What it means
The account is what the profession calls hypothetical: no individual pot of shares or bonds sits behind it. The employer runs one pooled investment fund, and each employee simply sees a balance built from two credits, a pay credit and an interest credit.
The pay credit is a set percentage of salary, often between 3% and 8%, sometimes rising with age or service. The interest credit is a guaranteed return, either a fixed rate such as 4% or a rate tied to a published benchmark like long dated government bond yields.
The reason this matters to a business is risk. If the pooled fund earns less than the promised interest credit, the company must make up the shortfall from its own money, which is why the plan appears as a liability on the balance sheet rather than as a simple expense.
These plans are popular with professional firms and owner managed businesses because contribution limits are far higher than in a typical defined contribution scheme, and contributions are usually tax deductible. That makes them a genuine tool for older, highly paid owners who need to build retirement savings quickly.
The main nuance is what happens on conversion from a traditional final salary pension. Older employees can find their new opening balance is worth less than the benefit they had already earned, so their pension stops growing for several years, an effect known as wear away that has caused significant disputes and requires careful plan design.
In practice
Real-world examples.
Example
A twelve partner law firm adds a cash balance plan alongside its existing retirement scheme so that partners in their fifties can put away far more than the defined contribution limits allow. The staff receive a 5% pay credit, which is the price of keeping the plan compliant with non-discrimination rules.
Example
An engineer leaves after seven years with a stated balance of $84,000 and elects a lump sum rather than an annuity. Because the balance is a defined benefit promise, the amount she receives is set by the plan formula rather than by whatever the investment fund actually earned.
Example
A manufacturer converts its final salary pension to a cash balance design to cap future liability growth. It gives long serving employees a choice between the old formula and the new one for a transition period, specifically to avoid the wear away problem.
Formula
Calculation
Closing balance = (Opening balance x (1 + Interest credit rate)) + Annual pay credit
Take an employee earning $120,000 with a pay credit of 6% of salary and a guaranteed interest credit of 4%. The annual pay credit is $120,000 x 6% = $7,200, and pay credits are added at the end of each year.
Year 1: opening balance $0, no interest, pay credit $7,200. Closing balance = $7,200.
Year 2: interest = $7,200 x 4% = $288. Closing balance = $7,200 + $288 + $7,200 = $14,688.
Year 3: interest = $14,688 x 4% = $587.52. Closing balance = $14,688 + $587.52 + $7,200 = $22,475.52.
After three years the employee has been credited $7,200 x 3 = $21,600 of pay credits plus $288 + $587.52 = $875.52 of guaranteed interest. If the pooled fund had returned only 1% over that period, the employer would have had to fund the difference, because the 4% credit is a promise rather than a projection.Case study
Seen in the real world.
The following is an illustrative and entirely fictional example. Pemberton Orthodontics, an invented three partner dental practice, had strong profits but the partners were in their late fifties with modest retirement savings. Their existing scheme capped annual contributions well below what they needed to accumulate in the ten years they had left.
Their adviser designed a cash balance plan in this fictional scenario allowing each partner a $150,000 annual pay credit, a total of 3 x $150,000 = $450,000. To satisfy coverage requirements, the eleven support staff received a 5% pay credit on a combined payroll of $600,000, costing $600,000 x 5% = $30,000.
Total annual deductible contributions came to $450,000 + $30,000 = $480,000, worth $480,000 x 37% = $177,600 in tax relief at the partners' marginal rate. The trade-off, which the practice accepted in writing, was that the plan carried a guaranteed 4% interest credit, so a poor investment year would oblige the partners to top up the fund from practice cash rather than simply accept a lower return.
Watch out
Common mistakes.
- Treating the stated balance as a real investment account, when it is a bookkeeping figure backed by a pooled fund and a legal promise from the employer.
- Assuming a good investment year means larger employee balances, when in fact the surplus benefits the employer because the credited rate is fixed.
- Setting up a plan for owners without budgeting the mandatory pay credits for staff needed to pass non-discrimination testing.
Questions
People also ask.
Is a cash balance plan a defined benefit or a defined contribution plan?
Legally it is a defined benefit plan, which is why the employer bears the investment risk and the liability appears on the balance sheet.
What happens if the fund underperforms the interest credit?
The employer must contribute the shortfall, so a run of weak markets converts what looked like a fixed cost into an unplanned cash call.
Can an employee take the balance when they leave?
Once vested, yes, usually as a lump sum that can be rolled into another retirement account or converted into an annuity under the plan rules.
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