To understand how a cash balance plan differs from the traditional 401(k) plan, we first have to know exactly what a cash balance plan is and how it works. Here is some information provided by the Department of Labor website.
Cash Balance Plan: A defined benefit plan that defines the benefit in terms that are 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.
How Does a Cash Balance Plan Work?
A typical cash balance plan works like this:
A participant’s account is credited each year with a “pay credit” (such as 5% of compensation from his or her employer) and an “interest credit” (either a fixed rate or a variable rate that is linked to an index, such as the one-year treasury bill rate). Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance.
How They Differ From 401(k) Plans
According to the Department of Labor, Cash balance plans are defined benefit plans. In contrast, 401(k) plans are a type of defined contribution plan. There are four major differences between typical cash balance plans and 401(k) plans:
Participation: Participation in typical cash balance plans generally does not depend on the worker contributing 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.
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 of the investments. Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. By 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.
Life Annuities: Unlike 401(k) plans, cash balance plans are required to offer employees the ability to receive their benefits in the form of lifetime annuities.
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 the authority to assume trusteeship of the plan and to pay pension benefits up to the limits set by law. Defined contribution plans, including 401(k) plans, are not insured by the PBGC.
You can find out much more about Cash Balance Plans by visiting the Department of Labor website.