Virtually all retirement plans fall into one of two categories: defined contribution plans or defined benefit plans. Here’s a review of these two types of plans.
Defined contribution plan: A defined contribution plan provides each participant with an individual account. Retirement benefits depend on the amount contributed to that account, and how the contributions are invested. If investments perform well, benefits will be higher. A defined contribution plan can be a profit-sharing plan or a money purchase plan invested in stock or mutual funds. 401(k)s are a very popular example of a defined contribution plan.
Defined benefit plan: These so-called “traditional” plans promise participants a specific benefit at retirement. Plans express this as an exact dollar amount or a formula. A plan might provide a flat dollar amount per month, or a monthly amount for every year of service with the company, or a percent of a worker’s salary times years of service. Generally, a company funds the pension plan and plan assets are invested, usually by a professional money manager.
Cash balance plans, often called hybrid plans, are defined benefit plans. These plans express retirement benefits as a balance in a hypothetical account. A worker accumulates pay credits (usually a percentage of pay) and interest credits (usually a percentage of the total account balance). The interest credit is frequently based on the interest rate on a U. S. Treasury security. The pay and interest credits, specified in the plan, resemble the actual contributions and earnings a worker accumulates under a 401(k) plan.
Cash balance plans contain many of the important advantages of traditional defined benefit plans:
- Benefits do not depend on how much a worker is willing or able to contribute.
- The employer bears the investment risk.
- Plans must offer an annuity with a survivor benefit.
- Benefits are insured by the Pension Benefit Guaranty Corporation (PBGC)
- They offer a predictable benefit at retirement.
Cash balance plans also have advantages of defined contribution plans:
- They are easier to understand.
- They often provide higher benefits for younger workers and shorter-service workers.
- They offer benefits that are more portable than a defined benefit plan.
For more information on selecting and administering a retirement plan, please contact us.