Cash balance pension plans aren’t new, but their popularity has surged, especially among construction companies. Since 2018, the construction industry adoption of plans has nearly doubled. This is part of an overall trend seeing the number of cash balance pension plans across all industries grow at a whopping 17% from 2017 to 2018 (the last full year for which data is available from the Department of Labor) compared with just 2% growth in the number of 401(k) plans. Construction firms now account for 6% of all cash balance pension plans.
While the growth is striking, it should not be surprising. That’s because cash balance pension plans offer powerful retirement savings potential for business owners as well as potentially large income tax savings. Additionally, they are particularly well-suited to organizations, like construction firms, that are profitable and have a limited number of employees—especially highly compensated employees.
The Best of Both Worlds
Cash balance pension plans are employer-sponsored retirement plans that incorporate elements of defined benefit and defined contribution plans. Like in 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%—go to the business owner and not the employees. And, while 401(k)s have strict contribution limits of just $19,500 per year ($26,000 for those older than age 50), cash balance pension plans allow high income business owners and partners to accumulate significantly higher 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 also reducing current income taxes.
A Powerful Tool for a Select Few
Yet, 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. Although 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 then 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, an independent contractor who also owns (partially or in whole) a home design store. 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.
For small firms with consistently high cash flows 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. It’s advisable for business owners to seek the advice of qualified professional who can design a plan to maximize benefits, integrate with the company’s other qualified and nonqualified retirement plans, while also staying on the right side of discrimination testing.
*Source: Source: Kravitz (now part of the FuturePlan Cash Balance Center of Excellence), 2020 National Cash Balance Research Report and 2019 National Cash Balance Research Report 2018
