What Is a Cash Balance Pension Plan?

When it comes to saving for retirement, there is no single path that everyone follows. In fact, there are many different types of retirement accounts that you can potentially leverage in your journey toward financial freedom.  

One option that’s offered by some employers is the cash balance pension plan. Below, we’ll define what a cash balance pension plan is and explore how it works.  

What is a cash balance pension plan? 

A cash balance pension plan can be thought of as a variation on the traditional pension plan. They are also called “cash balance plans.” 

A traditional pension plan is known as a “defined benefit plan.” The plan offers a defined monthly benefit for life based on factors like your income and how long you have worked for an employer. With such a plan, the employer bears all the risk of the investments and payments until you die. 

More recently, employers have been shifting to plans known as “defined contribution plans.” These are things like your 401(k). With a 401(k) you and possibly your employer make contributions. Then you are responsible for managing your investments and using them to create income in retirement. 

A cash balance pension plan lies somewhere in between. With a cash balance plan, instead of the guarantee of a monthly benefit in retirement, your pension builds value that’s stated in the form of an account balance. Assuming you meet the right criteria, when you retire, you can either take the balance or annuitize it to create a monthly paycheck for the rest of your life (similar to a pension). 

How does a cash balance pension plan work? 

If an employer offers a cash balance pension, the employer will begin making contributions—known as the “pay credit”—to the employee’s account. These contributions are expressed as a percentage of the employee’s wages. The exact percentage will be specified in the plan documents, but often falls somewhere between 5 percent and 8 percent of wages.  

In addition to the pay credit, the employee will earn interest on the account balance. Known as the “interest credit,” this can be either a fixed or variable rate, depending on the plan terms. Often, this interest rate is tied to the interest rate on 30-year Treasury bonds. 

The employee earns benefits for each year of employment. The final account balance will depend on a number of factors, including these: 

1. How many years the individual was employed and covered by the plan 

2. The employee’s pay during working years 

3. The pay credit contributed by the employer 

4. The interest credit guaranteed by the plan documentation 

When employees retire, they are given the option to receive the account balance as either a lump sum (which can then be rolled over into an IRA, brokerage account, savings account, etc.) or as an annuity.  

An important thing to note is that benefits held in most cash balance plans are protected by federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC), though certain limitations do apply.  

Cash balance pension plans vs. traditional pension plans 

Cash balance plans and traditional pension plans share a number of similarities. In both cases, the employer is the sole party responsible for making contributions to the account, and investment risks are primarily held by the employer—not the employee. 

The primary difference between traditional pensions and cash balance pensions lies in how the guaranteed benefit is defined. With a traditional pension plan, the employee is guaranteed a defined monthly payment in retirement. By comparison, a cash balance pension plan guarantees a total account balance—which can either be annuitized and paid out in monthly payments or paid out as a lump sum. 

Cash balance pension plans vs. 401(k)s 

Among the most important differences between a 401(k) and a cash balance pension plan is the fact that, while a cash balance plan guarantees a certain account balance when an employee retires, a 401(k) comes with no such guarantee. Because a 401(k) is invested in stocks, the account’s final value is dependent on the performance of the market.  
 
 Other important differences include: 

1. Contributions: For a cash balance pension plan, contributions are made by the employer. For a 401(k), the employee is typically responsible for making the bulk of contributions. The employer sometimes offers a company match, though they are not required to. 

2. Annuitization: Cash balance pension plans are required to allow retirees to accept their benefits in the form of lifetime payments if they desire, while 401(k)s are not required to do so (though employees may choose to use 401(k) fund to purchase an annuity). 

3. Investment risk: With a cash balance pension plan, the employer bears all investment risk. With a 401(k), the employee bears all of the risk.  

4. Federal guarantee: As mentioned above, cash balance plans are federally insured by the Pension Benefit Guaranty Corporation (PBGC); 401(k)s are not covered by the PBGC.  

Is a cash balance pension plan right for you? 

If your employer offers a cash balance pension plan, it can be a highly effective means of preparing for retirement.  
 
Of course, it isn’t your only option. Even if you are covered by a pension at your current employer, it can be wise to diversify your retirement savings into a variety of different types of accounts. Traditional and Roth IRAs, 401(k)s, 403(b)s, annuities and other accounts can all play a part in your retirement planning, and it’s important to consider the ideal mix for your unique goals. A financial advisor can help you understand all of your options and craft a financial plan that will best empower you to get where you want to be.