximum Interest Credits

There are very few reasons to stay longer just for the money, but this may be one of them. If you’re close to a certain threshold or age bracket for benefits, staying just a tad longer might make sense. On the other hand, you don’t want to delay your retirement if there’s little benefit to you.

Pay close attention to the credit percentage calculations. Many plans give larger credit percentages to tenured employees versus newbies. Staying longer to meet the criteria for an additional creditable year might be worth it.

Pension Lump Sum Considerations

You might also keep an eye on the GATT rate and segmentation rates to determine a final date. We’ve written about pension lump sum options before, but your plan will have specific dates and crediting criteria. Make sure you understand what everything means.

Many plans now offer some type of benefits portal for you to run calculations on how much your pension payout would be in a lump sum. This is handy for comparing different options.

Navigating Payout Options

There are a variety of pension payout options available. Once again, this will be plan-specific, so check your plan documents carefully. You’ll need to decide between an annuity-type payment and a lump sum, among other options.

There might be survivorship options, increased payments in the first part of retirement (usually called level income options), or other options like straight life. Knowing if your pension will be adjusted for inflation is also crucial.

Planning for Inflation and Longevity

Inflation can eat into your retirement if you’re not careful. However, with careful planning, you can adjust your retirement plan to minimize the risk of inflation. Sometimes, you can make small adjustments early on to protect your retirement.

This is why we specialize in the transition phase of retirement. If you nail your transition, the rest of retirement will go much smoother.

Working with NextGen Wealth

We regularly review pension plan updates, tax law changes, and other programs affecting you. However, it’s more important to understand your own needs and retirement goals fully.

We guide our clients through our COLLAB Financial Planning Process™ to help uncover the deeper why in your life. Then, we help you craft a financial plan to support what’s most important in your life. Contact us today to see if we’re a good fit and get your free financial assessment!