Cash balance pension plans can grow retirement savings

Cash balance pension plans aren’t new, but their popularity has surged, especially among health care practices. Since 2001, the demand for cash balance pension plans has experienced double-digit annual growth almost every year, and a 17-fold increase over 18 years.

In 2018 (the last full year for which data is available from the Department of Labor), the number of cash balance pension plans had grown a whopping 17% from the prior year, compared with just 2% growth in the number of 401(k) plans. And just two sectors – healthcare and social assistance providers, along with professional, scientific & technical services (which include law practices) – account for more than 60% of the cash balance market.*

While these numbers are striking, they should not be surprising. That’s because cash balance pension plans offer powerful retirement savings potential for business owners, and are particularly well-suited to companies, like medical practices, that are profitable and have a limited number of mostly highly-compensated employees.

The best of both worlds

Cash balance pension plans are employer-sponsored retirement plans that incorporate elements of both defined benefit and defined contribution plans. Similar to a traditional pension plan, employers regularly make contributions for the benefit of each employee. And like a 401(k), each employee has a separate account where pre-tax contributions grow tax deferred.

But these flexible, hybrid plans can be designed so that the lion’s share of the employer’s contributions – as much as 90% – goes to the business owner and not the employees. And while 401(k)s have contribution limits of just $19,500 per year ($26,000 for those over age 50), cash balance pension plans allow high-income business owners and partners to accumulate significantly greater sums (as much as $261,000 per year) up to a total accumulation of $2.5 million.

And since contributions to retirement plans reduce taxable income dollar-for-dollar in the year they are made, cash balance pension plans are valuable tools for business owners looking to maximize retirement savings while reducing current income taxes.

A powerful tool for a select few

Although cash balance pension plans offer compelling benefits, they are governed by a set of rules limiting their usability to just a small subset of businesses. For example, companies cannot adjust funding levels to account for earnings that fluctuate from year to year. While the government does allow plan sponsors to make one-time adjustments up or down (usually down) in the event earnings are higher or lower than anticipated, that new funding level is locked in for three years. For that reason, these plans are best suited for companies that have consistent, predictable earnings.

In addition, like all qualified retirement plans, cash balance pension plans are subject to annual non-discrimination testing that aims to ensure that plans don’t disproportionately benefit highly compensated employees. When designed correctly, a business owner can retain most of the benefit of a cash balance pension plan by excluding all but a very small number of W2 employees, while still passing those tests.

That’s difficult for businesses with more than 25 employees, as well as for owners who also have a stake in an affiliated business—for example, a doctor who owns (partially or wholly) an MRI center. For the purposes of discrimination testing, employees of both companies would need to be counted. As the cash balance pension plan would need to cover both entities, this may prove to be prohibitively expensive and thus, economically unviable.

But for small firms with consistently high cash flow and a limited number of employees – especially highly compensated employees – cash balance pension plans represent a powerful tool for maximizing tax-advantaged retirement savings. But because a cash balance pension plan alone would most likely violate discrimination rules, these plans are normally designed to be an addition to—not a replacement for—a 401(k) plan, a profit-sharing plan, or both.

Making the most of the potential of cash balance pension plans must take into account a range of variables, including employee population and demographics, and careful adherence to a number of complex rules. Therefore it’s advisable for business owners to seek the advice of a qualified professional who can design a plan to maximize benefits, integrate with the company’s other qualified and non-qualified retirement plans, and stay on the right side of discrimination testing.

*Source: Kravitz (now part of the FuturePlan Cash Balance Center of Excellence), 2020 National Cash Balance Research Report.

Scott A. Poulin is a senior wealth advisor for Calamos Wealth Management, a Naperville, IL-based registered investment advisory firm with offices in Miami and New York.

Calamos Wealth Management LLC and its representatives do not provide accounting, tax or legal advice. Each individual’s tax and financial situation is unique. You should consult your tax and/or legal advisor for advice and information concerning your particular situation. For more information about federal and state taxes, please consult the Internal Revenue Service and the appropriate state-level departments of revenue, respectively. This material is provided for informational purposes only and should not be considered tax or legal advice. You should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized advice from Calamos Wealth Management LLC.