Disadvantages of a Cash Balance Pension Plan


In a recent post, we outlined cash balance pension Plans. Today, we're walking you through some of the disadvantages of this defined benefit plan.

  • Administration and compliance is expensive, though the cost benefits work out in favor of the sponsor.

  • An excise tax may be applicable if the minimum contribution requirement is not satisfied. However, the risk of this can be mitigated by carefully monitoring the plan and the rate of accrual of benefits.

  • An excise tax may be applicable if excess contributions are made to the plan resulting in over funding. Even this risk can be mitigated by adjusting the investment options periodically based on the investment returns.

How to set up a cash balance pension plan

Setting up a cash balance plan requires a certain amount of groundwork that needs to be put in before you can actually start contributing to the plan.


At first a calculation needs to be performed about how much you can actually contribute to a cash balance plan. They are typically based on the age of the individual and the compensation history. A final calculation needs to be performed by an actuary though. Once you have a final estimate from the contributions, you will need to ensure that you have sufficient cash flow to contribute and the actuary will need to draft the plan document for you.


For example, your actuary may calculate that you can contribute $200,000 in the cash balance plan in the first year. However, you might want a lower contribution amount and your actuary needs to be informed of that. Once you, the actuary, and your CPA agree on a contribution amount, you are all set to go ahead with the next steps.


Every cash balance plan requires a plan document which will list all assumptions of the pension plan and ensure compliance with all IRS rules and regulations. This document has to be drafted by an actuary before you can set up the investment accounts for the plan. A new TIN also needs to be registered for the pension plan as it is a distinct legal entity. The actuary will customize a plan document based on the contributions you need. Make sure your actuary provides you a plan document that is pre-approved by the IRS so you don't need to go through the hassle yourself.


After the plan document has been drafted, you are all set to open the investment account for the plan. You should reach out to your financial advisor or a broker to setup the accounts. Make sure you tell them to open a ‘qualified accountant’ so that the investment gains are not taxed at source.


You can start making contributions to the plan as and when free cash flow is available once the investment accounts are open. For the first year, the contribution will be what was decided between you and the actuary. The actuary will calculate a range for each subsequent year along with a recommended contribution amount. You are required to contribute within the range to avoid over funding or under funding the plan. The deposits can be made until you file the tax returns for your business.


All qualified plans are required to file annual returns with the IRS. Note that these returns are different from the company tax returns and your personal tax returns. Also note that the CPA or financial advisor cannot file these returns since these are required to be certified by an actuary.


The actuary will prepare a form called the Form 5500SF and certify another form called the Schedule SB. You will need to sign the form as the plan sponsor and the actuary will file it electronically. The penalties for not filing these forms run into hundreds of dollars and the pension plan could end up getting disqualified.


Most cash balance pension plans provide that benefits are "earned" once employees complete 1,000 hours during the year. For full-time employees, 1,000 hours is usually reached in June. At least 15 days prior to this date, the plan may be "frozen" by providing a notice to plan participants and amending the plan to curtail benefits. Once amended, this will stop plan benefits from increasing, thereby eliminating the "normal cost," which is typically the largest component of a plan's required contribution.


The IRS considers a plan as a permanent company program. The IRS assumes plans will carry on indefinitely or at least for a ''few years." The regulations do not define clearly what a "few years" means. But practically speaking, the IRS has historically not often questioned a termination that occurred more than 10 years after plan inception. Furthermore, employers that are terminating a cash balance pension plan that has been in existence for 5-10 years do not normally receive push back from the IRS.


Can a plan be terminated?

Yes it can. The IRS states that it is a permanent plan. However, it can be terminated for reasonable cause. This could include (1) business owners in the process of selling the business; (2) a material change in business finances that restrict the ability to fund the plan; or (3) a significant business change that negatively impacts the plan on an ongoing basis.


Freezing a defined benefit plan usually results in some immediate cost savings because future benefit accruals are stopped. However, the freeze does not fix unfunded liabilities or eliminate cost volatility. Instead, the frozen plan remains subject to the interest rate, investment and demographic risks that apply to ongoing defined benefit plans. In addition, the frozen plan is still subject to all of the same minimum funding, compliance, administrative and fiduciary requirements as an ongoing defined benefit plan.


The employer is subject to tax under Section 4980 when pension plan assets revert back to the employer upon termination of a pension plan.


For example, say you have a defined contribution plan that is made up of both employee and employer contributions. The employee is not vested in any employer contributions until after three years.


Let’s say that out of $100,000 of total assets in the employer's defined contribution plan, only $60,000 represents vested employee benefits. That means only $60,000 can be allocated to the employees (who can then take their distribution and roll their money over into an IRA to avoid penalties.


As you can see, there are both pros and cons to a cash balance plan. To talk through what's best for you and your business goals, contact the Robin S. Weingast & Associates Team.

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